Many experienced long-term trend followers were looking forward to 2006. They were hoping to see a return to market dislocations they could take advantage of after a couple of difficult years for trend followers. While 2006 looked promising in the first quarter, for many it returned to the choppy difficult markets of recent years, and once again many managers needed a positive fourth quarter to just break even.
The Barclay CTA index returned 3.53% in 2006 with a positive fourth quarter of 2.97% making the difference. In many ways 2006 mirrored 2005, a difficult year for most trend followers, particularly larger ones who had a greater allocation to currency and fixed income markets. The Barclay Currency Traders index was down 0.16%, its second negative year in a row.
“You had a couple of things make it difficult,” says Sol Waksman, president of CTA tracking service Barclay Trading Group. “Commodities, which were on a tear, broke during the summer. You had interest rates moving in one direction at the beginning of the year and then in another direction in the middle. Crude oil was down and gold, which was rallying at the beginning of the year, broke. You had a lot of crosscurrents. You had the dollar that weakened against the euro but strengthened against the yen. It is hard to get your arms around anything. There was a lot of conflicting crosscurrents.”
Long-term trends were hard to come by, and when they were present they often were accompanied by sharp reversals. And just like 2005, discretionary managers outperformed systematic traders: 7.86% for discretionary managers and 2.24% for systematic traders, according to Barclay. As with recent difficult years, diversification helped, as many of the best trends were in physical commodities and managers who diversified across multiple sectors outperformed the larger trend followers with concentrations in financial futures and energies. Unlike recent years, the burgeoning long-only commodity indexes underperformed as reversals and corrections in energies and metals offset bull markets in agricultural commodities.
Just like 2005, trend followers who were more flexible and included multiple time frames and countertrend methods did well. Fort Orange, a 2005 top trader had another solid year — up 20.82% — by exploiting trends in equity indexes and agricultural markets.
“There were a lot of great trending opportunities last year and our models were able to capture those. We also had some difficult market conditions and we didn’t escape all of those,” says Daniel Byrnes, president of Fort Orange. The CTA did well in metals early in the year, and in stock indexes and corn late in the year. “Our big winnings were in base and precious metals and global stock indexes,” Byrnes says.
Ironically Byrnes gave back a large percentage of profits in the second half by being wrong about energies. “We got crude oil, unleaded gas and heating oil dead wrong,” Byrnes says. Despite the drawdown, Byrnes says embracing the volatility of markets is key to outsized returns and says some managers miss opportunities by being too risk averse.
“We are throwing out a lot of nets and we need a few big hauls to make money,” Byrnes says. “Most of the risk-adjusted strategies cause you to lose those fat right tails. We try and exploit those fat right tails. Occasionally we have larger drawdowns, [but] one of the biggest risks is not making money. So we trade fairly aggressively and we try and control drawdowns.”
While Byrnes’ multiple time frames caused him to get whipsawed in crude oil, other managers failed to exploit the large moves in the market. Many were hurt by the correction and several others became gun shy of volatility.
It was another successful year for the burgeoning class of option writers. In June Futures asked, “Are option writers due for a fall?” And right on cue volatility spiked and several managers had a scare. But volatility subsided and the spike simply served to boost premiums for option writers.
“It has been a perfect year for premium sellers,” Waksman says. “It has been an excellent environment for them and they are doing extremely well. I am seeing money flowing into these guys and we are adding them to our database on a regular basis. They used to be a tiny little sector [but] it has gotten bigger.”
Waksman points out that the one market that trended well, crude oil, may have been too risky for some managers. “You haven’t had sustained trends [in other markets] you’ve had in energies the last couple of months. The problem is that given the current [geopolitical] environment there is tremendous reluctance in being short energies because the likelihood of an unexpected event that could drive prices sharply higher overnight,” Waksman says.
“The geopolitical risk is to the shorts not the longs. So even though prices are down you are seeing a lot of CTAs taking a smaller position on the short side than they would on the long side. Some are very reluctant to be short at all, so even though their system is generating a sell signal, they are implementing it by going flat rather than going short because they don’t want to take that risk,” he adds.
One of those managers is Stanley Haar, president of Haar Capital Management. Haar stayed away completely from the energy sector. “We didn’t trade a single energy contract. Corn and sugar were surrogates for energy. The contango market of crude oil made it difficult to profit on the long side and we felt there was too much geopolitical risk to get short.”
Not that Haar suffered, returning 27.41% for the year. He accomplished this by concentrating on physical commodities and through his nimbleness as a fundamental discretionary trader. “Our approach worked well. We didn’t see any big opportunities in financial futures. Our focus on tangible commodities worked better for us.”
Haar’s best trades were in coffee, wheat, corn and the soybean complex. “There were nice moves in all those markets and we avoided being dragged into the choppiness of the currency markets.”
Haar points out he was able to take advantage of trends on both sides of the markets. “We made money being short soybean meal early in the year, and made money [in soybeans] on the long side in the fourth quarter.”
The grain complex was key for many successful programs in 2006 and it helped to have a discretionary element because of the increased volatility, reversals and peculiar moves due to the money flows in and out of the complex. Two factors have turned the grain complex upside down: the amount of money benchmarked to the long-only indexes and the emergence of biofuels. Both of those factors seem to benefit fundamental discretionary managers who are able to measure in real time these two influences on the market.
“All of this money in these markets is creating dislocations that don’t make sense. The discretionary trader, by the nature of his trading style —assuming he can manage not to get run over by the bus — is going to have an advantage,” says Richard Morrow, portfolio manager of Bullfrog Capital Manager. BCM had a successful year but Morrow is finding the new fundamentals difficult to read. “There are so many crosscurrents in what I am trading; the price of crude affects the price corn, which affects the price of everything and then you have these long-only funds,” Morrow says.
“I am very up on ethanol profitability and biodiesel profitability. They are major players in the ags. You have to have an opinion on crude oil if you want to trade corn long term. It is just another variable to be wrong in.”
The increased liquidity in grain markets created opportunities to trade multiple-contract months in individual commodities and treat them as stand alone markets. All the additional variables affecting commodities, while making it harder to read, also creates greater opportunities.
“Hopefully something will become obvious to me, like corn did last year, and there will be a lot of money to be made. But I don’t know what it is right now,” Morrow says. He adds, “There are more variables than there ever have been. But the good news is that there is more liquidity than there ever has been, so the opportunity is there to make a lot of money.”
