It is no surprise that commodity trading advisors (CTA) had a tougher go in 2009 after what arguably was their best year ever in 2008, especially when measured against all other alternatives. But putting a finger on exactly why some managers did better than others is a little more difficult.
While it was a bad year for trend followers in general, several did well, and while some managers define themselves more for marketing purposes, it seems there are always trend followers who do well. It would be too time consuming for us to apply some sort of purity test to trend followers and absent that, we have to conclude that there is much greater diversification in the space than many give it credit for.
Based on conversations with numerous managers, traders who are extremely long term did better in 2009, as did those who allowed themselves some discretion. The Barclay Discretionary Traders Index was up 2.16%, while its Systematic Traders Index dropped 3.3%.
John Hummel, principal of AIS Futures Management, describes his program as trend following, but it is discretionary and very long term, which worked in his favor. His 2X-4X program returned 64.31% and his 3X-6X program returned 97.26%. He stayed in for the long haul, meaning he didn’t catch the 2008 mid-year reversals but was able to avoid the chop of 2009. His programs have been long gold off and on since the market turned in 2000.
It was a year of unprecedented intervention, or at least proposed intervention, by government into markets. Several managers cited the Federal Reserve’s quantitative easing decision as a major factor of market activity.
“The political situation is fragile,” says Stanley Haar, whose discretionary agriculture program dropped a few percentage points. Haar, who trades off of fundamentals, was hurt by interventions that tilted the dollar/ag balance.
The Barclay CTA Index was down (-0.1%) for only the fourth time in its 30-year history. The index was down in the first quarter as numerous downward trends reversed course and it was down in the fourth quarter, specifically December, when the dollar reversed.
Oddly enough, concerns over sector correlation may have prevented even worse returns. Last year many managers noted that they had reduced position sizing as positive returns mounted and it became apparent many markets and market sectors had become highly correlated. And while most CTAs underperformed in 2009, you didn’t see the type of negative returns in managed futures in 2009 that you saw in mutual funds and hedge funds in 2008, which may be due to managers being more cautious.
Jay Feuerstein, principal of 2100 Xenon, believes this may have helped keep losses down. Feuerstein dropped 7.56% in his managed futures program and attributed the tough conditions to choppy markets and the Fed’s quantitative easing. When asked about the difficult conditions, Feuerstein simply produced a daily bund chart, which illustrated extremely choppy conditions. “Choppy markets hurt our mean reverting trades,” he says.
And it wasn’t just fixed income markets, but grains and energies that produced a lot of chop. Perhaps trends in metals, currencies and equity indexes could have offset the choppy markets if it weren’t for the sharp reversals at the beginning and end of the year.
While the negative correlation of the dollar to almost everything caused some managers to be cautious, it provided opportunities for others. Discretionary trader Michael Frischmeyer noticed that traditionally non-correlated positions showed negative correlation and was able to treat them as a hedge. “Because I recognized the markets all ebb and flow together, I loosened my risk management a bit and allowed my positions to move adversely because I recognized the counterbalanced positions. I wasn’t kicked out of positions as quickly, so it prevented me from being chopped up as much as if I carried normal stops,” Frischmeyer says. His discretionary program returned 42.09% in 2009.
Niche managers did a little better as currency markets offered long-term trends against the dollar and equity indexes had an impressive rally following the March lows. Several extremely long-term traders produced solid returns by riding out the chop and avoiding the whipsaws.
Becker Asset Management made 39.59% in 2009. They trade a traditional trend following strategy along with a short-term counter trend strategy. Oddly enough, Becker earned more profits in its traditional trend following model. “We trade all the liquid U.S. futures markets except for energies,” says John D. Becker. “We had money in currencies, interest rates, grains, gold and silver. There was not one home run. Profits were kind of spread out.”
And while there appear to be quality short-term traders who have emerged in recent years, the best performers aren’t coming from their ranks. One exception is Quantitative Investment Management (QIM), which produced a 31.81% return in its X3 program and seems to make money in all market conditions. QIM earned nearly all of its profits in equity indexes but managed to tread water in most other sectors despite taking a hit when the Fed announced its quantitative easing policy. “We [had a big drawdown] as the quantitative easing was announced,” says QIM Principal Michael Geismar. “Government manipulation is not a good thing.”
Pixley Capital Management produced returns of 32.98% with its short-term countertrend system. Pixley holds trades a couple days at a time and concentrates on stock indexes and currencies. While they are short-term and countertrend, their success may be most attributable to trading in the two sectors that offered the best long-term trends in 2009.
YOU NEEDED A SCORECARD
In 2008, it was easy to know who did well. If you followed trends, you did well. Last year’s successful managers were an eclectic mix of niche managers, extreme long-term traders, short-term traders in the right sectors and discretionary traders who chose well. It demonstrated the growing diversity in managed futures.
When analyzing managers, we have learned that it is sometimes better to look at how they handle tough market conditions — how much they lose in reversals for example — than their returns when the market winds are at their backs. And while 2009 was a tough year for most CTAs for some obvious reasons (choppy markets) and some not so foreseeable actions (quantitative easing), the drawdowns for most managers were reasonable, particularly given the returns of the previous year.
Most managers we spoke with expect 2010 to be a better year, and it certainly could be, but there also is a good chance that unforeseen factors will again work against traders as the fallout of our economic crisis is far from over. But CTAs have always been a good play when large market dislocations occur, so chances are they hold the best potential for providing a hedge against the unforeseeable turns that undoubtedly will come as we work through the most severe economic crisis in several generations.
BRIARWOOD: THE ORIGINAL ODD COUPLE
Paul (Bucky) DeMarco was following in his father’s footsteps as a coffee trader on the Coffee, Sugar & Cocoa Exchange when a sting operation of floor traders in Chicago in the late 1980s convinced him that the floor might not be around forever and that he needed to pick up additional skills.
Fred Schutzman was first a student and then an instructor at the New York Institute of Finance, where he studied under and taught alongside famous technical analyst John Murphy.
The two were introduced when DeMarco took a class on technical analysis. “I was teaching the class and met Bucky,” Schutzman says. “His desire was to learn more about technical analysis so he could trade better; my desire was to learn more about trading so I could apply my theoretical knowledge. Everything was nice in the text books but I always had in the back of my mind, ‘can I make money with this.’”
DeMarco says, “Freddy and I are opposites. He likes peace and quiet, I am the trader, the extrovert and loud guy.”
Despite their differences, the chance meeting began a 20-year collaboration and friendship that eventually led to the creation of Briarwood Capital Management.
“I remember our first trade. I told Bucky ‘I am really bullish on 30-year bonds, let’s buy it,’ so he said to me ‘if we are wrong, where is our stop?’” Schutzman says. “And I said ‘Oh my gosh, I didn’t think of that. I realized how much I had to learn. Technicians don’t worry about being right or wrong, you just look at a chart and make a prediction.”
That began a learning curve for both men, with Schutzman learning the realities of trading and DeMarco learning the intricacies of technical analysis.
The two worked well together and Schutzman would expand his studies to computer programming and begin to program their trading concepts. By 1996, they had a program and one customer and they would trade and optimize their method over the next five years. “It was a combination of discretionary and systematic, and by 2001 we were fully diversified and 95% systematic — we were professional at this point,” Schutzman says.
The program launched in 2001, trading three systems: a long-term and two intermediate systems. Two of the systems are trend following in nature and the third system uses pattern recognition.
Schutzman is a fan of Jesse Livermore’s pyramiding approach but was wary of the volatility. “We found that by trading three systems independently we are getting all of the benefits of pyramiding without the downside,” he says. “The systems are buying it piecemeal. If the trend continues, we are adding to our winner. On the best trends hopefully we are fully invested and on the failed breakouts we have less than a 100% position.”
The approach allowed Briarwood to be successful in 2009 despite a difficult environment for trend followers. Their standard low volatility program, which has more than $200 million under management earned 8.77% with the X2 program returning 22.02%.
“We are trading three systems. They enter and exit at different times,” Schutzman says. “Ideally they should have drawdowns at different times.”
The discretion comes in the form of a risk overlay borne of DeMarco’s unease with holding positions too long. “Me being the floor trader, I have more of the shorter-term mind set,” he says. “When markets go up hard, they often come down just as hard. We found that V tops and V bottoms are our worst enemies. It doesn’t give our trailing stops enough time to catch up to price action, so we developed a risk management overlay that says if risk is too great, do something.”
What they do is tighten up their trailing stops or take profits. Their approach is not complex but a combination of Schutzman’s technical knowledge and DeMarco’s trading expertise. “When I was a technical analyst all of the top technicians used simple stuff,” Schutzman says. “Speak to any of the top traders and they tell you simple is better. If you can build something simple with very few parameters, that is likely to work well into the future,” he says. And he should know. One of Briarwood’s models only has eight lines of code but it helped them average double digit returns since 2001 with a solid risk profile and no down years.
Their approach isn’t so odd after all.
FCI: DIVERSIFYING RISK BRINGS SUCCESS
It is no surprise that Financial Commodity Investments’ (FCI) Credit Premium Program (CPP) did well in 2009 — most option writing programs had a good year — but it was also up in 2008, making it quite unique. FCI President Craig Kendall is a certified public accountant and longtime investor with a pretty good sense of timing. He exited real estate in 2006 and took profits in equities before the dotcom bubble burst.
As an accountant who had helped take a couple of companies public, he was amazed at the valuations he was seeing in the late 1990s and knew he needed to diversify his holdings.
In the early 2000s, he opened an account with famed option writer Max Ansbacher and became a protégé of his. What struck Kendall about the strategy after a conversation with Ansbacher was its simplicity, so he went about creating his own advisory.
“First of all, in futures you have increased leverage and if you take some risk, the returns can be commendable but managing the risk is ever so important, especially in options writing. I don’t need to tell you that a lot of the competition is not around today,” Kendall says.
So in 2003 he became a registered CTA and investment advisor. He launched his Options Selling Strategy (OSS) in 2004 and the CPP in 2006. What distinguishes both of his programs is that they trade a diversified group of markets instead of concentrating on equity indexes as most options writers do. Each program has roughly $10 million under management.
“There were a lot of options writers out there and I thought why not take the same strategy and diversify it across different commodities,” Kendall says. “With this strategy we are really a short volatility play and there are times when the volatility on the S&P doesn’t warrant doing credit premium selling because the risk/return just isn’t worth it. But by doing the extra research and finding the volatility opportunities amongst various commodities [we find opportunities] to make good trades that can be a lot less risky than doing the S&P.”
FCI trades energies, currencies, bonds and grains; all the major liquid markets. The downside to the diversified approach is that he is researching two dozen or so markets instead of one or two indexes. “You really have to monitor a lot more markets. [But] if we monitor all these markets and take only the safest volatility trades, we should have better returns for the clients with reduced risk.”
Both programs are discretionary and look at both technical and fundamental inputs. The OSS sells mostly naked options two standard deviations out-of-the money. The CPP gets in on credit spreads and is always hedged.
“Prior to putting on any trade we have a predefined stop loss. If stuff moves against us we are pretty consistent with getting out,” Kendall says. “What is discretionary is whether we roll up or whether we roll forward or roll out and we take that on a case by case basis although historically, nine times out of 10, we roll out and look for other opportunities.”
Being hedged and diversified allowed the CPP to earn positive returns the last two years: 29.04% in 2009 and 6.94% in 2009. The OSS returned 38.91% in 2009 and lost 23.02% in 2008, still outperforming most programs in that space.
OSS got caught in the extreme volatility in 2008, says Kendall. “We went back and looked at the volatility. We are not poker players and in 2008 it became a poker game. Right now when volatility explodes to those levels we just sit on the sidelines. We let all those opportunities pass.”
The upside to writing options across a diversified group of markets is that you can afford to be choosy. “Volatility shifts from time to time,” Kendall says. “Last year we did a lot of energies, this year it has been currencies and Treasuries. We follow the volatility opportunities.”
FCI will have about eight positions on at a time, in markets with the best risk/reward profile. “Our best success is when we wait for the opportunities to come to us,” Kendall says. “The best trades are when we wait and catch extreme volatility.”
That happened in sugar in 2009. “Volatility really exploded. We were selling calls but we waited until we got to high prices.” Kendall says his programs are well suited for current uncommon market conditions; based on his timing and track record he may be right.
EMIL VAN ESSEN: FRONT RUNNING THE FRONT RUNNERS
For many people, the exponential growth of commodity index funds has been cause for great consternation. But from a traders perspective the changes in the nature of commodity markets, particularly in spreads, that the funds caused provided great opportunity.
Emil van Essen created a program in 2007 to exploit those opportunities, which he has done to the tune of 218% since launching. He earned 28.88% in 2009 and his assets under management ballooned above $100 million.
Van Essen noticed how the growth of index funds and commodity exchange trade funds throughout the middle part of the decade became a dominant force on commodity markets. “I looked at how we could take advantage of their behavior and their size. We were looking at how they rolled their positions and also how a lot of participants were front running the roll of the index funds and trying to get in front of that whole wall of money, essentially we were [front running] the front runners,” van Essen says.
When long only commodity index funds roll they sell the front month and buy the next contract, and a front runner sells the spread (bear spread) in front of them.
However, van Essen’s program is more complex than simply placing bear spreads in front of the Goldman roll. He modeled every aspect of commodity spreads and found multiple ways to exploit anomalies in that relationship. “Spreads are much more consistent in their behavior and it is a lot easier to take advantage of the nuances of spread markets,” he says. “Our ability to capture alpha in this market became a combination of getting an edge by front running the front runners in the index funds and also being able to model the markets to take advantage of price movements.”
“We were modeling this wave of money. If the long only funds roll through a nine-day period, when are the front runners starting to put on their positions? And how could we model [it to] get in front of that movement of money so we can put on our positions and let all of those front runners push it in our direction,” van Essen says.
He found that he didn’t always have to wait for the rolls to realize profits.“A lot of markets that have a lot of noise end up spiking and then reverting back to the mean,” he says. This allowed van Essen to profit long before the major index rolls and, at times, exploit one roll period multiple times. “If we know that a market is mean reverting we can sell the spread on a spike and then if it gets back to the mean just take a profit and wait for another spike. And if it doesn’t come back right away we can wait for the roll period to bring it back.”
This is valuable because one criticism of the bear spread strategy is that it can act like an options writing scheme, producing consistent profits for a while and then a huge drawdown when a significant commodity shortage occurs. This happened in October 2006 when a wheat shortage in Australia caused a spike in the front month wheat contract and bear spreaders lost millions. By getting in earlier and on occasion taking profits early, van Essen avoids some of this risk. He has also deleveraged the program from it original format. The 2009 return is based on using approximately one third the leverage of when he started in 2007. Van Essen is also adding an additional risk overlay that will take small offsetting futures positions in case of a sharp rally. “We found that all of our drawdowns were the results of spikes in the [front month] market,” van Essen says.
Constantly updating research is important because contango markets and front running bear spreaders create a drag on the performance of the index funds and indexers are looking for ways to alter their indexes to reduce these headwinds and create a smaller footprint. But van Essen is not worried it will affect his program. “I love when these guys do this because they are still rolling in a kind of dumb way. They have a standard way of operating and the more they try and change it, we will know exactly what they are doing and we will just be in front of them.”
Van Essen has researched how spreads work, so if the phenomena of the index funds changes, either due to demand or new regulation, his strategies likely will still produce profits. “We have spent a lot of time and money over the last few years building models for how to trade spreads. We have state of the art models [and] more than half of our alpha comes from modeling the spreads before a roll ever takes place.”
