Bank contagion fears on the heels of the collapse of Silicon Valley Bank, Signature Bank, and Silvergate Bank have prompted Moody’s Investor Service to downgrade the entirety of the U.S. banking sector from stable to negative. Market volatility continues as investors weigh this new element of risk in the Fed’s fight against inflation, an environment that the KFA Mount Lucas Index Strategy ETF (KMLM) could benefit in, given its global diversification and equal dollar weighting across global bonds, currencies, and commodities.
“Although the Department of the Treasury, Federal Reserve and FDIC announced that all depositors of SVB and Signature Bank will be made whole, the rapid and substantial decline in bank depositor and investor confidence precipitating this action starkly highlight risks in US banks’ asset-liability management (ALM) exacerbated by rapidly rising interest rates,” Moody’s wrote in their outlook update.
It remains to be seen how the Fed will respond to the bank failures; the creation of the Bank Term Funding Program will buy relief for many banks in the short term and could leave room for the Fed to continue rate hikes in the coming months. However, the collapse of SVB and the other banks are strong warning signals of the stress cracks spreading in the banking sector, and even if the Fed were to halt interest rate rises for now, quantitative tightening is still churning away in the background and likely to reduce funding for banks, which is a noteworthy risk according to Moody’s.
KMLM’s Diversification Could Mitigate Risk
Managed futures provided some outsized performance in 2022, a huge bonus on top of the non-correlated hedging opportunities the strategy can provide during times of increased volatility for portfolios. The KFA Mount Lucas Index Strategy ETF (KMLM) from KFAFunds, a KraneShares company, invests in futures contracts in commodities, currencies, and global bond markets.
KMLM’s benchmark is the KFA MLM Index, and the fund invests in commodity, currency, and global fixed income futures contracts. The underlying index uses a trend-following methodology and is a modified version of the MLM Index, which measures a portfolio containing currency, commodity, and global fixed income futures.
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. This means that when many CTA strategies were caught in a pain trade in the last week from short positions across any number of U.S. bonds, KMLM had just one allocation to the U.S. bond market, a short position in the 10-year note. It’s diversified across global bond markets and is also currently short on British, European, Canadian, and Japanese bonds, as of March 13, 2023.
The index and KMLM offer possible hedges for equity, bond, and commodity risk and have demonstrated a negative correlation to both equities and bonds in bull and bear markets. Investing in managed futures offers diversification for portfolios, 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. Currently, KMLM is long on sugar, soybeans, copper, cattle, the euro, and the Swiss franc and is short on all of its other holdings, which include commodities like natural gas, crude oil, wheat, gold; currencies like the yen and the pound; and all bonds the fund takes positions on as of March 13, 2023.
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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