The increasing correlation of everything has been a recurring market theme for much of the last two years. But the combination of a little-known Standard and Poor’s index and the Rydex Managed Futures Strategies Fund (RYMFX) delivers an investment that over more than 20 years of market history—and almost any period within that history—is pretty much uncorrelated with everything. And that includes the investment class it is named for, one of the most historically reliable portfolio diversifiers of all: actively managed, managed futures strategies.

RYMFX was launched in March 2007 aiming to replicate the performance of the S&P Diversified Trends Indicator, a long-short futures investment strategy based on 24 U.S. exchange-traded futures contracts, in 14 sectors, divided evenly among commodity and financial markets.

The DTI, like most actively managed futures strategies, is based on technical indicators and is “positioned each month ... based on price behavior relative to its moving average,” allowing it to capture profits in both up and down markets, according to an S&P white paper. Its extraordinary noncorrelation is a function of a design that, while implementing its market view through futures contracts, includes a package of rules that few, if any, managed futures advisor would follow:

• The deliberate 50/50 split between financial and commodity futures is rare, at least as a point of portfolio discipline. Leading ‘commodity trading advisors’ have long concentrated their portfolios in financial futures, including stocks, bonds and currencies.
• The DTI ‘trades’ only futures contracts that are listed on U.S. exchanges, although some, including currency markets, offer international exposure; most large, diversified CTAs trade markets worldwide.
• In a bid to minimize stock market correlation, DTI does not play stock index futures, which account for a material proportion—20 percent is not uncommon, sometimes more, depending on the strength of the trading signals—of large diversified active futures managers.
• It does not short the energy complex, because “no other sector is subject to the same continuous supply and concentration risk,” according to the white paper, although an alternative explanation is that energy proved a tough short in development and backtesting. (That does not mean it is always long energy: If a sell signal is issued, the DTI goes flat.)
• Finally, and perhaps most importantly, the index’s monthly rebalancing interval.

Active futures managers generally fall into two camps: short-term traders, who initiate positions expecting to be out of them within a week and merrily scalp intra-day moves; and long-term traders, who initiate positions hoping to hold them for at least several weeks, and often months, as trends play out.

The latter group is largely responsible for the industry’s overstated reputation for volatility. Risk management will kick them out of positions when inevitable corrections disrupt long-term trends; cutting, sometimes viciously, into profits.

Performance Charted
Because it’s still not possible to buy groceries with noncorrelation, Figure 1 shows the annual performance of two widely followed active managed futures indexes against the DTI and stock and bond benchmarks over the current market cycle, from 2000 through June 30, 2007. Both conventional managed futures benchmarks, Barclay Trading Group’s BTOP50 and the Credit Suisse-Tremont Managed Futures Index (see definitions below), clearly outperformed the S&P 500 during the 2000-2002 bear market, but have since underperformed.



And while the DTI has hardly blown any doors off, it has been profitable, avoided the stock market declines and shown a fraction of the volatility of the other benchmarks.

Correlation NonCorrelation
Long-term: Figure 2 shows the correlation of the same benchmarks since the pro-forma introduction of the BTOP50 on January 1, 1987, based on monthly data. (Most managed futures advisors report monthly; the CS-Tremont Managed Futures Index pro-forma start date is January 1, 1994.)



Ten years: Figure 3 shows the correlations over 10 years to June 30, 2007.



Recent history: Figure 4 shows the correlations since January 1, 2004, when live calculation of the DTI began.



The picture is clear. While the indexes of actively managed futures performance are historically uncorrelated with conventional investment benchmarks, they have become significantly correlated in recent years, surging to 0.60 over the last three years. Over the same period, the DTI’s correlation has moved from solidly negative, but is still barely positive; as well, its correlation with the active managed futures benchmarks is consistently in the 0.4-0.5 percent range.

Volatility And Performance

Figure 5 shows the standard deviation of annual returns over various time periods; historically, the DTI has exhibited barely half the volatility of the active managed futures indexes, although it has blipped up over the shortest period analyzed. It’s also worth noting that, despite managed futures’ reputation for volatility, both active benchmarks are less volatile than the S&P 500 over all time frames.
The data clearly confirms Rydex’s contention that the pro-forma risk-return profile of the DTI is more conservative than active managed futures investments.



Figure 6 shows annualized compound returns of the same periods as the volatility table. Much of the long-term advantage of the managed futures strategies is the result of a handful of highly successful years, most of them more than a decade ago in a much different market environment. As well, those strategies, demonstrating their capital protection attributes, have never experienced drawdowns of the size endured by the stock market in the 2000-02 time frame.



Implementing The Strategy
The Rydex Managed Futures Fund is structured as a plain vanilla mutual fund, with a $2,500 minimum investment, daily liquidity, subject to a 1 percent redemption fee on shares owned for less than 90 days, and a 1.65 percent expense ratio.

[Editor's Note: The RYMFX data page shows the minimum as $25,000; however, that is misleading, as it actually represents the minimum to open an account at Rydex].

According to the fund documents, the funds use “quantitative methods to construct a portfolio that correlates highly with the fund’s underlying benchmark,” and statistical techniques to determine the optimal asset mix. It “places particular emphasis on controlling risk relative to the underlying benchmark in order to maintain consistency and predictability.”

The fund implements much of its investment strategy not by trading the contracts underlying the benchmark index; instead, the bulk of its assets are invested in hybrid derivatives, such as commodity- and commodity-index-linked structured notes. The instruments are subject to both normal market risks, such as price fluctuations and liquidity, but add counterparty credit risk; while Rydex does not disclose the names of its counterparties, it only deals with those it believes to be creditworthy, according to the prospectus.

The use of structured notes allows Rydex to overcome the obstacles traditionally associated with offering managed futures exposure in a 1940 Act mutual fund format. Ed Egilinsky, who heads Rydex's alternative investment initiative, said that structured notes enable the fund to adhere to IRS requirements, which do not treat income derived from commodities-based futures contracts as “good income,” as well as other concerns, including the tax treatment of returns on futures contracts.

“The notes are fixed income instruments tied to the price return of the DTI. Our counterparties create the notes which mature in a year and a day, making the income eligible for long-term tax treatment.”

About one-third of the portfolio is invested in the structured products, with the balance in short-term Treasury instruments. “That's pretty analogous to a typical active managed futures portfolio that will have one-third of its assets in futures margin, and the rest in Treasuries. We get the managed futures return stream in a form that, for the purposes of a registered investment company, meets IRS requirements.”

Tracking Error
With barely five months' trading history, it’s a little too early to be making a call on how well the fund will track its benchmark over time. From inception, on March 5, 2007, through July 31, RYMFX has consistently outperformed, gaining 1.37 percent compared with the benchmark’s 1 percent.

That outperformance persisted in late July and early August, when severe whipsaws in global stock, currency and fixed-income markets hit many active managers hard; over that period, RYMFX lost 1.35 percent, compared with a drop of almost 1.6 percent in the DTI benchmark.

It’s almost a quarter century since the late Prof. John V. Lintner of Harvard University presented "The Potential Role of Managed Commodity-Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds" to what was then the Financial Analysts Federation. Its essential thesis, that the low correlation of managed futures to other investment classes both improved returns and reduced portfolio volatility, has rarely been disputed.

The challenge, especially for retail and mass affluent investors, has been gaining access to the strategy’s benefits in an inexpensive—in terms of both minimum investment and fee structure—and convenient investment vehicle. That happy day appears, at last, to have arrived.

NOTES

• RYMFX was launched as the Rydex Managed Futures Fund. The word "Strategies" was added recently.
• Apart from the figure for total assets, all performance and other RYMFX data is based on the H share class.