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Opalesque Futures Intelligence

The Untold Story

Discussion of the recent surge in commodity prices impacts managed futures performance and thoughts from the world of venture capital entering the managed futures space.

Monday, September 03, 2012

When Price Persistence Hits a Market Should All Trend Followers Participate?

As drought ravaged US agricultural regions for the second year, something not seen since the "dustbowl" that occurred during the great depression, crop supply generally decreased and prices of corn, soybeans and other agricultural products moved higher. Price persistence gripped these markets as commodity costs consistently moved in a singular direction.

Managed futures investors might assume that price persistence should benefit investments with agricultural exposure, but in fact all managed futures strategies should not be expected to perform positively during periods of price persistence. Corn is up near 60% from June to mid-August, while Soybeans are up 24% over a similar period. The BarclayHedge Agricultural Traders index was up 1.93% in July, mirroring similar gains across the complex of managed futures indices. Each CTA has a strategy that should be understood on many levels. The managed futures strategy along with trade time frame and markets traded all need to be considered.

CTAs with grain exposure across the industry spectrum mirrored this thought. "As a manager who benefits from directional movement and trends we have enjoyed steady performance primarily in the soybean complex throughout the year," noted Jeff Roy, senior portfolio manager at Pardo Capital Ltd., an NFA registered Commodity Trading Advisor and trend following program with a mid- to long-term trend following time window. "The abrupt regime change in the price action of the rest of the grain complex in June and July has been just the type of activity that a reactive, systematic strategy like XT99 thrives on."

Industry insiders have noted that some discretionary managers were caught off guard by the rapid price appreciation in the grains and, unlike systematic managers, they might not be accustomed to buying into buying so might not participate in such abrupt moves with the same commitment.

The recent price action in agricultural products is a good point to illustrate the importance of understanding how a CTA's strategy, trade time frame and markets traded relates to market environment. Take trade time frame, for instance. Long term trend followers such as Longboard Asset Management, which runs a diversified commodity fund, benefited during July as their algorithm picked up the trend in the grain markets and held on to the trade and continues to hold to this day.

"Our long term model identifies a trend and stays with the trade until that A to Z movement runs its course," said one long-term trend follower. "We trade very infrequently. Our algorithm identifies assets that are in the top or bottom 5% deciles, those markets we believe have potential to significantly outperform in either direction."

This long term model bought assets in the agricultural complex and held this exposure, some trend following CTAs with shorter term time frames didn't fare as well in this market environment. Neural Capital, for instance, which operates a short term trend following algorithm, found the intra-day volatility in corn and soybeans to be challenging. Patrick de Villiers, the trading manager for Neural Capital noted that volatility, particularly to close out the weekend on Friday, triggered sell stops on their long grain positions. "Our average trade time window is eight to ten days," Mr. de Villiers, said. The CTA noted their write off positions were impacted by end of the week volatility and position squaring. "We are using a trailing a stop loss according to our system, the formula behind our market philosophy. As increases in volatility occur there is a higher probability that the stop is going to get triggered."

While the CTA's time window is important to consider relative to market environment, so too is trade strategy. Jerod Leman is the primary grain trader for Typhon Capital, which operates a spread / arbitrage strategy in the agricultural markets. The CTA typically utilizes calendar spreads, buying and selling different time frames of the same contract. Mr. Leman noted that the front months of corn, for instance, had dislocated from historic norms. "Most spread relationships are inverted, with the front months gaining on the back month," he said.

Performance and related market risk in the CTA space can vary based on strategy, risk management regime, trade time frame, volatility and market environment. CTAs that benefited from the recent market environments in the agricultural complex tended to be those whose systems identified that volatility lead to price persistence but had stops in place that gave the position a wide berth. This is not to say that any one strategy is better than another; it is to provide understanding that many just work under different market environments. It is to point out that each strategy operates differently depending on the market environment. It is in understanding the CTA's strategy and how it impacts risk and performance expectations that investors can better understand the managed futures investment.

Is Venture Capital Entering the Managed Futures Space?

A recent trip to the equity belly of the beast revealed interesting developments. Casual conversations with venture capital firms revealed the dynamic current state of affairs.

"We're starting to see the wirehouses come around to the notion that managed futures might be required in a portfolio," he said. "Not all wirehouses are moving with the same speed."

One of the benefits of accepting funding from well-connected second stage VC firms is not only their rolodex, but their knowledge of industry trends. "Most institutional investors are aware of managed futures, but don't really understand how performance is generated. This is a frustration, and it puts the strategy in a 'black box' category. This black box treatment means the strategy is held to a higher standard, any unexplained diminishing in performance will be cause to drop the investment."

In terms of manager selection, participants in the meeting generally noted "institutions have a CYA attitude. If an investment decision goes south, they have the ability to cover themselves." For this reason, the largest CTAs in the industry continue to reap the primary benefit of financial professionals generally not understanding how the investment operates.

Keep an eye on the industry of uncorrelated investments. It will have its moment in history.

This article was published in Opalesque Futures Intelligence.
Opalesque Futures Intelligence
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