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Opalesque Futures Intelligence

Highly Volatile CTA That Trades Volatility

Wednesday, May 22, 2013

By Mark Melin

Can a trading strategy be transferred from father to son - and then systematized?

T2 Associates is a volatility specialist Commodity Trading Advisor founded by James Tann, who has been privately trading since 1967. Mr. Tann holds a BSE in Physics and Mathematics and an MBA in Quantitative methods from the University of Michigan. Mr. Tann essentially systematized the volatility trading methods of his father, a grain trader at the Chicago Board of Trade back in the 1930s and 40s. "I put my background in quantitative systemization to work defining a rules based system for trading volatility," Mr. Tann said, who worked for 30 years in California as an engineer and system developer for various semiconductor companies.

Counter Trend Trading Relies on Market Environment of Volatility

This niche emerging CTA, which typically is only recommended to highly sophisticated fund of fund investors. Investors should expect significant volatility with this investment. The primary strategy is to engage in countertrend trading during periods of high market volatility. The emerging CTA primarily trades the mini S&P 500 futures contracts, but is considering migrating the short-term time horizon strategy to other markets, according to the firm.

In the case of T2, they operate by counter trend trading during moments of market volatility spikes. Typically during periods of volatility, the theory holds that price trends are exaggerated in the direction of the trend and ultimately revert back to the mean. In the case of T2, they are looking for mean reversion on a short term basis. The counter trend trader, with a quantitative knowledge of the point at which a price trend might be overextended, establishes a position in the opposite direction, in this case holding trades for an average of three days but sometimes up to three weeks. It can be a highly risky play on a number of fronts, particularly if the portfolio isn't properly diversified even with the long volatility sub category.

T2 Associates is seeded by seasoned hedge fund allocator Curt Breitfuss of Jones Commodities. "I have spent most of my 27 year career as an asset allocator to CTAs and Hedge Funds," he said. "I started in this industry developing my skills as a trader. I quickly found that the T2 Associates trading algorithms contained many of the elements that match my own beliefs in trading futures. I have seen over and over again that many outsized returns are generated from emerging managers (along with more risk)."

Each portfolio manager has a different reason for interest in a particular CTA. From one portfolio management standpoint, the concept with such a niche long volatility program is to pair it along other long volatility components in the sub category of a portfolio. The long volatility might not find profitable market environments as the short volatility programs, but when the right market conditions exist is when this and other programs might be expected to benefit. From a portfolio standpoint, combining long volatility exposure to the market environment of price persistence, short volatility and divergence / convergence to a mean is an example of using volatility combinations with the goal to manage downside deviation. This is a sophisticated risk management technique operated by certain hedge fund professionals.

The market environment for their type of counter-trend volatility trading has been challenging over the past few years, according to T2 Associates. For a volatility specialty firm, sluggish performance when markets aren't appropriately volatile should be expected. The CTA is down -6.88% year to date, according to reported performance, after posting -10.3% in 2012. Yet when the appropriate volatility markets were in place they produced triple digit gains in 2011 and +21.5% in 2010, they year the firm started accepting client capital as a public CTA. The questions to ask are: What was it about 2011 performance that generated triple digit performance? Is this repeatable?

"2011 was a great year for our systems and we expect great performance in a similar market going forward," a firm representative said, noting that they reduced leverage during the winter of 2012 reduced as market environments changes. The key statement to consider is if and/or when the appropriate market environment might return. It should be noted that different, and more common, methods of trading volatility takes in VIX futures / options across time horizons and in option put spreads across major stock indexes.

(Performance information supplied by CTA, information believed reliable but no warrantee is being made relative to same. The firm said it had performance and business operations audited by the National Futures Association. No independent audit of performance has taken place. Click here for full performance reports from the CTA.)

Opinion / Partial Analysis of T2 Associates

By Mark Melin

This analysis relies heavily on the opinions of the author and does not analyze all risk factors

At this point in its growth, it is hard to recommend T2 in all but a well diversified, professionally managed uncorrelated investment portfolio. In particular, this means the portfolio has an emerging manager sleeve as well as a volatility sleeve with at least 5 additional managers in each. Emerging manager investing means the investor sacrifices on large back office staff and relies on pure trading alpha. Emerging manager risk involves more than trading, as professional investors must also keep an eye on business development / asset under management growth issues. It can be rewarding when the strategy hits the appropriate market environment, but can involve many risk factors.

When considering paring T2 with other managers in the volatility sleeve of a portfolio, one might consider five additional managers who should trade the more "traditional" volatility trading styles that are basically exposed to one beta market environment risk exposure. When this is in place along with the proper expectation for performance (it could come in spirts) and risk (it could be very volatile even during "good" times), the professional asset manager might consider an investment.

When considering the first point of analysis in this niche strategy one might want to consider the downside deviation, which is north of 20% according to the CTA's supplied data. In other words, even during positive market environments the CTA could generate significant volatility and periods of extended loss. What's the point you say? Combining this CTA in a portfolio with very specific short volatility and trend trading programs can yield interesting results. Remember, if anything T2 is a niche player in the portfolio and only makes sense if combined with other appropriate players utilizing different volatility capture methods.

Recognizing T2 Beta Market Exposure: Correlation Considerations

The emerging manager specializes in capturing opportunity when long volatility events strike, which are often few and far between. Statistics in equity market performance will generally conclude that major volatility causing market crashes strikes rarely but when it does the loss size can be significant.

To analyze just a few top level risks, there is beta risk to the appropriate market environment of volatility. What makes this strategy is not only the appropriate market environment of volatility, but then to this must be combined with mean reversion. This relies on two beta exposures, not one. One of the key points to understand form a risk management perspective is the CTA is looking for a volatility spike to carry a market past its normal logarithmic distribution and then revert to the mean. The key point to consider is how volatility and margin to equity is managed during this period of time. When the system determines volatility to have driven prices past a statistical average, it will buy or sell against this trend based on an algorithmic signal. These algorithmic signals are not always accurate and a point of alpha risk is when a position is taken and the market continues to move against the position and does not revert to the mean.

What to Watch For on An Ongoing Basis

A key risk management statistic to consider with this CTA is their margin to equity. During "normal" periods of time, the CTA's margin to equity is said to be near 12% to 15% -- near the benchmark for trend followers - but can change when a trade position moves against the CTA.

During periods of stress when the mean reversion algorithim selected a market entry position, the risk manager might recognize the trade is working against the program when margin to equity exceeds 30% -- a key inside point to consider if watching this manager. If margin to equity were to exceed the 30% level, this would raise a yellow flag and warrant examination, and above 50% might require a look at position diversification methods.

Another issue to watch with this emerging manager is assets under management. With under $10 million under management, the CTA can face business challenges unless they are properly incubated. One component to consider at this stage are the forces behind the CTA and how their business process are being managed - particularly if assets under management start to move in one direction or another in rapid succession. This can be a quick yellow / red flag even when assets under management are moving higher. For a small CTA, changing trade strategy, position sizing is a fact of life once AUM starts to move higher. An emerging CTA typically benefits from other professional assistance in developing their business or they are under supervision in a portfolio with the help of a knowledgeable managed futures portfolio manager. Allocators not intimately familiar with such investment volatility might want to keep an eye on the program, but investment, to date, has been primarily limited to fund of fund investors.



 
This article was published in Opalesque Futures Intelligence.
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