The term commodity trading advisor (CTA) has become a misnomer of sorts. It describes active managers in the futures arena and is a legal definition, but most CTAs — particularly the larger ones —have a small portion of their portfolios allocated to physical commodities.
Some of the largest managers have all their allocation in interest rates, currencies and equity indexes. Some will add energy futures and possibly metals. When the CTA designation was created the only liquid futures markets were in commodities, particularly the Chicago Board of Trade grain complex and the Chicago Mercantile Exchange meat complex. As more money came into the industry and financial futures became the most liquid futures markets, more allocations went to them. CTAs who wanted to keep a significant allocation to agricultural markets had to freeze their programs at a certain level of money under management. CTAs whose entire systems revolved around agricultural markets — once the entire industry — had become the exception. They now are marketed as an alternative among alternatives but with significant volatility in the sector and the ongoing bull market in commodities, more managers are returning to the space. Also, the added size contributed by the burgeoning long-only commodity indexes has injected greater liquidity into the sector allowing managers to take in great allocations.
The number of programs trading grain and meat futures has increased in recent years (see “Back to the ags,” below). And while the CTA industry as a whole is dominated by systematic managers, most agricultural based CTAs are discretionary. While entering markets in high traffic areas can be a problem with such enormous systematic money in the market, agricultural specific managers are able to take advantage of the added liquidity because they are rarely entering at the same time and they have the advantage of being able to read the movement of institutional monies as part of their strategy. So the increase in systematic speculative money increases the capacity of discretionary dollars able to safely trade.
Some programs have been developed specifically to take advantage of money flow in the sector. That money flow comes from long-only commodity index funds, estimated to have more than $100 billion benchmarked to them.
“It is kind of an easy way to go. ‘You say I have to have commodity exposure, lets buy an index fund,’ and that is what they do,” says William Plummer, president of ag based Range Wise Inc. “That is an easy way for a large institution or a large pension fund to gain exposure to the markets. A more difficult way is to analyze CTAs and pick a portfolio of CTAs. The pension funds and the large allocators worldwide who take the time to analyze individual CTAs ultimately outperform the index funds.”
Plummer acknowledges that in the current bull commodity market, index funds will outperform active managers. “Off course CTAs don’t have much of an advantage over long-only index funds in a strong bull market because the funds are simply long. The advantage of having an investment in a CTA will occur at the point at which we reach a plateau and trading in the individual commodities becomes very difficult,” Plummer says, adding, “The index funds can’t take advantage of bear markets and large corrections in bull markets like what has occurred in energy.”
And there will be bear markets as well. “Sometimes down moves are no-brainers. They are easy for somebody who focuses on particular markets. They are easy to capture because they become fairly evident. In the meantime an index fund is kind of stuck staying long,” Plummer adds.
As interest in commodities have grown, the bulk of investments have been in the index funds but that may be changing as some sectors have had extended runs and contango markets punish the funds every time they roll.
Bob Wiedeman, principal for Strategic Ag Trading, says index fund may face redemptions. “Goldman Sachs is [about] 70% energy; energy for the year is down 14%. Long-only programs have worked this year in corn, beans and wheat but there will be a time when you don’t want to be in a long-only program. There are a lot more opportunities,” Wiedeman says.
“Most of the money coming into the agricultural markets seems to be coming from the index products that are not restricted by virtue of position limits,” says Doug Carper principal of DEC Capital Inc. “If these people are putting money into these markets because they want long side exposure, it is a lot more efficient for them to go that way than to allocate to a smallish CTA.”
While active managers trading grain markets may be jealous of the allocations given to the index funds, they realize the fund’s size enable them to take in more money and expand the capacity of the entire sector. Open interest in corn has grown by more than 60% through the last year (see: “A bigger pool,” below).
“There is much more liquidity than there has ever been and as a result the ag markets are capable of absorbing far more money then they have absorbed [so far],” Plummer says.
“It enables your capacity to be bigger,” says Chris Myers, principal of M6 Capital Management. “I can trade $100 to $125 million.”
But it is not simply the opportunities offered by index funds but the new set of fundamentals that is bringing greater interest to the storied agriculture sector. Higher energy costs and the maturation of the bio-fuel industry have created new demand and new fundamentals and are creating greater liquidity and volatility in the grain sector.
Ethanol and soybean-based bio-diesel plants are being created at a rapid pace. Plummer says the development of biomass fuels is driving grain prices higher. “It is the high energy prices that sparked the construction of the facilities that produce ethanol. Also, there is the ongoing national security issue, which will continue to drive government policy towards the expansion of biomass fuel,” Plummer says, adding, “That adds supply to the world market for fuels and takes some of the edge off of the demand for crude oil.”
Wiedeman agrees. “There are 100 or so plants going up and more being proposed. Maybe it is not the answer [but] it is not going away. And we are going to have a hard time finding the acreage and that is what you can see in the [strong] bean and corn markets.”
The fundamentals of energy and ethanol production has added volatility to the corn market, creating opportunities for traders (see “Where the action is,” below).
Wiedeman says that despite the recent rally in grains and correction in crude oil, ethanol and bio-diesel production will continue. “It is still pretty good and it is going to continue because these plants are up and running and they [are not] going to shut down just because margins have gone from gigantic to [merely] profitable.”
“There has been a structural change in demand,” Plummer says. “There is an entirely new component of demand that has been added to the ag markets, specifically fuel. The price of traditional food producing commodities is now going to be greatly influenced by the price of petroleum based fuels.”
Plummer calls it one big universe and says the ag sector is playing catch up with petroleum. “Increases in supply of one component will impact the price level of other components.”
And it is a global trend. “Lets not forget that the same factors that are causing us in the United States to build ethanol and bio-diesel plants, is happening in Asia where profits almost don’t matter. China is very aggressive in building industrial facilities for corn usage,” Plummer says.
Another factor adding liquidity to the market is electronic trading. Carper points out that electronic volume in the grain markets has surpassed 50% in the lead months and is drawing more retail participation.
Wiedeman says, “With the increase in the electronic trade, slippage isn’t what it used to be. Numbers can be done; we could go to $100 million. The liquidity is huge and it is just going to get bigger. So much of it has gone to the screen.”
This bodes well for the creation of additional programs. The explosion of volume in electronic mini stock index futures eventually led to the creation of trading programs due to the ease of execution and the ability to profit from shorter-term trades. That could happen in the grain markets as well.
Managers report greater interest in their programs but have not seen that interest translated into large allocations. “We have not seen an influx of big money. Everybody talks about it but I don’t see anybody stepping up to the plate,” Wiedeman says.
Carper, whose program is up 40% for the year, has had a similar experience, “There is an interest and a clamoring for some people to be involved in the agricultural markets but we haven’t seen it translated to a lot of business.”
Perhaps they have been a little impatient. Others have seen the interest and while the money under management may not be pouring in, it is coming.
“I have had a surprising amount of interest,” Myers says. “One, my returns have been decent (12.85% in 2006 through October and 32.7% since July 2005); but two, I am the ultimate odd ball. I don’t trade systematically. I don’t trade energies or metals. I trade a small little niche market. In the last six months quite a few people came to me because they wanted somebody who is not systematic. They want to invest money somewhere that is not correlated with all the other traders out there.”
When Myers launched his fundamental discretionary ag program in July 2005 he did not dream he could reach $20 million under management in just a little more than a year, but he has and the sector itself has grown, giving his program greater capacity. “From August of last year until today open interest in cattle has doubled,” says Myers, who is seeing interest from fund of funds. “They got new products they are offering to their investor base that are ag focused or discretionary/ fundamentally focused. I have quite a few guys that will come to me and say ‘we have one fundamental discretionary guy in energies, we have one in metals, we want to get one in each [sector].’ If you look at ags there are only a handful of traders who do what I do.”
Carper is taking it slow. “We have been guarded in our acceptance of new investors. We are trying to stay clear of hot money. We would rather stay small and nimble than get too big and clumsy. That is the key,” Carper says.
The commodity bull market is alive and well and featuring the often forgotten grain sector. While a simple long only approach may be appropriate to some investors, the size of the energy and metals sectors — which have had their day in the sun — could diminish the exposure provided to the grain sector. Added volatility will provide opportunities on both sides of the market and managers, new and old, are seeking to exploit that volatility.