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Managed futures secret weapon: Interest earning Treasury Bills

August 11, 2008

 

A Wall Street Journal article last week trumpeting the fine returns of Harvard’s endowment fund, which at $35 Billion has been among the best performing institutional investors over the past several years, pointed out an interesting tidbit - that part of Harvard’s success over the past year was due to “plain vanilla [US] Treasury debt”.

The article also mentioned how Harvard remains one of the most aggressive institutional investors in terms of exposure to alternative investments including a hopping 17% in commodities, as well has hedge fund exposure.

While commodities and Treasury debt may sound like the big leagues and only accessible to billion dollar institutional investors such as Harvard, they are in fact two of the cornerstones of the much more accessible managed futures industry.

We can easily see how commodities fit into the managed futures industry; with the professional Commodity Trading Advisors (CTAs) who make up the industry managing client’s money through investments in commodity futures. Many people seek out a managed futures for just that – commodity exposure on both the long and short side.

But managed futures secret weapon, so to speak; is its ability to harness the power of US Treasury debt at the same time it is putting trades on with commodity futures. In short, the secret weapon is the ability to earn both interest and trading returns on the same money.

Most asset classes simply can’t offer this. You can’t buy a house for $500,000 and earn interest on that $500K for example; nor can you purchase $100,000 worth of stock, and at the same time earn interest on that $100K. But in managed futures, you can invest $250,000 in a CTA, and at the same time earn interest on the majority of that $250K.

I would venture to guess that many of you have been told that futures accounts don't pay interest, and have your money sitting there only increasing due to trading gains, with no interest gained at all. It is true that futures accounts generally don't pay interest - but it is one of those half truths my mother used to warn me about. The real truth is that while the account itself can't pay interest - you can purchase US Treasury debt instruments such as T-Bills in the account, and those sure do earn interest.

For all those within ear shot - let me repeat that. You can purchase a T-Bill in your futures account and earn interest on your trading capital. You're either with a broker who has been honest and told you this, or you're not and it may be time for a change (call Attain at 800.311.1145).

Why is this not advertised and more widely talked about in the futures industry? Just follow the money. The clearing firms earn the interest on your money when you don't, then share a portion of that interest back to the broker. It is a large portion of a clearing firm's revenues, and a nice paycheck for the brokers as well. Nobody wants to spoil the golden goose, and Attain is likely to get booed and hissed by the brokerage community for writing it up in a newsletter.

But we have long recommended investors purchase T-Bills to gain a little extra every year, and will continue to do so - as we believe you should make the interest on your money - not us.

How do Treasury Bills work?

Well, first of all - Treasury bills, or T-bills, are short term government debt obligations (meaning bonds). The government issues them every week to cover short term shortages in their cash flow, following the scary logic of you can always pay it back later. Investors lend the government the money for 1 to 6 months, and the government pays the investors back what they lent them, plus interest when the time is up.

The bills are sold at a discount from their face value, meaning you might pay $49,000 for a 180 day, $50,000 T-Bill on January 1st. In 180 days, or roughly six months later on July 1st - the bill matures and you would be paid the full $50,000. The $1,000 difference between the purchase price and face value is the interest you earned.

Some of you might be saying – “So what? I can buy T-Bills in my normal investment account”. Why tie up money buying them in my managed futures account. The answer is the “secret weapon” we spoke of earlier and the good part for futures traders: the T-Bill can be used as margin.

So you don't need to have $100,000 to cover the margin for your investment in a CTA or trading system; and another $100,000 to put into T-Bills. You can use the same $100,000 to both buy T-Bills and cover margin for your investment in a futures program.

That’s right, the T-Bill does double duty – with the clearing firm posting the T-Bill to the exchange on your behalf to cover margin and you earning the interest on it while it sits with the exchange. The clearing firms do build in a little buffer for themselves as a risk precaution, and only allow around 90% of the T-Bill's face value to be used as margin, but that's plenty enough for most investors purposes.

Attain recommends holding 80% of your total account value in T-Bills. This allows for the account to go through its normal fluctuations without having to "bust" the T-Bill to cover margin requirements or because there is not enough cash in the account. "Busting" a T-Bill is little more than selling it back before it matures, which costs a little extra in fees - but you do get back any accrued interest up to that point. (in rare cases, the price you sell it back for could be slightly less than you purchased it for)

As an example, if you have a $100K account, and buy an $80K T-Bill at the discount price of $78,000, you would have roughly $22,000 in cash left in the account. If the CTA or trading system you're invested in had a drawdown of -$25,000, for example; that would leave your cash balance below zero, and the T-Bill would have to be busted to bring the cash balance back into positive territory.

One downside to holding T-Bills in your futures account is that the clearing firms have made it nearly impossible for you to read your statements accurately when you hold a T-Bill. Depending on the clearing firm, they either list the Bill's face value or 90% of the face value, even though the actual value is the purchase price, plus any accrued interest to that date - and they don't include any of the T-Bill's value in your liquidating value or cash balance. For first time buyers of T-Bills looking at their statements the next day, it’s as if they lost $50,000 in the day following the purchase of the T-Bill - as the totals they are used to looking at don't reflect it.

And one other important note for those investors having their accounts professionally managed. You don't want to purchase a T-Bill in the account the advisor in managing. The interest earned will increase the value of that account, and you don't need to be paying the advisor 20% of the profits due to interest, just pay him or her on the profits due to their trading.

Attain solves this by holding an investors total cash balance in a master account, then purchasing T-Bills in that account and allocating out to CTAs through related sub accounts.

And finally, if you have a broker telling you that you can only purchase a T-Bill on the margin excess in your account (which is sometimes just 30% to 70% of the account), don’t believe it. Again, 90% of the T-Bill can be used for margin, so the truth is you can purchase bills above the amount of margin excess you hold.

So why not earn an extra couple basis points on your account balance. They don't require huge accounts to do so - anything above $30,000 or so is a good starting place. T-bills can be used as margin, they can be busted in a day's notice and turned liquid, and they are considered to be the most secure and safe investment in the world. In short - start using your money to make money - start holding T-Bills in your futures account.

The charts below show the hypothetical growth of $100,000 invested in T-Bills over the past 15 years (no risk sure looks nice when charted, doesn’t it), and the comparison of the compounded growth of $250,000 invested in the Clarke Global Basic program on its own, and again with 80% of the balance rolled into 180 day T-Bills every 6 months. You can see that the T-Bill account earns nearly $200,000 more over the past 10 years !

-Walter Gallwas

PS - The ability to post US Treasury Debt instruments such as T-Bills also opens up the ability to do Capital Protection plans in a managed futures account; where the discount amount of a zero coupon amount is only put at risk, insuring that even if that amount is lost, the account’s principal will be intact when the bond matures. You can read more about this technique in a past Attain newsletter here: http://www.attaincapital.com/newsletters/238

PPS - If you're asking what if I hold my account in Euros, Pounds, Yen, or others, unfortunately T-Bills must be purchased in US dollars, but for large investors with balances of $1 Million or more - Attain has secured clearing arrangements in which Euro Bunds or Bobls can be held in the account in the same manner as US T-Bills.