Tim Pickering on Managed Futures, Part 2

Here’s part two of my interview with Tim Pickering, president of Auspice Capital Advisors, who manages both the Horizons Auspice Managed Futures Index ETF (HMF) and the iShares Broad Commodity Index Fund (CBR). You can read part one here.

Managed futures has traditionally been a hedge fund strategy, used mostly by institutions. Can it really be adapted for the retail ETF investor?

TP: All we’ve done at Auspice is said, this is what we do in our alpha program. It’s been around, it’s got a great history. So what are we are willing to make transparent by putting it in an index? How far are we willing to lift the kimono? Can we do that with an ETF-like price? We started talking about that years ago and people thought we were out of our minds. Nobody has done this before, and we are definitely getting a lot of eyebrow raising—that’s a polite way of putting it.

When it became known that we were publishing these broad commodities and managed futures indexes, I got a call from the CEO of a major company in Canada that has a managed futures program. He said, “Tim, you are about to wreck the managed futures space in Canada,” because of these indices, and because you can get them with a 95-basis-point ETF. And I said, hold on a second. First of all, what managed futures space in Canada? Nobody even knows about this in Canada. It’s the number-one alternative strategy in the world, and nobody uses it in Canada. And second, if you are good at generating alpha for fair price, then you’re fine—the ETF is not going to hurt you. But if you’re just expensive beta, or if you’re overpriced and underperforming, then you’re screwed. And whether I do it or someone else does it, this is the evolution of markets.

The Horizons Auspice Managed Futures ETF (HMF) is an index fund. Does that mean all of this is done quantitatively, without any hunches or intuition from the manager?

TP: Exactly. Hunches and intuition are for amateurs. We follow a three-step process and each of the those steps can be quantified and replicated, and they’re published in the index methodology.

The first is the trend following algorithm, where we look across all of these 21 positions and identify whether the market is going up or down. Then we decide whether to participate in the market, and do we go long or short.

Step two is position sizing and rebalancing, based on volatility. Once we know whether the market is going up or down, the question is how big do you trade, and when do you adjust that position size. Then we normalize the risk across all of those assets: we want to take the same dollar risk in natural gas as we do in five-year notes, and cotton, and all of these other things.

Going forward in time the risk of those assets changes, because the volatility doesn’t stay static. So let’s say we put on natural gas and it starts to trend up, and volatility goes from 30% to 50%. A month later when we look at it, we need to make a decision on that position size: should we adjust it? If it meets the threshold we use, then we rebalance that position back to where it was. The index calls for this on a monthly basis.

Finally, the third step is rolling the futures contracts. We look at the forward curve and we say, is there a more intelligent decision we can make than simply rolling month-to-month? That’s always a decision we have to be dynamic about: where we want to be on the forward curve based on the risk-reward in the market. We have a process and methodology that we follow, and I don’t need to be staring at a screen to do it: we’ve taken our experience and programmed it, so we are consistent about it, and when it comes to executing we can do it systematically so we don’t mess it up.

The iShares Broad Commodities ETF (CBR) uses the same strategy, but instead of trading commodities and financial futures long and short, we just trade the commodities long. If the trend is going up, we go along, and if the trend is going down, we go to cash. Otherwise the three steps are the same.

One of the problems with ETFs like this is that they may not track their indexes well because of fees and transaction costs. Will we be able to measure the tracking error reliably?

TP: Yes, absolutely. Because the step we made at Auspice—why that CEO was ticked off at me—is that we published the index. You can download it from Bloomberg or Reuters and get your numbers daily, and see the holdings and the movement of that index. And HMF should follow that quite closely, keeping in mind that the fee is 95 basis points.

One of the interesting things about what we do is that this is not a very active strategy. We are taking a medium- to long-term trend following approach, so there’s not a ton of trading. And because we position ourselves on the futures forward curve that also eliminates transaction costs: by positioning ourselves properly we don’t have to overtrade. For example, I could trade every month in natural gas, or I can just put myself in January, April, and December. So not only are we not trading a lot, by just being long and short, we are positioning ourselves to eliminate some of that transactional aspect.

Futures are also great because they are so cost-effective: it costs me a couple of bucks to round-turn futures. The thing that can cause deviation is slippage: you go to buy crude at $80 and by the time I execute it, it’s $80.50. That’s a risk, and that’s where we have been hired to do our best job. We have been hired for that execution ability as well: hopefully we are good at that.

The other part of the equation for HMF is this: because of the leveraged ability in futures, I only have to put a certain amount on margin, and the rest is in cash. Most of that money in cash—that 90% to 95%—is earning a return. Not a lot in this environment, but 100, 120, or 130 basis points.