KMLM - KMLM: Useful As A Portfolio Diversifier

2023-06-20 11:58:02 ET

Summary

• The KFA Mount Lucas Managed Futures Index Strategy ETF is a low-cost way for retail investors to access managed future strategies, offering strong returns and low correlations to traditional portfolios.
• KMLM outperforms the DBMF ETF with better absolute and risk-adjusted returns, making it a potentially superior managed futures fund.
• However, the KMLM ETF significantly underperformed its benchmark index in 2022, raising questions about its true utility and making it a tentative buy.

In the past few months, I have reviewed several managed futures funds, including the iM DBi Managed Futures Strategy ETF (DBMF) and the WisdomTree Managed Futures Strategy Fund ETF (WTMF). This article reviews the KFA Mount Lucas Managed Futures Index Strategy ETF (KMLM).

Overall, I believe the KMLM ETF has merits as a portfolio diversifier as the ETF delivered strong returns in 2022 when the rest of the world was in a bear market. However, one caveat is that the KMLM ETF significantly underperformed against its underlying index, the KFA MLM Index, upon which much of its marketing material is based. If this underperformance is persistent, then investors may overestimate the true utility of the KMLM ETF. I rate the KMLM ETF a tentative buy .

Fund Overview

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 that measure the returns to risk bearing in futures markets. The commodity/currency/bond market baskets are weighted by their historical volatilities and within each basket, the constituents are equal dollar weighted.

The KMLM ETF is sub-advised by Mount Lucas Management, the creators of the MLM Index and long-time managed futures managers. The KMLM ETF is a low-cost way for retail investors to access managed future strategies, with over $300 million in AUM charging 0.92% in net expenses.

Introduction To Managed Futures

Managed Futures, for those not familiar, is a quantitative strategy that uses trend-following or momentum strategies across a broad range of assets to deliver superior risk-adjusted returns. The benefit of a managed futures strategy is that it can go long or short different asset classes so it typically has low correlations to traditional portfolios and can act as a portfolio diversifier (Figure 1).

Traditionally, managed futures as an asset class is difficult for retail investors to access, as investors need to be accredited (have income greater than $200,000 / year or net worth greater than $1 million) in order to invest with commodity trading advisors ("CTA"), the providers of managed futures investment funds.

KMLM Strategy Details

The KMLM ETF's implementation of its strategy begins with the 22 highly liquid futures contracts as mentioned previously. Risk is allocated across the sectors and markets based on historical volatility and rebalanced monthly.

Based upon a daily trend signal (either long or short), the ETF will enter the appropriate trade in the particular futures, with the portfolio rebalanced monthly and futures contracts rolled forward on a market-by-market basis (Figure 2).

The KFA MLM Index's trading signals use trend-following algorithms to identify the inception of price dislocations and are executed in small increments over a period of several days (Figure 3).

Portfolio Holdings

Figure 4 shows the KMLM ETF's portfolio as of May 31, 2023. The fund is generally net short commodities (-24.8% net short), flat in currencies (-0.3% net short) and net short bonds (-35.9%).

However, investors should note that KMLM's portfolio can change very quickly, depending on the trend signals. For example, as of June 16, 2023, the KMLM ETF has gone from a small 1.2% long in Canadian bond futures ("CAN 10YR BOND FUT SEP23) at the end of May to a large 22.5% short (Figure 4). So historical position reports need to be analyzed with a grain of salt.

Returns

The KMLM ETF itself was launched only relatively recently in December 2020, so it does not have a long history of performance. In 2021, the ETF delivered modest 7.6% returns, while in 2022, the KMLM ETF returned a spectacular 30.5%. So far in 2023, the KMLM ETF's returns have been modest, returning 2.3% YTD to May 31, 2023 (Figure 6).

However, the KFA MLM Index on which the ETF is based upon has more history (Figure 7). Overall, the KFA MLM Index delivers on what is designed for: low correlation to traditional 60/40 portfolios with positive aggregate returns, especially during the bear market in 2022.

Investors should note that there appears to be significant slippage between the KFA MLM Index returns in 2022 (36.7%) compared to the KMLM ETF returns (30.4%). I could not find any reasonable explanation for the slippage in the ETF's reports or marketing materials.

KMLM As A Portfolio Diversifier?

According to the KMLM ETF's marketing materials, a 10% allocation to the KFA MLM Index can both improve a 60/40 portfolio's returns and reduce overall portfolio volatility (Figure 8). The proverbial free lunch.

The question is whether the free lunch is still available considering the slippage between the index and the ETF returns that we observed in Figure 7.

I Prefer KMLM Over DBMF

I believe the KMLM ETF may be a superior managed futures fund compared to the DBMF ETF. First, on the strategy, the KMLM ETF does not suffer from the lagging effect that I identified as a serious flaw in DBMF's strategy. Yes, all managed futures strategies suffer from a time lag, as they need to wait for trends to develop before placing long or short bets.

However, the DBMF ETF goes one step further by basing its portfolio on a proprietary quantitative model called the 'Dynamic Beta Engine' that uses regression analysis on the trailing returns of a pool of top performing CTA hedge funds to identify a replicating portfolio. This introduces further lag in its signals compared to the underlying CTA hedge funds and may cause the DBMF ETF to be 'whipsawed' during volatile markets.

Objectively, we can see the KMLM ETF has outperformed the DBMF ETF with better absolute (KMLM has CAGR returns of 16.0% vs. DBMF CAGR returns of 9.4%) and risk-adjusted returns (Sharpe Ratio of 0.94 vs. 0.60) in the comparable period January 2021 to May 2023 (Figure 9).

Conclusion

The KMLM ETF is a relatively low-cost way for retail investors to access managed futures strategies. The underlying index, the KFA MLM Index, has a long history of delivering strong absolute returns and low correlations relative to traditional long-only portfolio allocations like the 60/40 portfolio.

I believe the KMLM ETF is worth a consideration as a portfolio diversifier to hedge against bear markets like 2022. However, one caveat is that the KMLM ETF significantly underperformed its benchmark index in 2022. It is unclear why the ETF underperformed nor whether the magnitude of underperformance will persist. Therefore, investors basing their portfolio allocation decisions on the data presented in its marketing materials using the KFA MLM Index may be overestimating the performance of the KMLM strategy.

My verdict on the KMLM ETF is a tentative buy .

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