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managed futures

How To Make Money In A Bear Market

portfolio strategy May 10, 2022

Right now many investors are asking themselves, "Are my investments safe and where should I be investing?"

Given we invest over the medium to long term, we stand by all of our historical & upcoming research, picks, & portfolios.

But in the short term, as we've mentioned one thousand times, volatility is here to stay.

So with rising inflation, one solution that many investors are turning toward is inflation-linked assets such as oil, gold, wheat, soybeans, corn, etc.

But commodities aren’t a perfect solution. They can be volatile. Their prices can stay in holding patterns even as inflation runs rampant, prompting you to pull your hair out, despairing: “Why isn’t anything making any money yet?”

In times like these, it can be smart to start thinking about diversification of strategies rather than stocks.

Enter “managed futures.” This strategy is “market-neutral,” which means it can thrive even in bear markets. And it just may be the outlet for investors who want to hedge against this downturn.

We won't bury the lede. We think a small allocation to a Managed Futures strategy is a protective hedge against the uncertainty ahead in the stock market. And, our favorite managed futures ETF is DBMF.

Check out its recent performance vs major indexes:

For the uninitiated, here’s how it works👇 

What are Managed Futures?

Managed Futures are portfolios of futures contracts. Professional and registered trading advisors go through a gamut of regulatory requirements to manage these portfolios, but the gist of it is simple:

Managed Futures are a bit like mutual funds for futures contracts.

Dizzy yet? Yeah, we’ve still got some ‘splaining to do to make sense of managed futures.

So let’s back up and tackle the first concept: trading futures.

Futures Contracts: Turning Wheat into “Stocks”

While futures contracts sound complicated, the reality is quite straightforward.

A futures contract is an agreement between two parties. That agreement decides on a price today that the buyer will pay at a later time.

Remember in Back to the Future, when Doc Brown always chastised Marty for not thinking fourth-dimensionally? It’s kind of like that. Take an ordinary contract and start thinking in terms of time travel.

Let’s take an example. Imagine you have an agreement to buy 100 bushels of wheat on December 16th, 2022 for $500 a bushel.

No matter what the price of wheat is on that day, you have to pay $500 per bushel and take on the full 100 bushels.

Kinda scary, right? After all, no one has a crystal ball. If your judgment is off, you could pay $500 per bushel on a commodity only worth $450.

So what kind of investor-slash-wizard has the confidence to make that kind of bet?

Well, all investments are, to some degree or another, bets on the future. If you buy a stock today, you hope it will go up in the future. If you short a stock, you hope it will go down.

Futures contracts turn commodities like wheat into investable assets. And when you own a futures contract, you can sell that contract on an exchange to another investor. It’s similar to trading stocks.

Putting the “Managed” in “Managed Futures”

If trading futures on commodities turns them into stock-like investments, then “managed futures” turn those stock-like investments into fund-like investments.

To be clear, managed futures are not mutual funds.

But they do create an alternative asset class for investors who are concerned about high inflation with a slowing economy. Those same investors can outsource the management of these future portfolios to the experts.

And how do those experts approach trading futures? There are typically four variables you need to know:

  • Momentum

  • Asset class

  • Risk

  • Time horizon

Let’s zoom in on each and find out what they’re all about.

Momentum: Where the Wind is Pointing

In this case, momentum isn’t about the literal wind. Instead, it’s about the direction a stock or commodity is heading.

In physics, the laws of momentum say objects in motion tend to stay in motion unless acted upon by another object.

It’s often the same with investing. You can watch the trends to try and predict the future.

For example, futures going up will tend to continue that way (positive momentum). Futures going down tend to continue that trend, too (negative momentum).

How does this relate to managed futures? Managed futures investors buy the futures going up (“going long”). They then sell the ones going down (“going short”).

The highly original name behind that strategy? The long-short strategy.

Asset Class: Beyond Commodities

Okay, we admit it: we used wheat as an example of a futures contract earlier.

But who says you have to use wheat to trade this way?

There’s no reason to limit managed futures to one asset class, like commodities. Fixed income, currencies, equities, and yes, commodities, can all factor into this strategy.

Let’s take an example. If the S&P 500 is declining (as it has been in recent days) and the Nikkei Index (Japan’s stock market) is climbing, the long-short strategy says to go short the S&P 500 futures contract and go long the Nikkei futures contract.

Now, take that same basic logic and apply it anywhere. Nikkei. Gold. U.S. Treasuries. Euros. The S&P 500. Copper. Brazilian Debt. U.S. Dollars. Donut futures. Okay, we made that last one up.

The long and short of it (pun intended) is this: managed futures help you diversify this strategy across multiple asset classes. This helps you potentially identify moneymaking opportunities in otherwise tough markets.

You know, like the current market.

Risk: Not Just a Board Game

The risk of this strategy is volatility. Let’s say we go long on wheat and the next day, a company announces it’s created a wheat-making machine that only runs on water. The possibility of infinite wheat now sends the price plummeting. Not good for our investment.

Another risk: sometimes, momentum isn’t so easy to identify. What if the price of wheat is up one day and down another? Down one month, roaring back the next?

In managed futures, managing risk means sizing our positions to the volatility of that asset class. The harder it is to predict, the more risk we face.

Let’s use our previous example. Imagine we’re long both the Nikkei and gold. They’re both looking like they’ll be up 20% over the next year.

That’s good, right? Sure. But imagine gold is 2% up or down every day. If the Nikkei moves 0.25% up or down every day, we would say gold is more volatile. The Nikkei is looking like the more stable risk.

To balance out that risk, we might move more money into the Nikkei than gold, even though they both have the same expectations.

That’s how managed futures “smooth out” the bumpy ride of commodities and economic turbulence.

Time Horizon, or “Signal Type”

Almost there! I promise.

Let’s go back to thinking “fourth dimensionally.” If we’re thinking in terms of trends and momentum, we have to admit not all momentum is made the same.

For example, momentum in short windows is better at predicting short-term momentum. Ditto for momentum over longer windows. It’s better for predicting long-term momentum.

If a stock goes up over the past month, that’s nice, but it’s a short window. We might not be as confident in its long-term prospects.

But if a stock has climbed steadily over the past year, maybe it has some long-term legs.

In this strategy, we incorporate multiple momentum signals. That means we don’t go all-in on a single time horizon. We can then weight our positions based on the most consistent (and least volatile) signals.

Putting it All Together

Back to the Nikkei and Gold example. (Yeah, we really like this example. Bear with us.)

Let’s say the Nikkei and gold are both up over the last 12 months. We’ve got positive momentum established. We take two long positions.

But with Nikkei’s momentum much sturdier than gold’s, we figure Nikkei is less risky. We put a larger position in Nikkei relative to gold.

But let’s add the fourth dimension to it. What if the Nikkei is more volatile over the last three months? What if there’s some negative momentum there?

And what if gold is steadily increasing over that same period?

We’ve got a new short-term signal which tells us to…

  • Short the Nikkei because of negative momentum

  • Go long gold because of the new positive momentum

But we’re not going to go all-in because there have been some developments. We also have to factor the past 12 months into account.

What do we do? We combine these two smaller strategies with the one based on the past three months. We now have a fresh strategy. It takes the large long position in the Nikkei, but with a slight modification to factor in these short-term signals.

The result? We have a strategy for steady, diversified returns.

How to Use Managed Futures:

Yikes. Yes, we know: it sounds like a complicated way to arrive at a well-diversified momentum strategy.

And there’s still one question: why not just invest this way in stocks?

The beauty of managed futures is that it follows trends, which makes the strategy “market-neutral.” Bull market? It can still work. Bear market? It can still work. Sideways markets? You get the point.

It’s not without its weaknesses. For example, if there’s a sharp reversal, throwing off all of the market trends, it’s difficult to identify a trend before taking a position.

But even with that in mind, remember that managed futures aren’t supposed to be like general stock funds. They’re there to help you diversify your assets and spread out risk.

Our Recommendation:

Where do you go from here?

Because managed futures can work in a bear market—and it’s looking like a bear market out there—we recommend allocating 5-10% of your portfolio to a managed futures strategy.

And because implementing this strategy is complicated, we recommend an ETF to make this strategy as simple as a purchase.

There are a few funds that successfully implement the managed futures strategy, but our confidence goes to iMGP DBi Managed Futures Strategy ETF (DBMF).

DBMF has been active since 2019, and year-to-date, it’s returned 23%! Not bad, especially when you consider the S&P 500 is about -16% YTD. The NASDAQ is even worse, at approximately -25% YTD.

That isn’t to say you should expect this kind of performance all the time. When the market begins to bottom, it may be time to start bargain hunting equities.

But even so, a small allocation to managed futures can help diversify your portfolio. That’s especially important when stagflation hits and you’re not sure where else you can go.