On Monday I wrote about managed futures, a strategy that can add a layer of diversification to a traditional portfolio of stocks and bonds. Tim Pickering, president of Auspice Capital Advisors, manages both the Horizons Auspice Managed Futures Index ETF (HMF) and the iShares Broad Commodity Index Fund (CBR). I recently had a chance to interview Tim about these ETFs and the strategies they use. Here’s part one of our discussion. I’ll run part two on Friday.
I’ll start by asking you to simply explain what managed futures are.
TP: The general thesis of managed futures is trend following. We’re looking to capture trends by going long and short in the underlying futures. We are “direction agnostic,” which means it’s our job to capture the trend whether the market is going up or down. One of the most important points is that we are making these decisions based on quantitative measures, without regard for market fundamentals. That’s a key piece of the puzzle, because in order to be agnostic about the markets and to generate non-correlated returns, we need to be fundamentally non-biased.
We are not attempting to find perfect pivot points, to get in at the bottom and out at the top. Getting in at the start of a trend—that’s extremely challenging. Ultimately we are more worried about participating in trends rather than finding the perfect scenario. Instead of worrying about having extremely high-probability trades, we’re the other way. We are probably right 40% of the time, and wrong 60% of the time, but the concept is that the average winning trade pays three units of capital, and the average loss is one unit.
But isn’t this just a big zero-sum game, where the only way you can win is at someone else’s expense? After all, if you’re short a particular commodity, someone else has to be long by an equal amount.
TP: That’s right, in the end it’s a zero-sum game. But CTAs [Commodity Trading Advisors] are very small part of that game. People get confused by this, and it’s a complete fallacy. They think that if one CTA is winning, another one has to be losing. But people use the futures market for many, many reasons. Most people use the futures market to lose money—as a risk management tool. That’s the inherent concept behind futures.
Look at something like the grain market: you’ve got farmers producing grain, so they use futures to hedge the grain. You’ve got large companies like Cargill and Dreyfus participating in hedging using futures. They are losing, and in general, that’s a key part of the underlying way the markets are built. You’ve got hedgers and you’ve got speculators. About 80% of the liquidity comes from speculators in almost every market. So all we’re doing is participating in a very liquid exposure.
Another reason futures are a perfect tool for that exposure is cash efficiency: you only have to put up a small amount to get a much larger gross notional dollar value. In fact, on average only about 6% of our money goes on margin, and 90% to 95% is in cash. So this is a very cash-efficient strategy based on the underlying leverage of futures contracts.
Let’s talk about what exactly that leverage means in this sense. Looking at the portfolio of the Horizons ETF, it says there is almost 150% exposure. When I see 150% exposure, I think that if the index falls 10%, I’m going to lose 15%.
TP: No, that’s completely wrong. That 150% exposure refers to the gross notional dollar value of the futures contracts. That tells you nothing in terms of risk. This is one of the big misunderstandings about managed futures, and it’s very confusing to people. It’s probably steering people away from what we do.
I’ll give you an example. I may be long five-year notes, and they may have a gross notional dollar value of $10 million. And I may also be long natural gas, with a value of $500,000. So those are totally different in terms of dollar values, but the risks are the same. The reason is that natural gas has far more volatility than five-year notes: natural gas can go up 20% in one day, and five-year notes can’t.
When I look to put on positions with all of these 21 disparate asset classes—ags [agricultural commodities], metals, currencies, interest rates—what we’re doing is normalizing the risk across these different things. I’m looking at the volatility of natural gas and I’m adjusting my position size so that I’ve got the same dollar risk as I do with five-year notes. To do that, the number of contracts is going to be different, and the gross notional dollar value is going to be totally whacked out. But there is going to be equal risk—or at least similar risk—in each of these asset classes.
Here’s the reality: we run a volatility of about 13% or 14%, which is 40% less than the stock market. Over the last five years, our worst pullback has been –11.4%, not –50% like the stock market. So we take way less risk, have way less volatility, and use way less money to generate the returns.
Let me know if I understand correctly. The 150% leverage refers to the amount that the fund is committed to in contracts. In the unlikely event that every contract went perfectly wrong, the fund value would drop to zero AND Horizons would be on the hook for another 50% of the original fund value. This is why you have to hold so much cash, even though it just sits there.
In addition to Kiyo’s question, I would also be curious about knowing in more detail the explanation as to why it is expected that the strategy of managed futures will be non-correlated to the market.
Just to see if I got it right, their model thinks crude oil will go down, they short crude. Some companies can not bear the cost of increasing crude oil prices so they hedge. Four scenarios can happen here: crude oil up/down and market up/down.
If crude oil does go down and say the market goes down as well then they make money because they shorted crude oil and as a bonus they are non-correlated to the market return. This is the best scenario for this strategy.
At the other end of the scenario spectrum, crude oil goes up and the market goes down. Here the strategy would have lost money and would be correlated with the market.
Ok… Probably good to know this stuff… but I don’t think I am likely to add it to my coach potato portfolio anytime soon as it strikes me I have to keep a bit more than an occasional eye on my these types of scenarios???!!!
I’m looking into getting a detailed to answer to Kiyo’s question. Stay tuned.
@Philippe: It’s not that commodity futures deliver returns that are uncorrelated with the commodity markets. The idea is that a basket of managed futures (including commodities, interest rates and currencies) will tend to have low correlation with stocks and bonds.
A long-only commodity fund will also tend to have low correlation with stocks and bonds, but it is prone to fall in a global crisis like 2008. That’s when managed futures (in theory anyway) can help.
@Illogica: This is definitely not something for the index investor who wants to keep things simple, but I think it’s worth learning about how these strategies work, even if you decide not to use them.
This is an active management strategy, so one’s success depends on the success of the management. There may be managers who can outperform, but I suspect that such managers would not be available to retail investors. If a manager was successful, hedge funds, with their 2/20 model, would probably be more renumerative.
I would be interested in knowing the hurdle of costs and taxes that the manager has to overcome. Don’t futures contracts last months? If true, this is a high turnover strategy, so tax efficiency will not be a strength.
@Park: Do these index ETFs use active management? I’m not sure: this is a grey area, in my opinion. It’s interesting that no one ever calls dividend ETFs “active strategies,” even though they apply a rules-based screen to select individual stocks.
All indexes have embedded rules, including those that track the S&P 500 or other popular benchmarks. There is really a continuum with purely passive on one end and purely active on another. I would put total-market index funds at the far left of that continuum, as they are as “purely” passive as you can get. Most others fall somewhere left of centre, but not not all of them.
The tax-efficiency is a good question. According to Horizons: “As for the tax treatment of these ETFs – it’s all return of capital because it uses the 39(4) forward structure, so that all returns are actually re-characterized as return on capital. The only tax implication results from selling the ETF at a gain or a loss.”
The term “39(4)” refers to a subsection of the Tax Act. There is a long section about the tax treatment of these ETFs in the prospectus.
I agree that it’s difficult to say that a fund is active or passive in all cases.
These funds are managed according to transparent, disclosed rules and not by manager discretion. I think that makes it more of a passive approach, despite the fact the fund’s turnover is quite a bit higher than traditional equity index funds.
And the main downside of active management is underperformance due to human cognitive biases on the part of the managers, and high fees. Neither of these really apply to these funds, though the MERs are on the high side for an ETF.
@Kiyo: Here’s Auspice’s response to your question: “You can in theory lose 150% if all prices go to zero but in practice there is almost no chance of this. The fund would be liquidated long before they ate through the margin. This is the whole ‘what is notional exposure’ question posed in a slightly different fashion.”
Whatever your opinion on managed futures ETFs, I don’t they can be criticized for being unduly risky. They are likely to be less risky than a plain vanilla commodity fund.
At what portfolio size might it make sense to start to use a MF ETF like this?
I’m not sure you need much of a portfolio to be able to include a managed futures ETF. The literature from the fund providers suggest treating MF as an asset class in addition to stocks and bonds, so instead of 60/40 stocks and bond, something like 40/30/30 stocks/bonds/managed futures, in which case you could be going from two ETFs to three. So, $10,000 is not too small (in my opinion).
Good Q&A. I never heard of managed futures…well, now I know.
Like another commenter above I don’t think these guys are going in my portfolio. I’m happy with my vanilla ETFs like XIU, XBB, VWO and VTI.
Looking forward to reading future parts of the series Dan.
I hope everything is well.
Cheers,
Mark
Thanks for the comment Andrew F. I was wondering how much it would take to make a difference in terms of volatility. This would also be relative to the portfolio size from the perspective of size so that rebalancing is efficient.
I guess its also a general question. When portfolios get large is owning the basics XBB, XRB, XIC, ZRE, VXUS,VTI enough? Or do the larger portfolios portfolios contain more variety, small cap, value tilt, managed futures etc…