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Even in bad times,
you can't forget the future.
Fund your IRA.
- Lawrence Szczech | |
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Today's Featured Article
Investors should think about retirement planning year-round, but during tax season, the IRA account tends to be on everyone's mind. Looking at the recent performance of the stock markets, however, might make you hesitate to invest your annual contribution. Add in the near and long-term projections for the global economy, and a prudent person would review the retirement plan they had been following in hopes of achieving their retirement goals.
It is impossible to predict what asset classes will perform best over the remainder of your working years, but it is possible to re-examine your plan (provided that you had one in the first place): your goals, your saving habits, the risks and potential returns of the various investments you've made; and the interplay of those investments.
The mix of investments you consider for your retirement account could include futures contracts -- an asset class not considered by many. Futures can't save your retirement plan. However their inclusion can affect the probability of a retirement plan successfully achieving its goals.
The following are areas to consider as you re-plan your retirement plan.
Diversification and protection
Over time, diversification has become something of a mantra for advisors seeking to effectively manage their clients' risk: investing in regional mutual funds or large-cap stocks of a particular nation to achieve market diversification, or buying large-cap vs. small-cap stocks, or value vs. growth stocks, or the tech sector vs. healthcare.
And then 2008 happens.
If you cannot view Chart 1,
go here.
Source: Bloomberg
The Russell 3000 is owned by Russell Investment Group
The S&P 500 Index is owned by Standard & Poors
The FTSE 100 is owned by the FTSE Group
The Nikkei 225 is owned by Nihon Keizai Shimbun
The problem arises when the diverse assets you've invested in don't have a high non-correlation factor. That is the rating of how similar in price movement two assets behave. An all-stock portfolio -- regardless of the sizes, styles, sectors and regions -- is still an all-stock portfolio. | |
The CME Group, the world's largest exchange and a strong proponent of futures trading, has studied portfolio mixes and produced the following results.
If you cannot view Chart 2, go here.
Mixing in non-correlated assets such as managed futures can make a difference. In fact, they have zero correlation with the S&P 500 index, only 0.05 correlation with U.S. bonds and 0.16 with world bonds. Managed futures, discussed below, provide an uncomplicated way to use futures as a diversification tool for your retirement portfolio.
Another direct way to protect your retirement portfolio using futures is hedging. Hedging was actually the original purpose of futures; using futures contracts to protect against the price movements of specific commodities. Futures markets have evolved to include financial indices so one could now hedge a broad stock market position.
Futures by their very nature allow an investor to protect against price movement in either direction because buying and selling a futures contract, i.e. being long or short, takes the same actions. (Note: there is no "borrowing" to short in futures as there is in the equity markets.)
An investor who is near retirement and has a substantial equity holding in their retirement account may believe there is still some potential upside in this investment, and may not want to liquidate the position and keep cash in the account, in what would currently be a low-interest-bearing position. However, if the investor also believes that there is risk of additional significant selloff in the near term, he or she could sell a futures contract on the S&P 500, locking in the market price. This protects the investor if the market goes against the equity position, as the futures contract would conversely increase in value.
Types of investments
There are over 1,000 actively traded futures contracts that can be used to protect or to diversify a retirement account. The following table is just a sampling:
And while there are more products within each category listed above, there are also more categories ranging from actively traded interest rate contracts on the US, EU and Asian markets to much more esoteric products such as weather. | |
IRAs and 401Ks
Individual Retirement Accounts remain one of the few actions a taxpayer can take post the tax year to reduce their tax bill. This does not mean that waiting until April 15th each year is the best plan regarding the funding of your IRA. Your annual contribution can start earning tax-deferred returns the first of that tax year if you have funds available.
If the 401K plan administrator of your prior employer only allowed a limited selection of mutual funds, and you have changed jobs, you can roll your prior 401K assets into your current 401K or into an IRA of your choosing. This can be a non-taxable event.
Your annual contribution limits to an IRA or 401K are not determined by the asset you are investing in. For example, if you contribute the maximum allowed in a traditional IRA (in 2008, that's $5,000; unless you turned 50 or older in the tax year in which case it is $6,000) in a given tax year, that total amount could be allocated to a single asset or to a variety of investment vehicles; the same holds true for SEP IRAs, ROTH IRAs, etc.
Many financial firms offering retirement accounts do not provide access to alternative investments such as futures contracts so discuss this prior to opening an account.
Account Management
As with a taxable account, an IRA account investing in futures can be handled in more than one way. All IRA accounts require a custodian who oversees contributions and distributions. It is not uncommon for the custodian to be a separate firm from the brokerage firm where the actual investing or trading takes place.
Another approach to consider -- with a twenty-year history among individual investors -- is Managed Futures. Assets under management have recently climbed from US$170 billion in 2006 to over US$206 billion in 2008.
If you cannot view Chart 3,
go here.
In Managed Futures, professional money managers, or Commodity Trading Advisors, direct investments across the spectrum of futures markets. They do this through the use of futures contracts and also options on futures.
Once an investor has decided to commit capital, he or she fills out a power of attorney with the CTA and then opens a separate account. A complete listing of all account activity and day-to-day account balances can be tracked online. Investors can also receive emails of all purchases and sales, daily performance reports and a month-end summary.
Leverage in a retirement account
Leverage has specific implications for a retirement account with fixed contribution limits each year. Given the small percentage of asset value required (i.e. initial margin) to hold a position in your account, a moderate price move can lead to a margin call. A client in a margin call has alternatives as to how they meet the call. The client can reduce their position, hedge the current position, or deposit additional funds into the account.
If you used your maximum annual IRA contribution to open the account and establish the position, you would not be allowed to deposit additional funds for that tax year to cover the margin call. You could however, if available, use current year IRA contributions, or roll funds from other established IRAs. A simpler way to avoid any margin call is to allow room for near term drawdowns (i.e. the market moving against your position) by not taking advantage of leverage to the extent allowed by your futures brokerage firm or the futures exchanges.
If you cannot view Chart 4,
go here.
Because of the need to protect a retirement account from a margin call, some futures brokerage firms will require an initial deposit far in excess of the Exchange mandated minimums for contracts trading in non-tax-deferred accounts. This protects both the individual account holder and the firm executing the account holder's orders in the market place.
In this way an investor can still take advantage of the leverage available in the market, albeit to a lesser extent, but reduce the risk of margin calls due to price volatility during the time period the position is held in the account.
Summary
Keep in mind that when the investing environment changes, your retirement plan might also need to change. To assume otherwise could add unnecessary risk. It's important to continuously monitor your portfolio and manage accordingly -- not just at tax time.
If you're unable, or uncomfortable with undertaking such a review on your own, consult with a registered advisor.
Disclaimer: The risk of loss in trading commodity futures and options can be substantial. Before trading, you should carefully consider your financial position to determine if futures trading is appropriate. When trading futures and/or options, it is possible to lose more than the full value of your account. All funds committed should be risk capital. Past performance is not necessarily indicative of future results. | |
About the Author
With over 20 years in financial services, Mr. Szczech has worked with both institutional and retail clients in diverse roles such as managing director at the NYSE and as president of the Client Group at TD Ameritrade. He is currently the CEO of RJO Futures, the private client division of R.J. O'Brien & Associates LLC, in Chicago. | |
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