KMLM - KMLM: Review Of KMLM Vs. Peers

2023-11-25 05:45:49 ET

Summary

• The KFA Mount Lucas Managed Futures Index Strategy ETF is my preferred low-cost way to access managed futures strategies.
• Although WTMF has outperformed KMLM in the short run, the drawback is it is positively correlated to markets, which reduces its diversification benefits.
• Compared to DBMF, KMLM does not suffer from lagged response and over-concentration in a few key instruments.

I have written a few articles on managed futures ("MF") funds like the KFA Mount Lucas Managed Futures Index Strategy ETF (KMLM), the iM DBi Managed Futures Strategy ETF (DBMF), and the WisdomTree Managed Futures Strategy Fund ETF (WTMF). Of the three, I personally prefer the KMLM, as it does not suffer from the lagged effect of trying to copy other funds' performance like the DBMF, nor is it as correlated to the markets as WTMF.

However, one reader highlighted that on a trailing basis, the WTMF ETF had performed significantly better than KMLM and DBMF in the short-term, and so was a better fund than KMLM. Is this true, and am I being too cautious on WTMF?

To properly assess the various managed futures funds, we first need to understand their strategies and how they can fit in a portfolio.

Brief Fund Overviews

KMLM

The KFA Mount Lucas Managed Futures Index Strategy ETF tracks the KFA MLM Index, an index comprised of 22 liquid futures contracts covering 11 commodities, 6 currencies, and 5 global bond markets. KMLM uses a pure trend-following algorithm on each future, taking long or short positions depending on the direction of the price dislocation (Figure 1).

KMLM then weighs the commodity/currency/bond baskets by their historical volatilities, and within each basket the constituents are equal dollar weighted.

KMLM is one of the longest tenured participants in the managed futures space, with the MLM Index being in operation since 1988 (Figure 2).

The drawback of KMLM is that the KMLM ETF has underperformed its underlying index, with KMLM returning 30.5% in 2022 while the underlying MLM Index returned 36.7% (Figure 3).

This lag in 2022 was caused by a management oversight in its cash management policies, as the KMLM ETF invested in the Schwab Short-Term U.S. Treasury ( SCHO ), a short-term treasury fund with an effective duration of 1.9 years to manage its cash (Figure 4). On the other hand, the MLM Index assumes cash returned 30-Day T-Bill rates.

When interest rates rose in 2022, KMLM's portfolio underperformed as the SCHO ETF lost value due to its duration exposure. To management's credit, they have since moved away from the SCHO ETF and now hold short-duration treasury bills (hopefully held to maturity) to manage its cash (Figure 5).

So far in 2023, the performance lag has been reduced to 81 bps for October YTD 2023, which can be accounted for by the fund's 0.92% net expense ratio (Figure 6).

DBMF

The iMGP DBi Managed Futures Strategy ETF does not track any specific index. Instead, DBMF's positions are determined by a proprietary quantitative model called the 'Dynamic Beta Engine' that uses regression analysis on the trailing returns of a pool of top-performing Commodity Trading Advisor ("CTA") hedge funds to create a portfolio of financial instruments that deliver performance similar to those funds.

While a normal trend-following model may be stopped out of their positions when the trend changes (i.e. in Figure 1 above, when price falls below the moving average), DBMF will continue holding its position until the Dynamic Beta Engine no longer allocates to that particular instrument. By design, the manager of the DBMF ETF has no authority to override the Dynamic Beta Engine. This process could take days or weeks, and could be obscured by heightened return volatilities.

Historically, the DBMF ETF has seen dramatic declines at market inflection points, like in October 2022, when the fund was heavily short the Euro and the Yen and was caught offside when the Bank of Japan ("BOJ") intervened in the currency markets, reversing the negative trend on the Yen (Figure 7). Similarly, the DBMF was heavily short bonds heading into the SVB crisis and was caught offside when investors rushed into bonds as a safe haven trade.

More recently, the DBMF ETF was once again heavily short bonds and the Yen, and I warned it was inevitably going to face a selloff. Since my warning, the DBMF ETF has lost 4% as bond markets have inflected and the Yen looks to be reversing its weak trend (Figure 8).

Aside from the lagging effect of DBMF's 'Dynamic Beta Engine', another downside that many investors may not have considered is that during trending markets, DBMF's portfolio becomes increasingly concentrated, as its regression analysis hones in on the 'top performing' trends to the exclusion of everything else. Readers can think of DBMF's strategy as a gambler that keeps upping the ante when she's on a roll. This increases her winnings as long as her momentum continued. However, by betting big, she also risks 'losing it all' when the tide turns.

For example, in my prior article, I noted that the DBMF was 49.6% short 3-month SOFR futures, 49.7% short 2-year treasury futures, and 41.2% short the Yen as of September 25, 2023 (Figure 9).

This concentration is what allows DBMF to outperform other CTA/MF strategies in trending markets, but is also what causes the dramatic losses of value during inflection points. The DBMF ETF rides an escalator up, but an elevator down.

WTMF

Finally, the WisdomTree Managed Futures Strategy Fund is an actively managed ETF pursuing a managed futures strategy. WTMF is the longest operating managed futures ETF, with inception date of January 5, 2011.

WTMF is managed using a quantitative, rules-based strategy designed to capture both rising and falling price trends on listed equity, commodity, currency, and U.S. treasury futures. The WTMF ETF may also invest up to 5% of net assets into bitcoin futures and is rebalanced monthly.

In terms of performance, I have to agree with my reader that the WTMF has delivered strong returns in the short-term, with 10.2% YTD returns to October 31, 2023 compared to only 5.2% for KMLM and -0.9% for DBMF (Figure 10).

However, we need to keep in mind why we own CTA/MF funds in the first place.

For me, my allocation to the KMLM ETF is as a portfolio diversifier, with the hopes that it delivers returns that are uncorrelated to the equity markets. However, if we look at the historical returns of the three ETFs discussed, we can see that while KMLM and DBMF have -0.4 correlations to the market, WTMF actually has a 0.46 correlation (Figure 11, measured from January 2021 to October 2023).

This means that when equity markets have a tough time, the WTMF ETF also tends to perform poorly, exactly what we do not want to happen. In 2022, WTMF lost 6.5% when other CTA/MF strategies like KMLM and DBMF gained 24.2% and 21.6% respectively (Figure 12).

Perhaps WTMF's recent positive correlation is an anomaly due to the short observation period?

Unfortunately, if we stretch the measurement period farther back to WTMF's inception in 2011, we can see that since inception, the WTMF ETF has delivered a -0.9% CAGR return with a 0.14 correlation to the market (Figure 13).

In plain English, since inception, WTMF has given investors a 0.9% loss per annum that is slightly correlated to the markets. No thanks.

Conclusion

While WTMF's YTD performance has been impressive, we need to keep in mind why we own CTA/MF funds in the first place: portfolio diversification. The drawback to WTMF is that its performance is positively correlated to the markets, which reduces its diversification benefits.

In comparison, I believe the KMLM ETF is the best CTA/MF I have reviewed to date, as it trades commodities, currencies, and fixed income futures systematically. By not trading equity futures, it also minimizes the fund's correlation to equity markets.

Finally, I believe KMLM's strategy is superior to DBMF's because its portfolio is risk-managed, i.e. there is less risk of KMLM becoming overly concentrated in a few markets like how DBMF has behaved historically. This reduces the drawdowns during market inflection points and leads to higher returns in the long run. Furthermore, KMLM does not suffer from the significant portfolio lag that I have mentioned in previous articles.

I continue to hold a position in KMLM and rate it as a buy .

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