This probably won’t come as a surprise. The alternative investment asset class isn’t a monolith. Subsumed with the category are such diverse strategies as interest rate arbitrage, emerging market plays, managed futures and a lot more (have a look at our monthly data table to see some of the most significant alternative investment tactics).
One thing, however, ties these disparate approaches together: to one degree or another, non-correlation. Alternative investments aren’t just hopeful alpha generators. They specifically aim to deliver outperformance with little or no reliance on the vagaries of the domestic equity market (commonly benchmarked by the S&P 500 Index).
For years, alternative investment strategies were the exclusive purview of so-called hedge funds -- privately placed partnerships aimed at accredited investors. But now there are a growing number of alternative strategies packaged into exchange-traded products (ETPs) accessible by retail investors. Not a lot, mind you, but a growing number.
Each month, Alternative Insights will delve deeply into an alternative investment category, paying particular attention to the burgeoning ETP marketplace. We’ll provide interviews with industry professionals, feature articles chock-a-block with data, news summaries as well as question-and-answer forums designed to provide investors and advisors with useful and timely information.
This month, we’ll focus on collective investment in the futures markets.
Private placement futures funds, actively managed by Commodity Trading Advisors (CTAs), tend to be free of any bias to the long or short side (in futures, both sides of a trade are margined exactly the same) and, more often than not, are momentum followers. Most managers employ systematic trading programs that identify potential entry and exit points in their target markets, coupled with risk management rules designed to preserve capital.
The attractiveness of managed futures funds -- aside from their ability to earn alpha -- has always been predicated upon their lack of positive correlation to other portfolio assets. Futures funds, in fact, not only skew from equities and bonds, but also away from other hedge fund categories. Regard, for example, the table showing the performance of managed futures funds over the past two decades as represented by the Dow Jones Credit Suisse Managed Futures Index. The index is a 34-constituent metric representing portfolios with at least $50 million under management, a 12-month track record, and audited financial statements. You’ll note the funds’ negative correlation to the S&P 500 is complemented by a near-zero coefficient versus other hedge fund strategies (see our data tablefor the comparators).
While the funds’ average annual return is a couple of percentage points less than that of the S&P index (11.7 percent), futures have been, perhaps surprisingly, less volatile. The annualized standard deviation of monthly returns for the equity benchmark is 15.4 percent.
The dissonance in volatility is further reflected in the portfolio statistics for managed futures funds. Their slightly negative beta (versus the S&P) yields a positive alpha.
From this, we can conclude that managed futures have some utility in providing, if nothing else, a portfolio diversification benefit. Until recently, this advantage was enjoyed only by institutions and high net worth individuals.
But no more.
In 2006, the first ETPs offering broad-based commodity exposure were launched. These products weren’t exact analogues of managed futures hedge funds, though. There were, in fact, passive products that tracked indexes created and maintained by Deutsche Bank, Dow Jones and Goldman Sachs.
These first generation funds and notes are known as “long-only” products because they hold (or simulate the holding of) only long positions in their underlying index’s constituent futures. By their nature, these products leave some alpha on the table. After all, short sales provide profit opportunities equal to, and sometimes greater than, long positions in the commodities markets.
These products are also impacted by “contango,” a positive slope in the futures delivery curve. A contango exists when nearby futures sell at a discount to longer-dated maturities for the same commodity. If, for example, May crude oil futures are trading at $93 a barrel while contracts for June delivery change hands at $94 a barrel, we’d say a there is a $1 contango. Contango represents the cost of carrying a commodity from one delivery month to another and is made up of storage costs, insurance charges and interest.
Long-only commodity indexes (and the funds or notes that track them) are beset in contango markets because they’re required to “roll” their positions forward to maintain exposure. An index fund with a crude oil exposure is obliged to maintain a constant allocation to oil futures. If the index is invested in the front month (the delivery closest to today’s date), it must sell out of the expiring futures and buy, as a replacement, the next delivery month. In a contango, that means selling the lower-priced futures and buying the higher-priced contract. The resulting loss is characterized as a “negative roll yield.” Practically, that means a contango reduces the return for holding the commodity. Second generation commodity ETPs are designed to mitigate the contango effect by using an index methodology that either spreads the commodity holding across several delivery months or uses a “smart” technique that shops for the most advantageous roll.
Since 2006, the number of broad-based commodity ETPs has ballooned to include 16 long-only, one inverse and two long/short products together with a single actively managed fund.
The market share of the most popular commodity ETP is a testimony to the “first-to-market” advantage enjoyed by early entrants to this competitive field. The launch date of the PowerShares DB Commodity Index Tracking Fund (DBC) was just five months ahead of its nearest rival, the iPath Dow Jones-UBS Commodity Index ETN (DJP), but that lead time, in part, contributed to former’s nearly four-to-one lead in market capitalization.
Aside from the inherent liquidity of the larger/older products, investors often consider energy exposure when selecting a commodity ETP. The variance in petroleum complex commitments, as well as their sheer size, can be striking.
- PowerShares DB Commodity Index Tracker Fund (DBC) - DBC tracks the excess return and optimum yield version of the Deutsche Bank Liquid Commodity Index which mandates investment in a portfolio of futures including light, sweet (WTI) crude oil, heating oil, RBOB gasoline, natural gas, Brent crude oil, gold, silver, aluminum, zinc, copper, corn, wheat, soybeans and sugar. Energy represents 55 percent of the portfolio’s target weighting.
- iPath Dow Jones UBS Commodity Index Total Return ETN (DJP) - iPath exchange-traded notes are senior, unsecured debt securities issued by A+-rated Barclays Bank PLC. The underlying index is comprised of 19 commodities with a 31 percent weighting in energy futures.
- iShares S&P/GSCI Commodity-Indexed Trust (GSG) - Among the very first commodity ETPs launched in 2006, this iShares product’s underlying investment attempts to replicate the S&P/GSCI, a 24-commodity benchmark presently weighted 69 percent in the energy sector.
- United States Commodity Index Fund (USCI) - Launched in 2010, USCI mirrors the total return of the SummerHaven Dynamic Commodity Index. At any given time, the underlying benchmark is comprised of 14 equally weighted commodities, selected by its rules-based methodology from a universe of 27 futures markets. As of its most recent rebalancing, the portfolio’s commitment to the energy sector was 21 percent.
- GreenHaven Continuous Commodity Index Fund (GCC) - Equally weighted across 17 commodities, GCC’s positions are averaged across the futures curve six months out. GCC debuted in 2008 and allocates 18 percent of its assets to the energy sector.
Altogether, there are 16 long-only ETPs and one inverse (short-only) note which provide broad-based commodity exposure (see “Related ETPs” below). Whether all-long or all-short, none of these products are directly comparable to a managed futures fund. There’s no discretion in an index product.
Even ETPs marketed as managed futures strategies really track rules-driven indexes. Take the WisdomTree Managed Futures Strategy (WDTI) as an example. WDTI follows the Diversified Trends Indicator (DTI) Index which dictates investment -- long or short -- in an array of financial and commodity futures.
The DTI Index universe is populated by 24 futures contracts, equally divided by weight, and grouped into 14 sectors: eight financial and six commodity.Long or short positions are determined on a momentum basis. When a sector trades above its seven-month EMA, its component futures are bought; when it trades below its EMA, the subsumed contracts are sold. The one exception to the rule is the energy sector. Energy is either long or flat, never short. When the energy sector is long, index exposure is weighted evenly between commodities and financials (50 percent each). When the sector is flat, index exposure is weighted 60 percent to financials and 40 percent to commodities. Energy comprises 20 percent of the total index weight.
Obviously, this scheme isn’t as passive as a long-only or short-only mandate but, because, of its rulebook, it’s not actively managed either. It’s instead, mechanical.
So, too, is the strategy underlying the ELEMENTS S&P CTI ETN (LSC). That should come as no surprise since LSC’s driven by the Commodity Trends Indicator (CTI) Index, a subset of the DTI Index. There are no financial futures tracked within the CTI Index.
Long positions are mandated when a component’s priced above its seven-month EMA; shorts are tracked when a sector value slips below its EMA. Like the DTI Index methodology, when the energy sector value is less than its EMA, the CTI Index assumes a flat position. The 38 percent weight for energy is then allocated proportionately to the other five sectors.
Practically speaking, the ETP that most closely simulates futures hedge funds isn’t classified (at least by most observers) as a commodity fund. It’s usually considered an “absolute value” product, meaning its mandate is the provision, however meager, of a positive return in any economic environment.
The iShares Diversified Alternatives Trust (ALT) is truly an actively managed fund. The fund invests heavily in exchange-traded futures, but also engages in over-the-counter foreign exchange forward transactions. Historically, ALT’s investments -- short or long -- encompass only financials, i.e., equities, fixed income obligations or currencies. Commodities such as energy, metal or agricultural goods aren’t typically traded.
ALT’s managers engage in relative value strategies that capitalize upon the mispricing of financial instruments and attempt to capture the spreads between assets that skew from their fair or historic values. More specifically, ALT’s positions entail yield and futures curve arbitrage, momentum and reversal plays as well as fundamental relative value strategies.
The fund’s portfolio targets a maximum annualized volatility of ten percent and is geared to deliver a 0.50 to 0.75 Sharpe ratio over the long term.
As you can see from the accompanying tables and charts, ALT’s been the category’s standout performer over the past year. Granted, it returned just five percent but it did so with such low volatility that it earned a Sharpe ratio of 0.93, well above its target.
It remains to be seen whether ALT can continue on this trajectory, but if past history (the fund was launched in 2009) is any indication, the odds are good.
Category’s Representative ETP: ELEMENTS S&P CTI ETN (LSC), the oldest “managed futures” product, debuted in June 2008.
Related ETPs: (Long-only) - PowerShares DB Commodity Index Tracking Fund (DBC), iPath Dow Jones UBS Commodity Index TR ETN (DJP), iShares S&P GSCI Commodity Indexed Trust (GSG), ELEMENTS Rogers International Commodity Index ETN (RJI), United States Commodity Index Fund (USCI), GreenHaven Continuous Commodity Index Fund (GCC), UBS E-TRACS CMCI TR ETN (UCI), iPath S&P GSCI TR ETN (GSP), Goldman Sachs Connect S&P GSCI Enhanced TR ETN (GSC), UBS E-TRACS Dow Jones UBS Commodity Index TR ETN (DJCI), iPath Pure Beta Broad Commodity ETN (BCM), STREAM S&P Dynamic Roll Global Commodities Fund (BNPC), Dow Jones UBS Commodity Index 2-4-6 Blended Futures ETN (BLND), PowerShares DB Commodity Long ETN (DPU), iPath Pure Beta S&P GSCI Weighted ETN (SBV), RBS Rogers Enhanced Commodity ETN (RGRC).
(Inverse) - PowerShares DB Commodity Short ETN (DPP).
(Long/Short Strategy) - WisdomTree Managed Futures Strategy Fund (WDTI).
(Actively Managed) - iShares Diversified Alternatives Trust (ALT).
Related ETPs in Registration: ETFS All Commodities Trust, Guggenheim S&P Commodity Trends ETF (CTI), IQ Hedge Managed Futures Tracker ETF, Jefferies TRJ/CRB Commodity Index ETF (CRB), Jefferies Commodity Real Return ETF (RRET), Market Vectors CM Commodity Index Fund, ProShares Managed Futures Strategy, Rydex [Guggenheim] 2X GSCI Commodities Fund, Rydex [Guggenheim] Inverse 2X GSCI Commodities Fund.