CRANWOOD: The butterfly effectWhen you ask why his firm had such a good year in 2011, Cranwood Capital Management CEO Pete Powers says it simply was lack of a bad year. See, Powers has been trading butterfly spreads in the Treasury futures complex for more than a decade and the only truly bad stretch came in 2009 when the credit crisis dried up the liquidity. Even then his fund only dropped 1.78%.
“Liquidity dampens volatility to a tradable level for a strategy like mine. In 2009, the Citadels, the Bear Stearns, the Lehmans, all the interest rate desks shut down,” Powers says. “I don’t need volatility, I just need volume, enough to get in and out of the butterfly spread because we get flat every day at 3 p.m.”
The Ohio-based fund owns six seats on the Chicago Board of Trade (CBOT) to qualify for member rates for his highly active fixed income arbitrage strategy.
Powers learned the trade on the CBOT floor and perfected it in after-hours electronic markets, which allowed him to move back to Ohio and build an execution team made up of family and friends. The team of eight trades in shifts over the 23-hour market day.
Cranwood trades the two-year, five-year, 10-year Treasury note butterfly and the five-year, 10-year, 30-year Treasury bond butterfly with one trader executing one leg of the spread and another the other leg.
“We do them simultaneously,” Powers says. “One trader will be legging the NOB (buying 10-year and selling 30-year), at the same time I am selling the FYT (buying the 10-year, selling the five-year), so we are building the body of the butterfly together and we are always on the bids and offers trying to get an edge.”
The trade is not only market-neutral but also yield-curve-neutral. “If we are short 10s, we are long fives and 30s,” Powers says. “Basically, we are looking at discrepancies intraday in the relationship in those three maturities as they relate to each other. We don’t take any directional risk, and in theory we don’t take any steepening or flattening risk because each trade has both elements.”
The increased volume in the complex has led to greater opportunities as Cranwood earned 17.74% in 2011. That number comes with an annualized standard deviation below 10%, meaning they outperformed most managers on a risk-adjusted basis. “The risk profile that we present is by far our most attractive asset,” Powers says.
Good execution is key. “Obviously buying bids and selling offers is ideal, but more importantly we don’t do worse than bid, bid, bid; we are not going to give up an edge if we don’t have to.” The strategy is time and personnel intensive, so if they didn’t add value, it wouldn’t make much sense to have eight people executing. “We would probably look to automate, but automating the strategy has not proven to be fruitful because an automated system is going to sell the bids and buy the offers, giving up a chunk of the move,” Powers says. “Right now the team aspect, the assembly line approach, far outperform any type of automation.”
Surprisingly, the long-term zero-interest-rate-policy by the Fed has benefitted the program. “It is a lot easier to predict. [Price] stays in a band over a group of years,” Powers says regarding the effect of the zero-rate policy. “Volume takes off at any hint of an uptick in rates so the fact that volume is still strong and we are at these low rates gives me the confidence that things are only going to get better for this strategy.”
Rising volume and the need for more products is a good sign for Cranwood. “We are doing three auctions a week, two weeks out of every month. The volume is going to be astronomical over the next 10 years,” Powers says.
Not only is volume growing, but also the emergence of the Ultra Bond (30-year bond future with a longer minimum maturity) will add another facet as Cranwood plans to begin trading a 10-year, 30-year, Ultra butterfly in 2012. This should allow Cranwood, currently with $39 million under management, to spread its wings.
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