DBMF: Rising Market Volatility Warrants Caution

It has been a few months since I last updated readers on the iMGP DBi Managed Futures Strategy ETF (NYSEARCA:DBMF). In my last update, I was cautious on the DBMF ETF, as market direction was in flux and commodity trading advisor ("CTAs") strategies like DBMF need trending markets in order to deliver positive returns.

However, contrary to my expectations, markets have actually been smooth sailing for CTAs in the last few months as stocks rallied, bonds sold off, and currencies trended. The DBMF ETF has delivered a very respectable 10.5% return since March, although it is still down from when I initially downgraded the fund in November (Figure 1).

Looking forward, I fear we may be near difficult levels for the assets currently trending and would advise current holders of the DBMF ETF to exercise caution.

Brief Fund Overview

First, an overview of the DBMF ETF for those not familiar with or need a refresher. The iMGP DBi Managed Futures Strategy ETF is an absolute return fund that seeks positive returns by following a 'managed futures' strategy and taking long and/or short positions on a broad range of assets such as bonds, equities, commodities, and currencies.

The DBMF ETF's positions are determined by a proprietary quantitative model called the 'Dynamic Beta Engine' that uses regression analysis on the trailing returns of a pool of top-performing CTA hedge funds to identify a portfolio of financial instruments that can deliver performances similar to those funds.

The DBMF has been popular with investors, garnering $939 million in net assets while charging a 0.85% net expense ratio (Figure 2).

Strategy Drives Off A Cliff

In my opinion, DBMF's strategy is similar to someone driving by looking in the rearview mirror. On straight roads, the DBMF can perform very well and can even outperform the reference CTA hedge funds as DBMF's regression analysis can weed out poorly performing trades, leaving DBMF to bet only on the 'winning' ones.

However, the Dynamic Beta Engine can get into trouble when volatility increases and the road has lots of turns and zigzags. For example, in March during the regional bank crisis, DBMF was heavily short bonds and was caught offside when investors rushed to buy treasury bonds and treasury bills in a flight to safety. DBMF's returns took a nosedive as a result (Figure 3).

Similarly, DBMF's performance nosedived in early November as the fund was heavily short the Euro and Yen (a few of the primary macro trends of 2022) and was caught offside when the Bank of Japan ("BOJ") intervened in the currency markets, reversing the negative trend on the Yen.

A common theme of DBMF's historical performance seems to be periods of relative calm punctuated by major drawdowns, as the fund's increasingly concentrated bets in a few major trends eventually reversed.

Portfolio Deja Vu

Currently, the DBMF ETF is once again heavily concentrated in a few major bets. The DBMF ETF is 49.6% short 3-month SOFR futures, 49.7% short 2-year treasury futures, and 41.2% short the Yen (Figure 4).

These concentrated bets are worrisome because many of these bets are on macro trends that can be prone to sudden reversals. For example, the DBMF ETF is heavily short the Yen as it neared the important 150 JPY/USD level when the BOJ intervened last year (Figure 5). Already, there are rumblings that Japanese officials are getting ready to intervene again if the Yen breaches the 150 level.

The DBMF ETF is also very short 2-year treasury note futures at 49.7% of the portfolio. While this has been a winning trade, being short 2-year treasury notes is extremely crowded, as speculative positioning is the shortest in the past 5 years (Figure 6).

At the slightest sign of a weakening economy, traders short the 2-year treasury note could be in for a rude awakening similar to what happened during the March regional bank crisis, when CTAs suffered a 5 sigma loss event on March 13th (Figure 7).

Rising Volatility Could Be A Canary In The Coalmine

While markets have generally remained calm down since the March risk-off episode, recently, we are starting to see both interest rate volatility, as measured by the ICE BofA Merrill Lynch MOVE Index (Figure 8), and equity volatility, as measured by the CBOE VIX Index (Figure 9), stop declining and actually rising.

This could be a canary in the coalmine suggesting markets are about to become much more dynamic. Historically, heightened volatility has not been kind for the DBMF ETF, as seen by the major drawdowns in November and March.

Conclusion

The DBMF ETF has recouped most of its YTD losses by continuing to bet heavily on several key macro trends like a weak Yen, rising interest rates, and rising crude oil. However, I believe we may be close to another period of volatility in the markets which historically has not been kind to DBMF. I recommend current holders in the DBMF ETF to exercise caution.