3 ETF Pair Trades For Risk-Adjusted Futures Profits

by: Efficient Alpha

This is part of a series written exploring the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling. For an introduction to the series and the book, see our previous article looking at the return drivers for stocks.

By Joseph Hogue, CFA

Futures trading is where the author makes his bread-and-butter, so it’s no surprise that Myth #12 (Futures Trading Is Risky) is argued particularly strongly. The chapter compares the returns earned by the BTOP 50 managed futures index, a composite index of commodity trading advisors (CTAs), against the total return index for the S&P500 to study the relative riskiness of stocks versus futures investing.

What Are Futures?

Futures are contracts to buy or sell an asset some time in the future. Because they derive their value directly from the price and volatility characteristics of the underlying asset, they are called derivatives. A large part of the futures market is trading by farmers arranging to lock in prices for their crops. Companies use futures as well to hedge costs of their raw materials like oil and agricultural commodities.

When an investor buys a futures contract, they are buying or selling from a clearing house counterparty managed by the exchange. This eliminates the risk that the other side to your futures trade will not deliver on the contract. You must deposit a marginal amount in your account to initiate the trade and the account value is updated daily according to the investment value.

Futures, like most derivative instruments, have a reputation for being risky. The riskiness in futures comes from the ability to use leverage at levels unimaginable in the equity market. Leverage, the amount of borrowing available in investing, for silver and gold futures was recently revised to 8:1 and 20:1 respectively. This means that you only need $5,000 to buy $100,000 worth of gold futures. Conversely, to buy $100,000 worth of the SPDR Gold Shares (NYSEARCA:GLD) in the equity market, you would need to put down at least $50,000 for a leverage ratio of 2:1 times. A high amount of leverage in the futures market works spectacularly when the market goes your way. Imagine a 5% upside move being multiplied to a 100% profit because of 20:1 leverage.

The problem, of course, is that the market doesn’t always go your way and that 5% could mean the total loss of your capital. These large losses, according to the book, “from the abuse of leverage are the primary reason that (futures) appear riskier than stocks.” In reality, it’s not the investment that is risky but the investor’s irresponsible use of leverage. Hate the player, don’t hate the game.

The diversifying power behind futures, and managed futures investments, is the variety of return drivers within the strategies. The futures market allows investors exposure to trading systems based on trends, fundamental supply-demand factors, market sentiment, seasonality and arbitrage events.

The BTOP 50 managed futures index represents the trading of futures strategies across global equities markets: Currencies, interest rates and metals, energy and other commodities. The table below presents the return and volatility characteristics of the managed futures index versus those of the equity index, using the S&P 500 over the last 24 years. Though the average annual returns for the two indexes are almost identical, the risk-adjusted return of the BTOP is dramatically higher. Using volatility of returns is not as common for derivatives because of statistical idiosyncrasies, so we normally look at maximum drawdown which is the greatest loss from peak to trough. Here the difference is even more dramatic with the S&P index losing more than half its value in one downtrend while the most the BTOP has dropped is 13%.

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Futures Exposure Without The Futures Market

Though only "accredited investors" are allowed to open investment accounts with commodity trading advisors, anyone can open an account for futures trading. Most of the popular online investment platforms like E*Trade now allow futures trading or your broker can help open an account. Start with a small portion of your overall portfolio and do not abuse leverage. The Action Strategies section within the book explores some ideas on developing trading strategies within the futures market. It’s a different market but so were equities at one point, so spend a little time learning about your options and start small. Investors limiting themselves only to equities and fixed-income are limiting themselves to lower returns and higher portfolio volatility.

Investors can gain exposure to the class of managed futures through exchange traded funds like the WisdomTree Managed Futures Fund (NYSEARCA:WDTI) and the iShares Diversified Alternatives Trust (NYSEARCA:ALT-OLD). The WisdomTree fund invests in a combination of commodity and currency futures along with treasuries and money market instruments to provide a total return regardless of the direction in the general market. The iShares Diversified Alternatives Trust makes long and short investments in futures and forward contracts to maximize absolute returns. The fund does not seek to track any particular index or benchmark.

Three Pair Trades For Risk-Adjusted Returns

Three of my favorite futures trading strategies are also available through ETFs. Using the funds below to replicate the strategies will incur management fees and usually won’t perform as well as the strategy’s performance in the futures market. Despite being futures-linked funds, there is still an element of correlation with equities when dealing with ETFs.

The price of oil and natural gas are linked through macroeconomic and scientific forces. Demand for energy drives both commodities and many users of oil can, with some cost outlay, switch production to natural gas. They are not perfect substitutes, but they can be substituted. Through modern production, oil is converted to energy about six times more efficiently than natural gas. This combined with other factors contributes to oil’s price being historically about 10-15 times that of natural gas. Because of higher seasonality in natural gas prices, this relationship often breaks down just before temperatures plummet in the winter. Much of this could be attributable to greater uncertainty in nat gas demand from the winter heating months. Currently, the relationship is at 29.8 times ($100.74 for Nymex Crude and $3.38 for Nymex Henry Hub Nat Gas) which is a little high but not too far off from normal this time of year.

I usually wait until around December 1 to make the trade. If the price ratio is above 30 times and cold fronts have not slammed the U.S. yet, I will open up a short position in oil and go long in natural gas. The trade has worked well in the past if you can hold on to it until around mid-February.

United States Oil (NYSEARCA:USO) is an ETF that reflects the price performance of West Texas Intermediate (WTI) light, sweet crude. The fund invests in futures contracts for crude oil and other types of petroleum-based fuels. The fund may invest in natural gas futures, so the strategy will not perform as exactly as direct exposure into the futures market. As an ETF, it can be sold short just like any stock or futures contract. The fund is up 8.3% over the last 12 months but has been volatile lately due to global economic headlines.

United States Natural Gas (NYSEARCA:UNG) is an ETF that reflects the price performance of the near-month contract for natural gas through the NYMEX futures market. Investors looking to bet on the price relationship would buy the UNG while selling the USO short. The fund is down 32.8% over the past 12 months due to higher supplies of natural gas.

The strategy has dramatically outperformed the S&P 500 since 2007 but investors should wait for those years in which the spread is particularly high. Returns for 2007 through 2010 for the strategy were: 11.1%, 2.9%, 12.3%, and -3.1% respectively while returns for the S&P 500 during the same periods were: -8.0%, 1.6%, -0.9%, and 10.5% respectively. The cumulative returns for the strategy over the four years were 24.4% versus 1.3% for the general market. The data is limited by the relatively new natural gas fund and returns may differ depending on exact timing of entry and exit points.

The PowerShares DB Agriculture (NYSEARCA:DBA) has outperformed the S&P 500 by about 6.6% over the last year and by 35.1% over the last five. The fund tracks the Deutsche Bank Liquid Commodity Index – Optimum Yield Agriculture Excess Return and is intended to reflect the performance of the agricultural sector. The PowerShares DB Commodity Index (NYSEARCA:DBC) has outperformed the S&P 500 by 8.2% over the last year and by 24.8% over the last five. The fund tracks a similar Deutsche Bank index, but one diversified over a wider universe of commodities.

This trade is largely a global industrial production strategy, and China-related. China’s GDP has been trending weaker over the last few quarters and may need to slow its feverish importation of industrial commodities. This, combined with slower growth in developed markets, could make for strong headwinds on industrial commodities like copper and lead. Despite slowing economic growth, consumer demand for agricultural commodities in the emerging markets could remain strong. China has made it an explicit goal of supporting the growing middle class. This increases meat consumption, which uses more grain to produce. Investing in the agricultural commodities while hedging with a short in the industrial commodities will allow investors to benefit from global growth but remove some economic volatility from the trade.

I have always liked using spreads in commodity investing. Due to substitution across many agricultural commodities, certain relationships have borne out over time. One of these price relationships is that of corn and wheat. Corn, because it is used more widely as a livestock feed, historically trades for less than wheat on the futures market. Currently, the prices per bushel are close to par with corn selling for $646 and wheat selling for $634. Depending on political events or weather-related problems in producing countries, the relationship can break down dramatically. When this happens, investors should take a long position in the weak commodity and a short position in the strong commodity.

The Teucrium Corn ETF (NYSEARCA:CORN) replicates prices in the commodity by trading in three futures contracts on the Chicago Board of Trade (CBOT). The fund devotes about two-thirds of its assets to the 2nd and 3rd contracts to expire and the rest to the next December contract. The fund has advanced 21.3% over the last 12 months.

The Teucrium Wheat fund (NYSEARCA:WEAT) replicates wheat futures prices in the same way as the corn fund. However the wheat fund may also trade in the Kansas City Board of Trade or the Minneapolis Grain Exchange. The fund opened this year on September 21st and is down 6.9% since that date.

While a certain amount of hesitancy in futures trading is understandable, look for more research on the markets and gradually reallocate some of your investments. Stocks and bonds will still probably command the largest percentage of your portfolio, but futures can provide the kind of diversification in return drivers not available through a simple two-asset class strategy. Visit our website for a complete list of articles in the series and trading strategies to diversify your portfolio across return drivers.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. Efficient Alpha has been contracted to describe strategies and concepts used within the book but not to promote or recommend any strategies, the author, or the author's services.

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