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How Safe is your Futures Investment?

October 18, 2004

 

While the past few years as been a boom to alternative investments such as those Attain offers in trading systems and managed futures funds, the often tarnished image of the futures industry still keeps many investors from moving ahead with a futures based investment.

The first thing that comes to mind when many here the word "futures" is a slick salesman trying to convince a little old lady to buy Pork Belly futures. The reality is that the slick salesmen of old are nearly extinct, and in their place are sophisticated brokers who analyze risk and return more so than most of their stock broker counterparts.

But with memories of retirement accounts wiped out to due bankruptcies at the likes of Enron, and the spate of scandals at prominent mutual funds and now insurance companies in the news, investors are as wary as ever of losing money due to fraudulent activity or bankruptcies.

How Safe is my Futures Investment?

This worry was prevalent in the mind of an investor who recently opened an account with Attain. In particular, this investor wanted to know how safe a futures investment is? And whether it is any more dangerous, or safer, than a typical mutual fund investment?

Let me first say that an investment in a futures account (outside of the choices you make within the account) is no riskier (and no safer) than any other investment account. I would actually argue that a futures account may be a bit safer, given that the clearing firms, Brokerage firms, and brokers are more highly regulated than their stock and mutual fund counterparts - because of the stigma of futures investments as being overly risky.

The chance of a firm going out of business or closing its doors is always present, however. In comparison, the chance of a big mutual fund such as Fidelity doing so is probably much less because they have many, many times the assets - but you've heard the quote "the bigger they are, the harder they fall".

To combat the apparent problems and dangers to your account should your brokerage firm (stock, mutual fund, or futures) go out of business, investment accounts are held in the individual investor's name. This small distinction may seem obvious, but it is of the greatest importance - as it means it is not an asset of the firm you are dealing with (the clearing firm or stock broker's prime broker), rather an asset of yours.

So that if a firm does go bankrupt, or blow up in a 9/11 type event, etc. — there is no claim on your money. If Refco goes bankrupt, they can not pay their debts with your money. They have no access to your money except to post it as margin on the exchange when you place a trade.

Where things get sticky, and where 99% of the fraud is in the banking, brokerage, and financial industry is when your money is not in a segregated account. When you write a check to John's commodity fund, for example - the money is then under control of the manager - not you, and it is not in a segregated account. This small point is the most important point in understanding how all this works.

Beyond the segregated accounts, a more powerful motive for protecting client assets is the responsibility of all involved to keep the system running. If a clearing member blew a couple hundred million dollars betting on short S&P options - and was forced to sell its seat, liquidate all assets, etc - and threaten in any way individual client assets, either the US government or the other clearing members would step in.

This is because the system requires two parties to be successful. If party A has $100 MM in profits on its books due to taking the other side of trades Party B initiated — and Party B couldn't cover 100% of that loss - then Party A would in fact have lost $100 MM, in turn making them default on other monies it owed, in turn causing other defaults, etc.

This was the threat posed by the failing hedge fund Long Term Capital Management in 1999. The Fed invited the major banks to meet, and they came up with a multi-billion bail out package so that the whole system would not fall apart.

Is my money FDIC insured?

No investment assets, be it stocks, bonds, mutual funds or futures accounts are FDIC insured. FDIC insurance applies to money deposited in a bank only. And it is only available for the first $100,000. Many banks run mutual funds, and slyly put that the bank deposits are FDIC insured, knowing full well that the mutual fund deposits are not. It can be confusing. The following link sheds more light on FDIC insurance?

http://www.fdic.gov/consumers/consumer/information/fdiciorn.html

Transparency & Liquidity:

Two more important aspects adding to the integrity of futures investments are their transparency and liquidity. The question of "How is my investment doing" is called transparency - the ability to see you positions and profit or loss on a daily basis; and the ability to get your money out quickly is liquidity. The quicker you can convert your account to cash, the more liquid the investment.

Unlike other alternative investments in instruments such as private equity deals or hedge funds, where positions are not known and performance is reported monthly or quarterly - a futures based investment in an individually managed account has complete position level transparency. That means you see everything, right down to each trade, each day.

And unlike a real estate deal or venture capital fund where your equity may be tied up for years, a futures based investment can be liquid often within one day. While those who use a longer term horizon often see better performance, it is nice to know your investment capital can be back in your hands within a day.

The following link to the National Futures Association lays out some more information on the safety and protection afforded futures based investment accounts:

http://www.nfa.futures.org/investor/Storybehind.asp

Forex:

We would be remiss in talking about the safety of investments without mentioning the risks inherent in the ever more popular FOREX market, which every broker and his brother is screaming for you to try out. FOREX is an off-exchange foreign currency market, meaning your trades are not guaranteed by a clearing corporation as they are on futures trades.

This means you are not only betting on which way the Forex market will go, but also betting on the credit worthiness of the Forex dealer you are using. The Forex market is rigged against the individual investor, and Attain recommends steering well clear of it with anything less than a $1 Million account. For more information on Forex, visit the NFA link below:

http://www.nfa.futures.org/compliance/forexInvestorAlert.asp