Lee Munson, an adviser at Albuquerque, New Mexico-based Portfolio LLC, said MLPs are the “secret sauce” of his clients’ portfolios and he invests around 10 to 25 percent of an average portfolio in the assets. But he also preaches caution. “Everyone is talking about them but this is a tiny market and it’s misunderstood,” he said. Munson recommends sticking to large cap offerings as smaller partnerships can be volatile and are more likely to cut their distributions.

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IPOs With Brand Recognition – Familiar Names Like Skype, GM Stir Emotions but Carry Risks, Say Advisers

A few months ago, Morningstar published an unenlightening article. This article had little to say about the difficulties that arise for the managers of a fund to actually track an index such as the one this fund tracks, the S&P Diversified Trends Indicator (S&P DTI). The S&P DTI is a long-short momentum strategy that takes advantage of the trending and cyclical nature of commodities and currencies. This report is our response to the mediocrity Morningstar spits out each day.

The Allure of Managed Futures: Diversification Through Commodity Exposure

In the last five to ten years, commodities have been touted by academics as the place to find investments that don’t correlate to equities. And these theories have worked well. However, we should recognize these recommendations are reminiscent of the academic theories in the ‘90s that argued for global markets as the place to go to find non-correlating assets. Since then, the global stock markets have begun to correlate almost completely with American markets. As more investors put portions of their portfolios in global markets, these markets stopped being an effective means of diversification.

More recently, large institutions and individual investors have allocated a portion of their portfolios in commodities in order to find those elusive non-correlating assets. Unlike international stock markets and U.S. stock markets, however, commodities are a completely different asset class from equities. For this reason, there is less likelihood that they will start correlating as global markets have. However, investors should be cautioned that the theories that recommend investing in commodities are based on data from a time before investors used commodities to diversify. Since then, the playing field has changed. Because large institutions and individual investors are now participating in the commodities field, the game is different and unpredictable. Commodities as a way to diversify a portfolio is a history not yet written.

In addition, at the moment, commodities futures face a difficult case of contango. In a normal futures market scenario, the further out the futures contract the speculator is buying, the cheaper it will be. This discount is due to the time value of money and the cost to store a commodity. Sometimes futures contracts get turned around, however, into a situation known as contango. This is the general case in commodities markets today. Contango is when futures contracts are more expensive the longer you go out. It can happen for a variety of reasons, but all evidence points to new financial inflows.

Rydex’s Managed Futures Fund does provide exposure to these alluring commodity markets. But it also faces its own difficulties in tracking the S&P DTI. On June 9, we were able to ask Ryan Harder, the manager of the fund, about these challenges.

The Management Team

Before discussing the limitations faced by RYMFX, we want to say that we were impressed by Ryan Harder. To begin with, we asked him a question that very few people in the industry understand or want to answer: if we have a 60/40 mix between stocks and bonds, how does RYMFX fit into it? He gave a solid and immediate answer: right in the middle, 50/50. So now we have a general idea how to weight the fund in a portfolio.

We were pleased and impressed by his answer. The industry has been plagued by general ignorance, improper expectation of return, and reliance on dubious academic research by non-professional investors. Again, Morningstar does nothing to address this issue and the industry simply touts how “unique” and “alternative” these products are.

Flattened Performance Compared to Index

The big picture when it comes to Managed Futures Funds is: don’t be first! The problem is that size matters. Smaller funds are forced to use structured notes for their futures trades. A larger fund like RYMFX is able to invest in the actual futures most of the time.

Harder’s management team adds value in two ways. First, by investing spare cash in 9-month agency paper instead of the short term t-bill the index holds—that make essentially no return—the fund adds an additional 40-50 basis points. Second, because of the nature of trading futures based on a trend-following index, when the index is not performing well, they are able to generate extra alpha. During times when there are more signal switches, Harder is able to able to add extra value to his fund over the index. Since he is trading futures, he is limited on how closely he can follow the index. For instance, it is illegal to place too many buy orders on an illiquid commodity like cattle at the end of the day. But Harder is able to place his buys and sells carefully to generate more return. Thus, his ability to trade with discretion during signal switches adds value. However, on the converse side, when the futures are trending and the index is performing well, Harder’s fund loses alpha because of the fund’s expenses and lack of signal switches. Over time, the difference between the fund and the index is small. When an investor is impressed by the performance of an index, and then sees the underperformance of a fund tracking it (especially one he owns), he’s not going to be pleased. However, in the case of Rydex Managed Futures, investors should realize that over the long run, the fund and the index have balanced out. This is another case of how humans are useful tools in finance.

Costs

Onto the reason for RYMFX’s overall underperformance versus the S&P DTI—in one word, costs. The fund has an expense ratio of 2.05%. It suffers from these high costs for several reasons: expenses of trading commodities, especially futures, and the necessity of using structured notes because of the fund’s size.

Trading commodities involves expenses that normal stock trading does not. When investors are looking for investment opportunities, they often look to simple performance numbers and expense ratios. Because futures trading involves expenses beyond those of buying stocks, immediately the expense ratio of this fund seems high. One of the ways in which RYMFX trades is through a Cayman Islands subsidiary that we have written about before (http://www.portfoliollc.com/rymfx-rydex-managed-futures-strategy-fund). Though some such vehicles are necessary for a Managed Futures Fund, they always come with additional expense.

Even discounting the additional expenses involved in commodities trading, the RYMFX funds run high, largely due to their use of structured notes. It is not that RYMFX is inefficient in its use of structured notes, but simply that structured notes are an inefficient means of investing. For theirs, Rydex uses three different counterparties: JP Morgan and two European banks. Harder’s management team takes care to ensure the best value on these notes. However, using structured notes means that the fund has additional costs. If the fund were larger, it would be able to actually purchase the underlying futures contracts and avoid these costs. To be fair, the use of structured notes has declined substantially over the past few years.

Capacity

Since we have entered the brave new world of commodities mutual funds at an incredible rate, how big could it get? When we asked Harder, he said that he thought about three times bigger, or around ten billion dollars in assets. But, he said that a few years ago he thought he would be too big at six billion, so the fund might be able to expand to be larger than ten billion. It seems we will only know when we get there.

One of the major concerns for a larger fund that tracks an index would be front running. Harder isn’t too concerned about the possibility, however, because of the liquidity of financial futures, and his ability to spread out transactions over several days to ensure the best prices for investors.

One Last Word

On a general note about Rydex’s management of their funds, let us look at their Long/Short Commodities fund that tracks the JP Morgan C-IGAR Index. JP Morgan builds 90 basis points of drag into this index. This means that the index itself includes nearly a whole percent for transaction charges—or that when comparing a fund to the C-IGAR index, a full percent of the fund’s expenses do not show up when comparing its performance to the index, because they have already been built into the index. Rydex asked JP Morgan to take the 90 basis points of drag back out of the C-IGAR Index. While we find this impressive, if no one is aware of the drag that is built in or that Rydex excludes it, it doesn’t do anyone a lot of good. The bottom line is that, while Harder has a handle on his fund, few on the advising side know what to do with it.

Sources:

http://quote.morningstar.com/fund/f.aspx?t=rymfx

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Part II