The recent collapse of First Republic Bank is likely to be the last of regional bank failures for now but the underlying stress continues for smaller banks as the Fed eyes another rate hike this month and the real threat of commercial real estate loan defaults this year continues to loom for regional banks that carry the bulk of these loans within the banking sector. Managed futures strategies were caught off guard this year by the sudden banking collapse and reverse of the inflation trade but historically have performed strongly during times of economic and market stress.
The underlying index for the KFA Mount Lucas Managed Futures Index Strategy ETF (KMLM) has weathered many crises in the last 35 years, including banking crises, which KFA Funds (the sub-advisors for the fund) reviewed in a recent paper. In the first quarter, even with banking crisis, KMLM was down just -3.2% when many other managed futures strategies had more significant drawdowns.
“Managed Futures strategies generally tend to do better during extended periods of market volatility and economic stress, as it owns the investment premium associated with accepting price risk in the futures markets,” the authors wrote.
Crises in Focus: War in 2022 and the Pandemic
Image source: KFA Funds
2022 is an excellent case in point of how strongly the strategy can perform during prolonged volatility. KMLM benefited from long positions in commodities in the first half of the year, particularly in the wake of Russia’s invasion of Ukraine and the constriction that happened for many commodities already struggling with pandemic supply chain woes, including grains and oil. The rising strength of the U.S. dollar as the Fed began its aggressive rate hiking regime heavily impacted both the dollar and the global bond market in the third quarter, which KMLM capitalized on before falling marginally in the final quarter as dollar strength leveled out.
At the beginning of 2020, the KFA MLM Index, the underlying index that KMLM seeks to track, was short energy because of price declines that began in January.
“As the pandemic escalated in late February, these energy positions provided significant diversification for the Index. Meanwhile, the flight to safety led to lower foreign futures prices and higher bond prices, where the Index was well-positioned,” the authors explained.
The response of fiscal stimulus and monetary support reversed many of these trends in Q2 and the fund ended the year with “modest” performance but provided strong diversification during the most intensely stressful economic and market periods of the pandemic.
Fed Tightening in 2018 and the Global Financial Crisis
The KFA MLM Index was long the dollar at the beginning of the Federal Reserve’s quantitative tightening in October, 2018, and was also long energy, while short all other commodities and a mixture of long and short positions in global bonds. By December, the index was short all commodities and long the dollar and global bonds, and offered stable, flat performance while the S&P 500 suffered a drawdown of almost 20%.
Image source: KFA Funds
Surging energy prices in the summer of 2008 meant the KFA MLM Index went into the fall in “an unfavorable position” but shifted to be long the dollar and bonds by September.
“Although commodities, especially energy markets, were starting to develop some short positions, this trend accelerated towards the end of the month,” the authors wrote. “When markets collapsed in the fourth quarter, the Index was well-positioned to benefit from the resulting ‘crisis flows.’”
Managed Futures as Crisis Diversifiers
The KFA Mount Lucas Index Strategy ETF (KMLM) from KFAFunds, a KraneShares company, invests in futures contracts in commodities, currencies, and global bond markets and has offered diversification and performance during many notable crises historically.
KMLM’s benchmark is the KFA MLM Index, which uses a trend-following methodology and is a modified version of the MLM Index. The index weights the three different futures contract types by their relative historical volatility, and within each type of futures contract, the underlying markets are equal dollar-weighted.
The index and KMLM have demonstrated a negative correlation to both equities and bonds in bull and bear markets. Investing in managed futures offers diversification for portfolios by their ability to invest long and short on asset classes, and carrying them within a portfolio can potentially help mitigate losses during market volatility and sinking prices.
Futures contracts in the index include 11 commodities, six currencies, and five global bond markets, and will be rolled forward on a market-by-market basis as they near expiration.
The index evaluates the trading signals of markets every day, rebalances on the first day of each month, invests in securities with maturities of up to 12 months, and expects to invest in ETFs to gain exposure to debt instruments.
KMLM carries an expense ratio of 0.92%.
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