A Well Timed Managed Futures ETF Launches

New ETF aims for a safer alternative when it comes to managed futures.

So-called alternative strategies hold more appeal when the outlook for performance in conventional asset classes looks rocky. With volatility returning to equities, a nagging fear of rising rates hanging over bonds and a cruel summer for commodities, that time may be now.

A recent ETF launch got me thinking about one alternative strategy in particular: managed futures. Managed-futures funds make directional bets about the price movements of commodities, currency and fixed income.

They use futures simply because the derivatives offer liquid access to the underlying assets with daily pricing. Because the funds can take long or short positions, they can profit from a price trend that’s either up or down. For the same reason, and due to their broad asset class exposure, they can provide diversification in a portfolio, especially due to low correlation to equity.

Trending Markets Provide Tail Winds

With commodity prices trending steadily downward since July, and the dollar strengthening against the euro and other currencies, a managed-futures strategy should perform well.

The three popular broad commodity funds shown here are each built differently, but each headed south for the summer. These are the iShares S&P GSCI Commodity ETF (GSG | A-100), the United States Commodity ETF (USCI), and the PowerShares DB Commodity Tracking ETF (DBC | B-86).

One clear culprit is the strong dollar, shown by the bullish greenback ETF, the PowerShares DB US Dollar Index Bullish ETF (UUP | D-73).

A continuation of these trends could be a helpful tail wind for new fund ProShares Managed Futures Strategy ETF (FUTS). FUTS competes with three other managed futures ETFs, but I’d argue that it’s most comparable to the big dog in the space, the WisdomTree Managed Futures Strategy Fund (WDTI | C-73).

A Deep Dive

Before I delve into the strategy that drives FUTS, and how it stacks up next to WDTI, I’ll make three comments.

• First: Celebrate the transparency of its index-based strategy. WDTI essentially tracks an index too, but the point is that, if you really want to know what the new fund FUTS is doing, you can. There’s no black box, just a set of rules that’s detailed enough for you to decide whether to pass or play.
• Second: If you read through the strategy and don’t understand it, you should avoid not just the fund but the entire strategy.
• Third: There are lots of moving parts. The complexity highlights the number of bets the fund—or anyone in the space—must get right to perform well.

FUTS starts off in a straightforward fashion, with broad access to 16 commodities, fix currencies and two fixed-income assets (Treasury notes and bonds). These arbitrary boundaries are par for the course for index-based strategies, and even active managers must start somewhere.

Within these buckets, asset types are selected by liquidity, which is roughly analogous to market cap in equity funds as a proxy for size and relevance. Equities and emerging market currencies are out of the mix. To this point, FUTS differs little from rival WDTI, which accesses a similar basket of 16 commodities, six currencies, Treasury notes and bonds as well.

Risk Weighting Sets FUTS Apart

WDTI assigns weight to the commodities in its basket by production—more relevant commodities as measured by dollar value of production receive more weight. WDTI’s currency weights are determined by the GDPs of the issuing countries—another measure of relevance.

Here’s where FUTS offers its largest competitive distinction from WDTI: It ignores the economic relevance of each asset type in its weighting decision.

Instead, FUTS applies weights to the 24 asset types based on an equal risk contribution from each asset type. The goal is diversification, and the intuitive outcome is that riskier assets like oil and gas futures will have a lesser weighting, while those with calmer return profiles like Treasurys will have greater weighting.

While this “risk first” approach to weighting might remind you of a minimum-volatility equity fund, it’s different: FUTS aims for equal risk from each asset, not for a portfolio with the absolute lowest volatility.

Price Trends

Both funds approach price trends—the heart of the managed futures strategy—in a similar way, with one key distinction.

Price trends only determine whether the funds will take a long or short position in each asset. To get there, both funds look at the current price of each asset relative to a seven-month average, with more recent months having greater impact in the assessment. The outcome is binary—either long or short, with the weight in the asset not determined by the price trend but instead by the steps outlined above.

WDTI differs notably in its treatment of the energy sector—it will go long or flat, but never short. When flat, energy’s weight is doled out to other sectors.

Below is a list of the current top five positions for each fund short or long. Both have large short positions in currency and long positions in Treasurys. Still, FUTS’ largest position is in shorter-dated Treasurys, which are less volatile than the 30-year paper. WDTI makes bigger bets on the euro and the yen, which make sense given the strong dollar graph shown above.

Data from issuers. FUTS weights calculated as a percent of total nominal exposure.

Futures-contract selection plays a role too. WDTI relies on a fixed schedule, while FUTS attempts to minimize contango in its contract selection—a practice that yields mixed results in pure-play commodity funds and has uncertain implications in a managed-futures fund.

The Fine Print: Legal Structure

Aside from risk weighting, FUTS differs from WDTI is another key area: legal structure. Pure portfolios of futures and collateral are out of bounds in a vanilla ETF, so the four funds in the space must choose an alternate path. As a commodity pool, FUTS will issue a K-1 at tax time, and any gains for the year will be taxable (at a blended rate) to shareholders regardless of whether the shares were sold.

In contrast, WDTI actually is a plain-vanilla ETF registered as an investment company under the Investment Company Act of 1940. It does access futures, but through an offshore subsidiary in the Caymans.

There may be some regulatory risk with this indirect approach to owning futures, which is also employed by the First Trust Morningstar Managed Futures Strategy (FMF). A fourth product, the Elements S&P Commodity Trends Indicator - Total Return ETN (LSC | D-61), uses the ETN structure as a workaround. See The Definitive Guide To 2014 ETF Taxation for more on legal structures and their implications.

A Better Mousetrap?

Has FUTS built a “next generation” WDTI that’s better? We’ll know once the track record starts, but until then, I like the nod to risk reduction through equal-risk weighting. From a performance standpoint, weighing the asset types by production or GDP—as WDTI does—seems to offer little other than liquidity, which FUTS addresses in asset selection.

I’d expect a less volatile return pattern for FUTS than WDTI, and FUTS’ allocation may make it less correlated with equities. Still, FUTS may forgo some upside by underweighting more volatile asset types that can do well at times, as highlighted in the holdings snapshot above. All told, this gives FUTS the opportunity to become a safer version of WDTI.

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at [email protected] or follow him on Twitter @PaulBritt_ETF.