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Opalesque Futures Intelligence

James Koutoulas Speaks Out About Something Other than MF Global: Uncorrelated Agricultural Spread Trading, Margin to Equity Usage and Managed Futures Account Structures

Friday, October 05, 2012

James Koutoulas

While James Koutoulas is perhaps best known for his work defending MF Global customers, this interview reveals the managed futures side of his business activities, which makes for an interesting look at spread-arbitrage trading and leverage usage.

James Koutoulas is perhaps best known for his role in co-founding the Commodity Customer Collation, a non-profit entity that fought in court and in the media on behalf of MF Global and PFG customers. Not to overshadow this important work, Mr. Koutoulas has been an industry participant as founder and CIO of Typhon Capital Management. Typhon might best be considered a "manager of managers," as they oversee a variety of trading strategies and are involved in structuring various account types.

Mark Melin: How did you transition from graduating from Northwestern University Law School to running a managed futures program?

James Koutoulas: Well I started to trade when I was 15. Markets have been interesting to me from a very young age and I come from a math and programming background. I never intended to practice law. I got the law degree to really to just add another skill set to the mix which has been very useful in setting up our segmented business model.

Mark Melin: Now speaking of the legal angle I notice what is interesting about you is you do custom fund structures for your products. So I would assume that if an institutional investor wanted to customize a portfolio and then have it in an LP wrapper as opposed to a direct account that is a service you provide, is that accurate?

James Koutoulas: Yeah we could do LPs, Cayman offshore funds eventually a UCITS wrapper, a 40 Act mutual fund wrapper really whatever an investor wants.

Mark Melin: That is interesting. Where do you see the managed futures market going and how are you positioning yourself?

" …you are going to see more and more unification with the securities industry.  That trend has already started with the 40 Act mutual funds to which a lot of assets are pouring in."

James Koutoulas: I think you are going to see more and more unification with the securities industry.  That trend has already started with the 40 Act mutual funds to which a lot of assets are pouring in.  This is despite the fact they have lagged the general managed futures industry in performance and even the way that they are currently structured is such they are very fee heavy and investor unfriendly.

Mark Melin: You are referring to the CFC, the Controlled Foreign Corporation inside the managed futures mutual fund structure?

James Koutoulas: Yes

Mark Melin: What is your prognosis on what is going to happen with that? Do you hear any rumblings out of the CFTC that they might streamline that or what do you think is going to happen?

" …I think currently the disclosures are not up to par with what they should be. In a lot of these perspectives they do not even discuss the underlying management of incentive fees that are charged within the offshore vehicle."

James Koutoulas: Well the CFTC definitely wants to be involved in the regulation of those products and they probably should be. I do not think that the SEC is really in a good position to understand the underlying commodity trading. I think currently the disclosures are not up to par with what they should be. In a lot of these perspectives they do not even discuss the underlying management of incentive fees that are charged within the offshore vehicle. They only talk about the layered mutual fund fee so for retail investors to break-even, a lot of these products have 8% to 12% returns just to get back, that I even I do not think that is being properly disclosed right now.

Mark Melin: Right now that the CFTC is currently negotiating with the SEC and one of the issues is disclosure on the performance table net of fees.

James Koutoulas: All the stuff should be disclosed. If you look at just existing regulation for CTAs and commodity pools, investors need to see those performance tables, they need to see disclosure document that talks about all the risk factors inherent in investing in futures. And to a large extent all of that is absent in mutual funds where investors only really are seeing disclosure related to the mutual fund wrapper which is not where the majority of the risk is. The majority of the risk is in the underlying offshore vehicle which is pretty complex thing, it is understanding currently is not really properly addressed in disclosures.

Mark Melin: Tell me about your existing traders, how many programs do you offer?

" …he spent significant time structuring cash market trades, both futures hedging and swaps, which gives him kind of unparallel insight into what are the futures' markets going since the cash market generally leads the futures."

James Koutoulas: On the futures side we offer five strategies. Our firm is really based around ag trading. We have got little over $60 million split between our livestock strategy and grain strategy which are managed by principal of our firm Jerod Leman. He comes from a very strong ag background, grew up in a farm in Northern Indiana, worked for a grain elevator and dairy co-op running their hedge programs. He has also spent significant time structuring cash market both futures hedging and swaps which gives him kind of unparallel insight into what are the futures' markets going since the cash market generally leads the futures.

Mark Melin: So, he is a fundamental trader, can you describe his strategy?

James Koutoulas: Yes, he is a fundamental trader.  There are two different programs so that the grain strategy takes a little bit of a longer term view than a livestock, it all spreads, very conservative on the risk management part.

Mark Melin: Talk to me about that, margin equity, what are the leverage ratios looking like?

James Koutoulas:  We average about 2% margin equity on the grains.

Mark Melin: You are kidding me?  That's very low level of margin usage, even for a spread-arbitrage trader.

James Koutoulas: I think a lot of people do not really understand ag trade and just how much volatility is there.

Mark Melin: We have seen the ag volatility lately, oh my gosh.

James Koutoulas: We have definitely seen it and so if you look at all that vol and you look at the margin breaks you get from using spreads, you do not need to pile on a lot of margin equity.

Mark Melin: That can be very true in a spread trading strategy, definitely.

" …we looked at his prop track record and saw a great alpha but a lot of volatility. We adjusted the way he traded, putting relatively low position sizes on the program tapping the margin equity usage of 5%."

James Koutoulas: So one of the things we did when we first brought Jerod Tauros is we looked at his prop track record and saw a great alpha but a lot of volatility. We adjusted the way he traded, putting relatively low position sizes on the program tapping the margin equity usage of 5%. And we have retained basically about the same compound annual return as his prop trading but we have cut vol by about 75%. So the risk adjusted return profile strategy has greatly enhanced over his proprietary trading record.

Mark Melin: Is the spread trading strategy arbitraging different months or related products?

James Koutoulas: It is calendar spreads.

Mark Melin: Tell me about the other programs.

James Koutoulas:  I did not talk about the livestock strategy either. So the same trader manages our livestock strategy which has been one of the top performing, top performers in the CTA space since we brought it to clients last July. Our Sharpe ratio is over three on that, which show that we do a very, very good job on that.

Mark Melin: A Sharpe ratio of three?

James Koutoulas: Yes.

Mark Melin: How long is the track record?

James Koutoulas: Well including the prop it is three years, and we just passed the one year anniversary for clients. But yes, so that program it combines both an intra-day flat price scalping which is taking advantages of just inefficiencies in the livestock market with some longer term spread trading as well.

Mark Melin: With scalping, are you using electronic markets or the trading floor?

James Koutoulas: We do both but for scalping it is electronic. We go down the floor for option trades and complicated orders.

Mark Melin: How do you see the floor shaking out in the future?

James Koutoulas: I mean the floor is a ghost town.  I go down there and see Santelli (CNBC reporter).  You could almost see the tumbleweeds blowing.  People tell me volume is down about 20% and that big investors now would rather go off exchange because they do not trust the clearing system and they would rather take counterparty risk on a swap with a too big to fail bank than a trust that -- another MF Global type situation.

Mark Melin: I was on the East Coast speaking with a fund manager and, you know what he said? He would rather trade with too big to fail bank than any of the non-bank FCMs just because of MF Global. The damage MF Global has done is beyond comprehension. I look back at the history of the commodity market, I have never seen an incident in my opinion that has damaged the futures market like this, have you?

James Koutoulas: No. There is no question, MF Global has been the worst thing that ever happened to the futures industry.

Mark Melin: It's been a wild ride and the inside story, the real story, of what occurred has not been told and likely won't be told. The fact that we had to apply pressure to encourage the process along was an encompassing event that has significant ramifications in the financial services industry, particularly if the whole story is understood. 

MF Global has impacted so many lives.  One of my favorite stories is how you were in court for the first time representing just your clients and then looked around and realized no one was representing the general interests of MF Global customers and commodity market integrity. That was your second legal case, both pro-bono, and here you realize that by default you are representing MF Global clients in one of the most complicated bankruptcy cases against the most politically powerful forces in history.  This force has the power to influence not just the legislative branch of government and regulators, but also the judicial branch. They can apparently prevent proper investigations from occurring.

Most people reading this newsletter know that inside story, but they don't know what you were doing before MF Global, how one of your business strategies was put on hold. 

James Koutoulas: Do you want me to talk about something not in managed futures but more in the equity world?

Mark Melin: No, I don't want to talk about cash equities, but go ahead anyway.

James Koutoulas: Basically two weeks before MF global happened we formed Typhoon Securities, which is basically an entity that trades stocks.  The goal of that entity is to take the same approach we have in finding niche specialized trading strategies and apply it to the securities world.  That was put on hold after November 1, 2012.

Mark Melin: That will be interesting to watch for.  Don't forget you can trade single stock futures instead of cash equities.  A number of CTAs have moved in that direction recently.  Why don't you tell me about the other managed futures strategies you operate?

"Both programs on the face do not have eye popping returns… but if you combine that with the cash efficiency futures and the fact they can be cross margined…"

James Koutoulas: The rest of our strategies are basically designed to complement our two core ag strategies. We have two intra-day only programs in the financial space, so clients can cross margin them with our ag strategies and gain the benefits of diversification and bring down the overall risk of a portfolio and hopefully add alpha as well. Both programs on the face do not have eye popping returns, typically past performance between 7% and 9% compounded annual return, but if you combine that with the cash efficiency futures and the fact they can be cross margined with essentially a marginal increase in capital allocation, so to speak.

Mark Melin: There is also tax efficiency too, 60%-40% tax treatment in direct futures trading.

James Koutoulas: Right.

Mark Melin: We're talking about a direct account here. That is another interesting aspect of the managed features mutual funds, they do not get the same tax treatment. Income from the fund of funds model is treated differently than direct trading income.  So let me ask you a question, is your spread model directional spread trading or is market neutral trading; does the system expose markets to a directional bias?.

James Koutoulas: Yes.

Mark Melin: Ok, so his opinion is based on the variant between the two months or is it based on the direction of the market?

James Koutoulas: It really depends, some of it, like old crop, new crop type spread opportunities, or looking at supply shocks or just supply and demand imbalances between different crop cycles or just month on month analysis involves supply and demand fundamentals which can be directional in nature.

Mark Melin: Anything else you want to add about those two strategies?

James Koutoulas: Not really, but we are expanding on our ag focus and we are currently in the process of putting together a multi strategy agriculture commodity pool and this, as far I know, is going to be first of its kind.  It is a multi manager product, yet there are no portfolio level management incentive fees and no netting risk to the investor (relative to incentive fees). In other words, in a typical fund of fund, say you have one manager whose up $10,000 and one manager is down $10,000, the investor is going to wind up down because he has got pay a performance fee on the guy who is up. In our product investors are not going to have sort -- pay any incentive fees unless the fund as a whole is profitable.

Mark Melin: That is interesting, I have never seen that done before.

James Koutoulas: As far I know no, one has done in a true multi manager product and hopefully we are the first and would like to continue our philosophy of actually being in business with our customers and do whatever we can to not take advantage of them and to help them try and make money an efficient way as possible.

"…the track record was so bogged down by commission drag, it is tough to raise institutional assets in its current form."

James Koutoulas: I've described our institutional products.  We're currently working with a retail program and adapt his strategy for the institutional market.  He trades approximately 11,000 contracts a year and his retail account it is like an 8% commission grant.  Despite the high trading volume, he has a low vol strategy, so it is something could do well in institutional hands if properly managed, but the track record was so bogged down by commission drag, it is tough to raise institutional assets in its current form.

Mark Melin: There are a few really good retail products that might really shine if they didn't have the commission drag that comes with a retail product.  It's impressive you are working in that direction. Let's talk more about your risk management.  You hard code some of the trade execution applications so traders don't exhibit strategy drift.  I'm sure you look at leverage and keep an eye on margin equity? Address that a little.

James Koutoulas: We hard code both contract types and contract sizes, so they would have difficulty with strategy drift of any sort.  In regards to margin to equity, this is where the position sizes come into play. So for example our grain strategy can never go above 5% (margin to equity) and our livestock strategy can go above 15% (margin to equity) and our financial programs cannot take any overnight positions.

Mark Melin: During the ag run up in July, where we had limit market moves and volatile up and down market participation, were there any issues where margin exceeded risk management parameters?

James Koutoulas: Well no, on the grain strategy it is all spreads as well. So our vol was consistent with historical norms there. Our vol was kind of high earlier in the year in the livestock strategy where we were building a longer term position while we had like the pink slime crisis going on and just all sort of funky stuff going on in the livestock market, but it is still within our parameters.

Mark Melin: What's your overall market outlook for the future?

James Koutoulas: I anticipate professional investors are going to recognize the need for true asset diversification, particularly during crisis. I'm positioning my firm to benefit from this significant long term trend.

OFI: Thank you, James. Great insight as always.

 

(This interview was conducted before an investigation into Jon Corzine was leaked in the media, which first took place September 11, 2012 after a degree of pressure. Previous to this the New York Times had been reporting that an investigation into Mr. Corzine would not take place and he would transition into running a hedge fund. This interview also included detailed talk of both MF Global and PFG, which was not published at this time.)

For additional performance and risk evaluation regarding the Typhon Capital program, send an e-mail to melin@opalesque.com



 
This article was published in Opalesque Futures Intelligence.
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