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Opalesque Futures Intelligence

Founders Q&A: Learn about Rydex /SGI’s managed futures mutual fund. In little over two years, its assets have grown

Thursday, February 25, 2010

Building Futures Mutual Funds

After the experience of 2008, investors became interested in liquid and transparent investment vehicles. Managed accounts have received a lot of attention as one way of achieving these goals. Regulated formats, such as European UCITS III and American mutual funds, are another way of ensuring liquidity and transparency.

For a manager, these structures potentially offer a much larger and diverse investor base. However, whether futures strategies can make it in the many-trillion dollar US mutual fund market is a big question. This is a market dominated by huge fund complexes and regulated by laws that date to the early 20th century.

We were very interested to learn that Rydex /SGI has had some success with its managed futures mutual fund, which was launched in 2007. By the end of 2009, assets under management rose to $2.33 billion.

The growth in assets happened despite a 2009 loss of 4.25% (in Class-A shares). This performance is in line with managed futures indexes.

The Rydex managers we talked with are part of a group responsible for developing alternative products. Sanjay Yodh is managing director for alternative strategies. Before he joined Rydex / SGI, he was a managing director at Deutsche Bank. Ryan Harder is portfolio manager in the quantitative team. Previously he worked at West LB Asset Management and CIBC World Markets.

Rydex /SGI is a $22 billion mutual and exchange-traded fund manager owned by Security Benefit Corp., which was recently acquired by Guggenheim Partners LLC. Guggenheim, with $100 billion in assets, is a big player in alternatives.

Alpha Financial Technologies developed the indicator and quantitative method used by the Rydex / SGI Managed Futures Strategy Fund—see the April 7th, 2009, issue of Opalesque Futures for an interview with Victor Sperandeo, founder of Alpha Financial. On the related topic of UCITS III managed futures and macro funds, we’ve presented a number of examples in the past, for example in our June 16, 2009, issue.

Sanjay Yodh “(This) is a low-risk way to go long volatility and have a safety net in your portfolio.”

Opalesque Futures Intelligence: What is the strategy of the managed futures fund?
Ryan Harder: The fund seeks to match Standard & Poor’s Diversified Trends Indicator, which uses seven months of data to determine long and short positions on the basis of trends. By using an exponential moving average, the latest data is weighted more heavily than previous months.

OFI: Which markets does it trade?
RH: The benchmark is designed to be a 50/50 mix of financial futures and commodity futures, covering eight financials and 16 commodities. The commodity portion is weighted by global production estimates and the financial part by countries’ gross domestic products. Small weighting adjustments are made to account for the liquidity of the underlying futures contracts. Having both financial and commodity futures gives you another layer of diversification and leads to low volatility over time.

OFI: Does it correlate with managed futures indexes?
RH: It is not designed to track any group of managers but the strategy uses a trend-following signal that many commodity trading advisors use as well. It makes sense that there will be a fair degree of correlation between S&P DTI and managed futures, given that most CTAs use trend-following systems.

OFI: Does the strategy include discretionary adjustments?
RH: No. If the indicators says long copper, we will be long copper. We do not over- or under-weight any component.

OFI: What effect do mutual fund regulations have on the strategy?
Sanjay Yodh: Rydex /SGI was built on executing alternative investment strategies within the 1940 Act mutual fund format. We launched the first mutual funds with leveraged and inverse index strategies in 1993, acquiring the special skills necessary to deliver such strategies. Our trading desk and quantitative team have substantial experience. However, this type of legal structure could hinder other managers in executing their strategy.
RH: Mutual fund rules do not prevent us from pursuing our objective of matching the S&P DTI.

Ryan Harder “With this fund, there is no question about manager selection. You don’t take that risk.”

OFI: What is the time horizon of the trades?
RH: The fund has a medium-term time frame. We do not trade in and out of positions daily. The portfolio is re-balanced every month. We hold some positions for a month but hold others longer because the trends continue for several months.

OFI: Do you go long and short all markets?
RH: Energy is the only sector that is never short. It is either long or neutral When it is neutral the weighting that goes to energy is spread out proportionately among the other futures contracts. The fund maintains 100% gross exposure long or short.

OFI: How does the strategy differ from a trend-following CTA?
RH: It has lower volatility than most CTAs because we do not use any leverage to get returns. By contrast, a typical CTA may be leveraged three or four times. Our fund is re-balanced each month to get back to 100% gross exposure. We hold a lot of cash. Because you put up only a small amount for capital for margin with futures contracts, typically only 5% to 10% of the fund is used for margin.
SY: So this is a very low-risk way to get exposure to futures. It tends not to have major drawdowns. It is a low-risk way to go long volatility and have a safety net in your portfolio. This fund provides a buffer against significant drawdowns in the S&P 500. When equity markets are doing well, typically it does not make a big loss and can provide positive returns. Last year was the biggest loss in a calendar year that the benchmark has had.

OFI: Why did the strategy make a loss in 2009?
SY: There was unprecedented market activity last year. After volatility spiked in the fourth quarter of 2008, it decelerated persistently though 2009. We had not experienced anything like that before. What drove equity returns was investor psychology, not economic fundamentals—those pointed to high unemployment, distressed real estate and significant illiquidity. By contrast, in currencies and commodities there was a lot of shifting between long and short positions which did not create discernable trends in the market, so many trend following strategies had a very difficult time.

OFI: Why should an investor choose a managed futures fund that will likely make lower returns than many CTAs?
RH: When you invest with CTAs, you may get a manager who will make 20% or a manager who will lose 20%. With this fund, there is no question about manager selection.
You don’t take that risk.
SY: This fund gives you core exposure to an asset class that diversifies your portfolio, in particular against difficult equity markets. As a mutual fund investor, you get transparency and daily liquidity. You can get different exposures and take idiosyncratic risk with other managers who employ leverage and may make higher returns. But we believe this fund is a pretty strong solution for asset allocation at the strategic level.

OFI: What do you mean by strategic asset allocation?
SY: The way you build wealth is by preserving your capital and looking for risk-managed ways to grow it. To do that, you always want some allocation to this type of strategy. When times are good for the rest of your portfolio, managed futures has a zero to slightly negative correlation to other investments. When things go really bad in the rest of the portfolio, it tends to have a very negative correlation to other investments. This fund is best used as a strategic allocation that can be increased or reduced, depending on overall portfolio positioning.

OFI: Isn’t the 2.2% expense ratio (for class-A shares) high for a mutual fund?
RH: For a typical mutual fund, yes. But you really should compare it not with other mutual funds but with managed futures investments. Compared with a CTA, the fund is very reasonable, since CTAs typically charge a 20% performance fee that adds up over time in addition to a 2% management fee.

OFI: Does the Rydex /SGI Long/Short commodities fund work the same way?
RH: That fund also uses trend-following signals. It makes sense that most long/short commodity indexes follow trends because commodity prices tend to move in line with the business cycle. As the economy expands, they tend to go up and as it contracts, they go down.

OFI: Would you describe the model that generates signals?
RH: The goal is to match the performance of the JP Morgan Core Commodity-Investable Global Asset Rotator Sigma Long-Short Total Return Index, which determines long, short or neutral positions for each commodity using 12 months of data. If there is no consistent trend, we won’t have a position is that market. As with the managed futures fund, we implement the strategy with futures and structures notes.

OFI: Does the long/short commodities fund differ from the managed futures fund in other ways, besides trading only commodities?
RH: The two indexes are different. For instance, each commodity has a separate signal in the JP Morgan Core Commodity-Investable Index whereas S&P DTI uses sector-level signals. Also, the commodity fund can short energy futures.

OFI: How would a investor decide between these two funds?
SY: The risk/return profiles are different. Let’s consider the commodity fund first. There are investors who want only commodities. Our long/short commodities fund can be used as a replacement or a complementary addition to a long-only commodity allocation. It allows you to take advantage of situations where it is better to be, say, long oil and short natural gas. If it is best not to be exposed to a certain commodity, that part of the portfolio can go to cash. So it has advantages over long-only commodity funds, while providing the same transparency and liquidity. The managed futures fund is a volatility dampener for your overall portfolio; it is a defensive position for capital preservation in difficult environments. By contrast, the commodity fund is an offensive position with much higher volatility, more in line with traditional equities. It can be used to get higher returns.

OFI: How do you deal with the volatility in commodity markets?
RH: The fund has a reversion test to avoid over-bought or over-sold situations and a volatility cap that scales back positions when historical volatility is high. The positions are equally weighted. The 14 commodity futures that are components of the index are highly liquid instruments. Commodities that are thinly traded are not part of the index.
Gross exposure typically ranges from 70% to 130%. It could go as low as zero if no commodity market trended or as high as 200% in the extreme case of seven commodities trending downwards and seven trending upwards. But those situations are very rare.

OFI: Commodity index investments have faced negative rolling returns because of contango situations in futures contracts. Does this have an impact on the Rydex /SGI futures funds?
RH: We’re not totally immune to the contango effect but not as affected as long-only index investments. If we’re short a commodity that is in contango, we benefit from it!



 
This article was published in Opalesque Futures Intelligence.
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