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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.)
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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.
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