Managed Futures ETFs: You Are Being Paid to Absorb Somebody Else's Risk

Almost every explanation of trend following starts with the trend, which is the wrong end. It leads to the obvious objection, that a strategy which buys what has gone up and sells what has gone down cannot possibly work for a durable reason, and the objection is hard to answer from inside that framing.

Jerry Prior of Mount Lucas, who runs an index that has been doing this for four decades, answers it from the other end. The return does not come from predicting anything. It comes from standing on the far side of a transfer that somebody else genuinely needs to make.

That framing is the reason this category deserves a serious look, and it is also the reason the honest version of the pitch is narrower than the marketing.

The trade at the bottom of it

Futures markets exist because producers and consumers of real things need to remove uncertainty from their businesses. A farmer, a miner, an airline, a manufacturer. Prior described the position they are in: the people who "harvest it and sell it face real risks to their margins, to their businesses" from the price moving against them between now and delivery.

They sell that risk. Somebody buys it. Prior’s firm sits on the "other side of that risk transfer. We’re systematically owning price risks through time," and in his description the practical way "that accepting price risk through time is through trend following."

Read that way, the return is a risk premium rather than a forecast. The hedger pays to be certain. The speculator is compensated for being uncertain. Trend following is the systematic method for occupying that seat across many markets at once.

You do not have to accept the theory to use the strategy, but it is worth knowing which theory you are relying on, because it tells you what would have to be true for the return to stop existing.

What the fund actually holds

Open a managed futures ETF and you will find something that looks nothing like an equity fund.

Paisley Nardini, then of Simplify, described the assets: "the underlying collateral for managed futures is often treasury bills," which means "T-bill collateral returns and yield is your starting point." The fund’s cash sits in short-term government paper and earns the short rate, which is the base return before the strategy does anything at all.

On top of that sit the futures positions. Because a futures contract requires only margin rather than full payment, the exposure is much larger than the money posted. Nardini was direct about it: "the underlying notional exposure that we’re achieving in this strategy is far greater" "than the margin that we have to post as collateral," and so "there is embedded leverage and just investing in futures contracts, of course."

That embedded leverage is a feature rather than an accident. It is what lets a fund hold meaningful exposure to thirty or forty markets while its actual assets earn interest, and it is also why the risk of the strategy is managed by position sizing rather than by how much cash is deployed.

The shape of the returns

The single most useful thing to understand before buying one of these is what the return distribution looks like, because it does not resemble anything else in a portfolio.

Jerry Parker of Chesapeake Capital, one of the original Turtle traders and a forty-year practitioner, described it in a way that is worth taking literally. Across many markets, "five to 10% of the trades will be a big mega outlier." Everything else is "taking small losses all the time, habitually just taking small losses and letting those profits run."

So the strategy is wrong most of the time by design. It pays for a long series of small, cheap errors with a handful of very large wins. Parker’s stated fear reveals the priority: "There’s nothing worse than missing the trend for a trend follower."

The mechanics that produce that shape are the stops. Parker: "we have predetermined stop losses" on each trade, and when a position works, "a trend begins and takes off. And then the trailing stop will move above that stop loss." The initial stop caps the small loss. The trailing stop is what lets the rare win run without giving it all back.

If you hold this strategy and check it monthly, you will spend most months looking at small losses. That is the strategy working, and it is the single most common reason investors sell it at exactly the wrong time.

The category is more uniform than the marketing

There are many managed futures funds and the differentiation between them is thinner than the brochures suggest.

Prior, describing his competitors without any particular edge in his voice: "Everybody’s doing a trend following in some sort of way."

Where they genuinely differ is in how they size risk. The industry standard technique is volatility targeting, in which the fund adjusts position sizes to keep the portfolio’s expected volatility roughly constant. Prior described managers holding "a constant vol target among all the constituents that they trade in," and then argued against it directly, calling the practice counter to what drives returns in trend following, because the manager captures the diversification benefit inside his own portfolio rather than delivering it to the client’s asset allocation. He softened it afterward, saying "that’s what happens with vol targeting. It’s not wrong," which is a fair summary of a technique that trades one thing away to buy another.

The consequence is that vol targeting cuts position size after volatility rises, which is often after a market has already moved sharply. It reduces the depth of drawdowns and it can also reduce participation in exactly the violent moves the strategy is supposed to capture. Two funds with the same signals and different vol targets are meaningfully different products.

Why the wrapper matters here more than usual

Managed futures lived in hedge funds and managed accounts for decades. The move into an ETF changes two things that matter.

The first is cost. Andrew Beer of Dynamic Beta investments, sub-adviser to the iMGP DBi Managed Futures Strategy ETF, was blunt about what the strategy used to cost, noting the "funds who do this and they charge hedge fund fees. It’s, you know, one in 20," meaning a one percent management fee and twenty percent of profits. Prior described the same migration, taking "the managed futures product sort of outside the SMA and the hedge fund world into the ETF world."

The second is transparency. Beer’s point is that you can see the book: an investor should be able to look "at 10 futures contracts. And so you want to know how much we are long non-US developed" equity, or short a particular currency, on any given day. A hedge fund tells you a number once a month. The fund publishes positions.

There is one structural quirk worth knowing. Commodity futures gains are not qualifying income for a registered fund in the ordinary way, so funds that want that exposure route it through a subsidiary. Brett Eichenberger of Cohen & Company described the arrangement from the audit side: "if you’re in a commodity ETF and you want exposure to different futures contracts, you’d have to do those within your controlled foreign corporation." It is standard, it is disclosed, and it is the reason a managed futures fund’s structure section reads oddly.

When it works, and when it does not

Prior gave both halves without being asked. On the favourable regime: "when trend following works, well, we work best when markets are more volatile." On the unfavourable one, he acknowledged "periods of time where trend following doesn’t work," which is a plain description of a strategy that requires persistent directional moves and receives nothing in a market that chops sideways.

The reason to hold it anyway is what it does when other things fail. Meb Faber of Cambria put the allocator’s case in one sentence: "trend following to us is really the premier diversifier to a traditional portfolio, particularly during the bad times."

That is the whole argument, and it is a specific one. The claim is not that this beats equities. It is that it tends to make money in the long, grinding declines where a stock and bond portfolio does not, because sustained declines are trends and this strategy is built to follow them.

What to check

The vol target and how it is applied. It is the largest differentiator between funds running similar signals.

The market set. How many markets, and which. A fund trading sixty markets across four asset classes behaves differently from one trading twenty equity index futures.

The collateral yield. In a high short-rate environment a meaningful share of the return is T-bill interest, and that portion will disappear if rates fall.

Your own tolerance for looking wrong. Small losses, most months, punctuated by occasional very large gains. If that pattern would make you sell in month eight, the strategy will not work for you regardless of how well it is built.

This is educational content and not investment advice. It is not a recommendation regarding any security. Investing involves risk, including possible loss of principal. Past performance does not guarantee future results.