By Kathryn M. Kaminski and Scott M. Sample, AlphaSimplex: Renewed interest in managed futures has been stoked by a series of disruptive events beginning with the COVID-19 pandemic, subsequent rising inflation, and geopolitical tensions, to name a few. Additional proof points for systematic trend funds’ diversification potential were particularly clear in 2022. During this period, increasingly seasoned track records were punctuated by a +17% average return as stock and bond indices declined by double digits. Product development and innovation have continued to accelerate alongside demand aided by regulatory tailwinds set in motion just a few years prior. Assets within systematic trend ETFs rose more than six-fold to just under $1.5 billion in the three years ending 12/31/23.^[1]

Critical to the recent innovation and accelerated adoption of alternative ETFs are two SEC rules, often referred to as the “ETF rule” and the “Derivatives rule”, which lowered the barriers of entry for bringing new ETFs to market.^[2] These rules created a more consistent and transparent regulatory framework, particularly as it relates to the utilization of derivatives within ETFs. The “ETF rule” and “Derivatives rule” were passed to help facilitate greater competition and innovation within the industry and the corresponding impact on the alternative ETF market since has been profound. In the five years ending December 31, 2023, the number of ETFs within Morningstar’s Alternative and Non-Traditional Equity category groups grew from seventy-seven ETFs representing $5.7 billion in assets to three hundred eighty representing just under $140 billion in assets.

Managed Futures ETFs: The Next Phase

One of the key advantages of public funds is their transparency, regulation, and access to a wider range of investors. ETFs provide a convenient access point for accessing fund investments in a daily liquid vehicle similar to a mutual fund. As a result they have several common use cases for both retail and institutional investors. Common use cases for Managed Futures ETFs are described below. 

Direct Investment in Managed Futures

Similar to Managed Futures mutual funds, ETFs provide comparable returns with an often simplified approach. Daily liquidity and ease of trading in ETFs provide a simple method to access Managed Futures returns and index tracking or replication strategies are one emergent trend amongst recent ETF launches within the liquid alternatives space.

When investing in managed futures products, it is important to recognize the dispersion of returns, which suggests potential benefits to taking a targeted approach to single-manager selection. Simply tracking the index or peer group may prove more appealing for those looking to target the broad characteristics of the space while seeking to limit the risk of a single manager failing to deliver upon expectations. 

Interestingly, managed futures index replication may be particularly well suited to the ETF vehicle structure because of the simplified set of markets typically utilized in the approach.^[3] Flagship mutual funds or LP offerings of prominent managers in the space often feature dozens or even hundreds of markets. Replication strategies, on the other hand, more commonly feature only one or two dozen markets across the core asset classes. A highly differentiated opportunity set is a potential source of alpha and return dispersion amongst the private fund managers, but the more modest basket of instruments associated with index tracking can help ETF market makers keep spreads tight and reduce transaction costs for investors, particularly in the formative stages of an ETF as it seeks to increase in size and trading volume. 

Model Portfolios: Diversification with Lower Fees

Model portfolios represent an important source of asset growth for alternative ETFs. Looking at the U.S. model portfolio universe under Morningstar’s coverage, AUM recently increased to $424 billion as of June 2023, up from $286 billion in June 2021. In addition to streamlining the investment process and providing a more consistent client experience, reduced costs are 

a sometimes-overlooked benefit for advisors that choose to adopt model portfolios. According to Morningstar, the average allocation model was 17bps less per annum than the cheapest share class of allocation category mutual funds.^[4]   

ETFs tend to have lower fees than mutual funds and provide index-like returns which can easily be incorporated into model portfolios that have an allocation to alternative investment categories. For example, while the average net expense ratio for the Systematic Trend category (which includes mutual funds and ETFs) has declined to 1.62%, the average ETF expense ratio is 0.85%. Alongside the industry trend of increasing model portfolio adoption so too has the opportunity set increased for alternatives within models for advisors looking to outsource this more complex corner of the portfolio construction process.

Liquidity and Portfolio Completion

Although many think that ETFs are a retail-specific product, there are a surprising number of institutions who are adopting the use of ETFs in their portfolios. Why is this the case? For many institutional investors, mutual fund investment is not a common access point due to their fee structures and approval processes. In addition, many institutions are already accessing the space via funds of one, co-mingled funds, or separately managed accounts. These access points are fee efficient, but they require more complex subscription and redemption processes for changing allocations with individual managers. As a result, a liquid ETF product can provide a method for building a liquidity buffer that can easily be adjusted daily. This can be a method for portfolio completion and allow a full allocation of capital with flexibility. This specific use case demonstrates why ETFs are also of interest to institutions as a portfolio completion and liquidity tool in addition to their uptake by retail investors.

The Evolving Managed Futures Ecosystem

Kaminski and Sample (2024) highlights the growth of the managed futures space as new products and vehicles begin to expand outside the private fund space. The U.S. ’40 Act space also provides a roadmap of possibilities for evolution in the newly growing managed futures ETF space. As more investors have access to diversifying returns, they will also have more tools and access points for building portfolios that include an allocation to alternative investments such as managed futures.