WisdomTree

Alternative, Liquid Alternative, Managed Futures

The WisdomTree Managed Futures Index: An Introduction

by Jeremy Schwartz, Director of Research on July 1, 2016

As of July 1, the WisdomTree Managed Futures Strategy Fund (WDTI) began tracking a new, proprietary Index, the WisdomTree Managed Futures Index.

Managed futures as a strategy is meant to provide diversification to a portfolio through the ability to go long or short various commodities, currencies and interest rates futures contracts.

During times of heightened uncertainty, and especially following strong bull markets in both equities and fixed income, managed futures strategies can play an integral role in providing noncorrelated and differentiated exposures to help lower overall portfolio volatility. Given the market environment in 2016, with uncertainty prevailing and what looks like a range-bound equity market, managed futures allocations may be especially timely.
 
Long/Short Positioning

Managed futures strategies typically incorporate a price momentum signal to determine how to allocate the positions, either long or short. When commodities are rising—and trends are positive—a managed futures strategy typically would go long that commodity; when commodities are falling—and trends are negative—a managed futures strategy typically would go short that commodity.

In developing its new Index methodology, WisdomTree looked to innovate in both the signal to determine the trend in the commodities—that is, the selection of which commodities should receive exposure—and how to scale the weight of the positions depending on the uniformity or conviction in the underlying price trends.
 
On Signal Time Horizon: A number of managed futures strategies will focus on one specific time horizon—say the trailing 12-month period or trailing six-month period—in determining whether to be long or short a specific commodity. There are benefits and drawbacks when it comes to short-term signals compared to long-term signals. WisdomTree created a composite momentum signal that incorporates three time horizons: a short-term horizon (three months), a medium-term horizon (six months) and a long-term horizon (12 months). The three signals are evaluated, and when two of the signals agree or all three signals agree, the position will be established as being either long or short the asset in question. A rising trend on this composite momentum signal indicates a long position, while a falling trend on this composite momentum signal indicates a short position.
 
Scaling Position Size: We believe that when all three time horizons (three, six and 12 months) agree on which direction the commodity is trending, there is a higher conviction in the signal, and a long position is established at full allocation. When only two of the three signals agree on a direction for that commodity, one innovation in this new WisdomTree Index is to scale position size to two-thirds of the notional amount that would be allocated to that position. Given that investors might look at different time horizons in establishing trends, WisdomTree’s research showed that when there was not universal agreement of the short-term, medium-term and long-term trends or signals, scaling weight down could help reduce the risk and enhance return potential of the Index.
 
Incorporating Multiple Time Horizons: Scaling Position Size According to Conviction in Trend
Composite Momentum Signal Illustration

Multiple Time Horizons

Further, our research showed that one of the great risks to managed futures strategies is the whipsaw risk, in which a position is established based on recent trends but commodity volatility whipsaws into a different direction. Scaling position size based on the composite momentum framework described above is one element to help reduce that risk, but we have further sought to reduce the risk of being caught on the wrong side of the trend by removing the commodities with the highest volatility over the last 36 months from the universe and allocations.

Our research showed that commodities with the highest volatility were some of the weakest performers for applying a long/short momentum approach.

The chart below reveals the standard deviation, or volatility, over the last 36 months of the various commodities, currencies and interest rates included in the WisdomTree Managed Futures Index. The four highest-volatility commodities are excluded from the Index for the upcoming month. Those commodities currently are corn, sugar, coffee and wheat.
 
Realized Volatilities of Assets in the Investment Universe (%)
Monthly Data, Last 36 Months under CMS framework as of 06/28/2016

Realized Volatilities of Assets

In a future blog post, we will take an in-depth look at how the new WisdomTree Managed Futures Strategy Fund (WDTI) is positioned in the current market environment. Until then, you can view the live WisdomTree Managed Futures Index constituents here.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. An investment in this Fund is speculative and involves a substantial degree of risk. One of the risks associated with the Fund is the complexity of the different factors that contribute to the Fund’s performance, as well as its correlation (or noncorrelation) to other asset classes. These factors include use of long and short positions in commodity futures contracts, currency forward contracts, swaps and other derivatives. Derivative investments can be volatile, and these investments may be less liquid than other securities and more sensitive to the effects of varied economic conditions.

The Fund generally does not make intramonth adjustments and therefore is subject to substantial losses if the market moves against the Fund’s established positions on an intramonth basis. The Fund is actively managed; thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager. Due to the investment strategy of this Fund, it may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile. 

Diversification does not eliminate the risk of experiencing investment losses. Investments in commodities may be affected by overall market movements, changes in interest rates and other factors such as weather, disease, embargoes and international economic and political developments. Commodities and futures are generally volatile and are not suitable for all investors.

 

Click to see more articles from this category