By Jim Fink on January 7, 2011

Managed futures still make sense for investors. Several studies have shown that adding a futures component to an investment portfolio lowers overall volatility and improves long-term returns. Because the performance of these assets is largely uncorrelated to the broader markets and they thrive in periods of high volatility, they make an excellent hedge for any portfolio.

On Wednesday January 5 th. fund firm WisdomTree launched the WisdomTree Managed Futures Strategy Fund (NYSE: WDTI). the very first managed futures ETF .

Dont get too excited. More on the specifics of this ETF later in the program.

Managed Futures are an Important Asset Class for Portfolio Diversification

Anyone who has read my free report on asset allocation knows that I am a big fan of managed futures. As Ben Shepherd, editor of Global ETF Profits . explains in the quotation above, managed futures are a great diversifier for an equity portfolio because their investment performance have a very low correlation with stocks. In a 2005 study by Ibbotson Associates. managed futures were found to:

exhibit superior performance during periods in which most traditional asset classes underperform. Overall, the results suggest that the managed futures funds benefit long-term investors, particularly in rising interest rate environments.

Other studies have reached similar conclusions. You can read them by clicking here (free registration is required) and here. Bottom line: low correlations between asset classes are the key to a low-volatility investment portfolio. And as I wrote in the Great Investment Truth . low volatility (specifically of the downward variety) is the secret sauce to above-average investment returns.

Description of Futures Contracts

Futures contracts are derivatives that track the performance of a wide variety of agricultural and financial commodities (e.g. soybeans, crude oil, copper, ten-year U.S. Treasury notes). They trade on regulated exchanges operated by organizations such as the CME Group (NasdaqGS: CME) and the Intercontinental Exchange (NYSE: ICE). The contracts are highly leveraged, meaning that you can buy them on margin for a small fraction of their underlying value (less than 10%), and they are used by companies to lock in the price they receive for their future production, as well as by speculators who aim to profit from their forecast of a commoditys future price movement.

Fundamental Analysis vs. Technical Analysis

Only highly sophisticated investors should trade futures contracts directly, because their high leverage makes them very risky if commodity prices dont move as expected. Consequently, most investors invest in commodities through passive long-only funds (such as iPath ETNs. PowerShares ETFs. or iShares trusts ) or actively-managed long/short accounts, where an experienced futures trader is at the helm to make directional, position-size, stop-loss, and profit-exit decisions. Some managers use fundamental research (e.g. business cycles. demographic trends, weather patterns, supply and demand) to guide their trading decisions, whereas others use technical analysis .

According to Ben Shepherd of Global ETF Profits . 85% of commodity trading advisors (CTAs) employ a trading system based on technical analysis rather than fundamentals. This makes sense, since futures are typically short-term trading vehicles where current supply and demand pressures have more sway than long-term fundamental considerations.

Trader Vics Momentum-Based Commodity Trading System

One such technical trading system is based on price momentum and was developed by Victor Sperandeo (Trader Vic). His master trading system is called the Diversified Trends Indicator (DTI) and is composed of 24 highly liquid, US exchangetraded futures contracts across 16 physical commodities (i.e. agricultural, energy, metals) and 8 financial commodities (i.e. global currencies and U.S. interest rates). He also has trading systems based on subsets of the DTI, including the Commodity Trends Indicator (CTI) composed of the 16 physical commodities and the Financial Trends Indicator (FTI) composed of the 8 financial commodities.

All three of Trader Vics indicators use the same trading methodology (see page 12). If the monthly return of an individual commodity is above its 7-month moving average, the trading system goes long the commodity. Contrarily, if the monthly return is below its 7-month moving average, the commodity is shorted (except for energy which Vic is so bullish on that his system never shorts energy but just goes flat during negative trending periods). The objective of this trading system is to ride the trend of price momentum, going long when commodities are acting bullish and going short when commodities are acting bearish.

Long-Only Commodity Funds vs. Long/Short Managed Futures

Unlike long-only commodity funds, which only make money when commodities are rising in price, this long/short strategy is supposed to make money in all volatile market environments, whether commodity prices are going up or down. For example, during the 2008 financial meltdown, the long-only GSCI Commodity Index lost more than 46%, even worse than the S&P 500s 37% decline, whereas the DTI gained more than 8%:

Source: Bloomberg

Now thats what I call diversification!

The next year (2009), however, was a different story. The long-only commodity index rose more than 13% while the DTI fell 6%. The one weakness of the DTI is low volatility. If commodities rise in a slow, choppy manner, the DTI will underperform the long-only commodity index because the DTI will buy commodities just as they are topping out and sell commodities just in time for them to bounce back. But periodic underperformance is okay with me since all asset classes and trading systems underperform sometimes. The key is to find those asset classes with low correlations to stocks, and the DTI fits the bill better than the long-only commodity index (at least during deflationary environments).

Dont get me wrong: I think that both a DTI fund and a long-only commodity fund deserve a place in your portfolio. Both types of commodity funds will likely outperform stocks during volatile, inflationary periods.

WisdomTree Managed Futures ETF

With that introduction, lets go back to discussing the new WisdomTree Managed Futures ETF. It is based on Trader Vics DTI. As far as I know, not only is it the first managed futures ETF, but it is also the first exchange-traded fund (ETF or ETN) based on the DTI. There is an existing ETN based on Trader Vics CTI called the ELEMENTS S&P CTI Fund (NYSE: LSC) which is issued by the British bank HSBC Holdings (NYSE: HBC). but as an ETN it suffers from credit risk of HSBC.

In addition, although the LSC ETN doesnt pay a cash distribution, there is uncertainty whether investors in non-currency ETNs nonetheless have tax liabilities on the implied capital gains from rolling futures contracts. Until the IRS definitively rules, most fund companies are telling investors that no tax is due until they sell the ETN. If this tax interpretation turns out to be accurate, non-currency commodity ETNs have a tax advantage vis a vis commodity ETFs. That could be one reason why it has taken so long for a managed futures ETF to be launched. In the ETF format, where actual futures contracts are bought and sold and incur capital gains, tax is due prior to sale. WisdomTree says in its WDTI prospectus that taxes are a risk of ownership.

Commodity-Based ETFs May Be a Bust

As an aside, let me say that I am very disappointed in the performance of the first MLP ETF (NYSE: AMLP). which came out last August. Since its launch, it has significantly underperformed the MLP ETN (NYSE: AMJ) 8.8% to 15.5%:

Source: Bloomberg

In retrospect, my earlier enthusiasm for a MLP ETF was misplaced. Similar enthusiasm over the new managed futures ETF may similarly be misplaced.

CTI or DTI, That is the Question

Which is better to invest in, the DTI or the CTI? There is no right answer, although the CTI has significantly outperformed the DTI over the past seven years 98.5% to 48.3%:

Source: Bloomberg

This outperformance could be an anomaly or it could signify that physical commodities are more volatile and thus more conducive to a momentum trading strategy than are financial commodities. Regardless, both the CTI and the DTI have outperformed the S&P 500.

Mysterious Underperformance of the LSC ETN

If you are inclined toward investing in the CTI, keep in mind that LSC has mysteriously underperformed its CTI benchmark (Bloomberg: CTITR) since February 2010, whereas a traditional mutual fund version the Direxion Commodity Trends Strategy (DXCTX) has tracked the benchmark much more closely:

Source: Bloomberg

The only reason I can think of for LSCs tracking error is investor fear spawned by the European debt crisis that HSBC may default on its ETN obligation. If anyone has a better idea, please let me know.

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