The Standard & Poor’s Diversified Trends Indicator on which the Rydex Managed Futures Fund (RYMTX) is based is an index composed of 14 sectors, equally divided between physical commodities and financial futures. The index is “managed” in the sense that it uses straightforward trend-following indicators in deciding to go long or short a particular sector, says managing director David Reilly. Management is overseen by an investment committee at S&P. The index uses a seven-month moving average of price observations. If the price of any one commodity or sector is above that seven-month moving average, that is a signal to go long. A price below that moving average is a signal to go short.

This is all quantitative, and the only discretion the management team exercises is to slightly alter sector weights determined by the index to account for such things as liquidity and investability, says the firm’s director of portfolio strategies, David Reilly. Sector weights on the commodities side of the index are determined by world production figures. Those on the financial side of the index, which are basically country exposures as well as U.S. Treasury exposures, are determined by world share of GDP.

All the sectors of the index but one can be long or short based on the price indicator being above or below that seven-month moving average. Energy is the exception because it is unique in being subject to short, sharp price spikes by the nature of the commodity, cartel production, and geopolitical considerations; so, as a risk-control measure, energy never goes short. If the price indicator for energy is below the moving average, indicating that it would go short, the index will zero out the energy weight and redeploy that pro rata across the remaining sectors of the index.

A true managed futures product might or might not place such a restriction on its strategy, says Reilly. “The common thread with managed futures here is that: one, it’s a futures-based strategy; two, it’s trend following, it uses the moving average and the price signal. The difference is that the index is neither purely commodities nor purely financials; it takes a more diversified approach by splitting the allocation evenly between the two [rebalancing every month].”

A nice byproduct is that the correlation of the S&P DTI is low relative not only to stocks and bonds, but also to managed futures indexes and to commodity indexes. As benchmarks, Rydex uses the Barclay CTA Index for correlation statistics, and the Goldman Sachs Commodity Index Total Return (GSCITR) for commodities.

The fund is implemented in structured notes in order to accommodate a new IRS rule that says commodity futures no longer qualify as “good income” in terms of 1940 Act products. The logic, says Reilly, is that a structured note is actually a security by virtue of being a note, and so will meet the “good income” test for mutual fund or registered investment company purposes. Rather than create a structured note just for the commodities portion of the S&P DTI, he says, Rydex decided it was simpler and more cost effective to invest in structured notes that it linked to the entire index. Rydex has entered into structured note transactions with Goldman Sachs and Merrill Lynch, with the price of the notes linked on a daily basis to the price behavior of the index.