Since the middle of February, the S&P 500 has spun its wheels as investors start to question whether the U.S. economy will grow at a faster pace and whether Washington will make legislative progress in 2017. The fact that stocks had been on a tear until mid-February, with the major indices rising an average 30 percent in the prior 18 months, leads some investors to grow concerned about profit taking and an end to the recent era of low volatility.
While we don’t know how the future will play out, managed futures exchange-traded funds can provide portfolio insurance against market turmoil, smooth out volatility and provide downside protection for a reasonable cost. “This approach tends to benefit when equity markets stall and fixed income is under pressure,” says Ryan Issakainen, ETF strategist for First Trust Advisors.
Managed futures are programs run by commodity trading advisors (CTAs) who are registered with the Commodity Futures Trading Commission. These specialized traders have a deep understanding of the managed futures landscape and seek to profit from the spreads in futures contracts of commodities, currencies and index futures, and can adopt a net long or net short bias.
But CTA management doesn’t come cheap, typically asking for “2-and-20” levels of compensation, a stiff price to pay for an asset class that is never going to deliver robust returns.
That’s where the ETFs come in. Their expense loads typically top out at around 1 percent. The First Trust Morningstar Managed Futures Strategy Fund (FMF), for example, carries a 1.0 percent expense ratio, the high end of what ETFs tend to charge but well below what you’ll pay at a mutual fund or hedge fund, says Issakainen. (The fund’s prospectus notes that First Trust has the option to raise the expense ratio to 1.25 percent after April 30, 2017, but it’s unclear if that will happen).
The FMF fund aims to exceed the returns of the Morningstar Diversified Futures Index, which owns a basket of futures based on 20 commodities, nine equity indexes, and six currencies. It has returned a negative 1.85 percent since it was launched in August 2013, or 111 basis points worse than the Morningstar index. The fund’s expense ratio explains almost all of that gap.
The WisdomTree Managed Futures Strategy Fund (WDTI), which carries a leaner 0.65 percent expense ratio, has also lagged with a negative 1.73 percent annual return over the past five years.
Although these funds have failed to keep up with stocks, that doesn’t mean that investors should abandon this approach, says Issakainen. “It’s an important diversifier that has proven itself over the long haul to smooth out returns.”
Chris Gannatti, WisdomTree’s associate research director, says clients have questioned the appeal of managed futures in recent meetings. “If people are dismissing them, then I see that as a contrarian signal,” he says. “They could be a much more beneficial asset class in the next 10 years than they have been in the recent years.”
These two ETFs approach the asset class from distinct angles. The First Trust fund uses the expertise of a pair of portfolio managers who utilize the futures contracts selected from the Morningstar index. Though they must rebalance the fund quarterly to ensure 50 percent exposure to commodities, 25 percent to indexes and 25 percent to currencies, they have the flexibility to select specific futures contracts based on trend following. In a nutshell, futures contracts that are priced above their one-year rolling average are bought long, while those priced below their average are shorted.