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.