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Risk Management

Managed Futures Replication Under Stress Due to Tail Risk

Photo by Sebastian Arie Voortman

Recent tail risk events and how fixed-income markets reacted to them have put pressure on managed futures replication.

The S&P 1500 banking sector index has plunged 14% in the last two trading days (Friday, March 10, and Monday, March 13, 2023).

As the chart shows, the financial crisis and the virus pandemic bear markets both caused big drops before. Usually, these large drops are not isolated, and volatility comes in clusters, with large drops followed by relief rallies until the markets get back to normal.

The iMGP DBi Managed Futures ETF (DBMF) has dropped 6% in the last two trading days and is now down 18% from all-time highs.

Tail risk happens fast in the markets, and DBMF has suffered from large and concentrated short positions in fixed-income futures. The ETF has a total of 13 open positions, with five of them in short bond and note futures and one in short rates. Concentrated positions are sensitive to tail risk. If the CPI comes in much softer than expected today, losses from this type of concentrated positions may increase.

For example, 2-Year Note futures have gained two points in the last three trading days.

As shown in the above chart, this is a highly extreme event since 1990.

Tail risk is a feature of markets, and diversification is one remedy but usually comes with lower return expectations. As far as managed futures replication, it is my opinion that it is a clever idea that adds great value due to the lower cost, but it should avoid concentration because that poses high risks, including the remote possibility of an uncle point in case something goes wrong.

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Disclaimer:  No part of the analysis in this blog constitutes a trade recommendation. The past performance of any trading system or methodology is not necessarily indicative of future results. Read the full disclaimer here.

Charting and backtesting program: Amibroker. Data provider: Norgate Data

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