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How did managed futures perform during last week's 'Flash Crash'?

May 10, 2010

 

Last week we discussed how we felt that Global Market Volatility seemed to be increasing and was perhaps due for a breakout, which would in turn help pull systematic managed futures programs out of their 16-month sideways funk.  Well, as the old saying goes, it is often better to be lucky than good, and we were lucky enough to be spot on with our volatility call as what is being called the "Flash Crash" pulled the Dow Jones Industrial Average down 1000 points at one point on Thursday of last week, including a record negative 700 points down move in 15 minutes.  The VIX, which measures investor fear in the market, spiked +63% from the day before when it hit its lowest levels since March of 2008.  These are jaw-dropping numbers that are still difficult for even the most seasoned traders to comprehend.

Luckily for long stock investors, stocks bounced back nearly as quickly as they went down, and the Dow finished the day down a more reasonable -348 points.  What exactly happened on Thursday is still being investigated.  And, from the sound of it will take at least a few more days to sort out.  But left in the carnage is the everyday retail stock market investor who may have thought she already had seen the worst of the markets during the credit crisis of 2008.  Now, eighteen months later, we are all left to wonder when the next "crash" will happen. 

Managed futures investors are often the most unpopular people at the party, who actually cheer on such volatile markets, cheering the market to zero; and everyone is asking - how did managed futures perform during the "Flash Crash".  Well, as might be expected given managed futures history as a crisis period investment - Thursday, May 6th was not that bad of a day for commodity trading advisors. They weren’t up, as one would hope, but with the NewEdge CTA Index posting a respectable performance at -0.28% , they were a far cry better than -3.24% stocks saw as represented by the S&P 500 stock index.   

The table below shows that the average performance of the programs on our watch list was right in line with the managed futures index, losing -0.41%. But upon closer inspection, we see that losses were mainly centered on option selling programs and contrarian programs Dighton and Paskewitz.  We would expect short volatility programs to be down during a volatility spike, and also programs which were buying into the sell off as contrarians to be down. The ‘traditional’ long volatility programs were ahead, on the whole.

Past performance is not necessarily indicative of future results

Manager - Program

Est. Daily ROR for 5/6/10

Manager - Program

Est. Daily ROR for 5/6/10

Manager - Program

Est. Daily ROR for 5/6/10

2100 Xenon (2X)

3.32

Rosetta Capital Mgt LLC

0.39

HB Capital Mgt Diversified

-0.70

FCI Option Selling Strategy

2.00

Mesirow - Absolute Return

0.32

Robinson Langley

-0.80

Futures Truth SAM 101

1.64

Mesirow - Low Volatility

0.30

Cervino Capital

-1.69

Covenant - Aggressive

1.50

NDX Shadrach

0.26

ACE - DCP

-3.16

Integrated - Concentrated

1.24

NDX Abedengo

0.18

Cervino Capital (2X)

-3.84

Dominion - Sapphire Program

1.15

Sequential Capital Mgt LLC

-0.07

ACE – SIPC

-4.96

2100 Xenon Fixed Income

1.10

Roe Capital - Jefferson

-0.15

Paskewitz 3X Stock Index

-5.26

FCI Credit Premium Program

1.02

Roe Capital - Monticello

-0.21

Dighton Capital

-5.82

Hoffman Asset Management

0.85

Emil Van Essen - Low Min

-0.33

All Program Average

-0.41%

APA Strategic Diversfication

0.62

Accela Capital Management

-0.50

Non option seller Avg:

0.21%

 

The next question at the forefront of most clients’ minds is where does the market volatility go from here?  Despite the VIX falling over -30% today in the midst of a hefty rebound, our view is that volatility is moving towards an expansionary period after having contracted for the past 16 months or so.  

It is worth noting here that the VIX actually measures only one side of volatility, the downside volatility represented by the price people are willing to pay for Put options (downside protection) on the SPX. Managed Futures programs are more concerned with BOTH sides of volatility, meaning even a 400 point up day like today can mean an increase in volatility despite the VIX telling us that volatility declined 30%.

This is because volatility measures how much a market can move both up and down, so how much it moves up on average each day is just one side of the equation (with how much it can move down the other). For long volatility investments like managed futures, they don’t really care whether an expansion in volatility is caused by large up days, large down days, or both – they just know that the more markets are moving (in both directions), the more opportunity of profits and losses.

So, when looking at volatility with a measure which considers both up and down volatility such as the Average True Range, we can see that overall volatility actually increased today. (and is now up 289% since the lows last Wed - or from the market moving 7pts on average to 27pts)

 
               

Our view that volatility is on the increase is also based on some heavy skepticism that the plan rolled out by the EU today will: 1. Be approved by all involved, and 2. Not cause more problems than it solves by putting the “good” Euro-zone countries further into debt, debasing their currency, etc.  We are now nearly two years into the credit crisis, and it appeared to us last week  that all that has changed is the names involved; with entire countries have replacing corporations as the ones with overleveraged debt portfolios.  

Finally, what no one is talking about anymore thanks to the quick turnaround from that 1,000 point loss is the flaws in the US market system exposed last Thursday. It is coming out that High Frequency Trading firms (some of which account for up to 5% of all trading volume in US stocks on any given day)were partly to blame as they stopped all trading during the fall, pulling a floor out from under the market. The stabilizing (or in this case destabilizing) used to be represented by human ‘specialists’ on the floor of the NYSE. Now we’re relying on computer algorithms to provide bids when no one else will, and they failed on their first big test. How this plays out in the months and years ahead is anyone’s guess, but to me it means more tests of the system either intentionally by hackers, terrorists, hedge funds, or prop firms thinking they’ll profit from it (ideologically in the case of the former two, financially in the case of the latter two).  

Stress Period Performance

The reality is that large stock market declines (whether they be of the single day variety like last week or multi-year variety like 2007/2008 are more common than all of us would like to see.  Stock market crisis periods happen, no matter what the government of the world try and do to keep them from happening (or perhaps because governments try and keep them from happening). Whether today’s rally signals the end of the ‘flash crash’, or whether it is a quick up move in the midst of a new leg downwards (there were two days with larger gains than today in the midst of the broad sell off in 2008), we don’t know and aren’t here to predict.

But everyone with investments tied to the stock market cringes  on a day like last Thursday when 16 months  of stock market gains were wiped out in mere minutes, and it pays in our humble opinion to protect yourself from such market crisis periods .

Historically, managed futures have been the asset class which performs best when global stock markets are struggling through a crisis. Managed Futures have gained an average of +17% during the past 6 major market crisis. (2008 Credit Crisis, 9/11 tragedy, Internet Bubble, Russian Ruble Default, etc.), as compared to world stocks being down an average of -27% during these periods. 

Past Performance is not necessarily indicative of future results

 

In addition to managed futures, individual trading systems like Compass SP and Strategic ES also present a unique investment opportunity for those looking for long volatility exposure.  This is because trading systems are designed in such a way that they risk a relatively small fixed amount ($1500 for example) per trade in hopes of making a variable amount based on how far the market moves in the trades direction.  So, the more a market moves, the larger the variable gain amount can become – while the fixed risk amount stays the same. (Disclaimer:  a system could lose more than the fixed amount via a limit down move, prices moving through a stop order, and other such market events)

Diversify now, not after another crash:

If everything above makes sense to you, we urge you to not be the normal investor who looks into diversifying his/her stock holdings AFTER a big sell off. Diversification works much better BEFORE you need it.  In our experience, successful investors look to diversify before there is even a hint of a problem. They even look to diversify when their main holding are making new highs. The other 95% of the investing public tends to chase returns and run away from losses, creating a death spiral of sorts where they are constantly getting in at the highs and out at the lows. Wouldn’t it be nice to break that cycle? To actually get out (of a portion) at the highs, and get in at the lows.

But what if we keep going up in stocks? Won’t I be worse off for diversifying a portion of my portfolio? Possibly? Stocks could outperform managed futures over the next 2,5, and 10 year periods, making a portfolio with stocks alone better than one including stocks and managed futures. But remember two things here.

One, we’re talking about diversifying a PORTION of your traditional stock & bond portfolio, not the entire thing. We recommend anywhere from 5% to 40% of your overall assets invested in managed futures, and a study by the CME, see it here, calculated 20% of assets as the ideal level of managed futures exposure.

Secondly, a managed futures investment will not necessarily lose money if stocks continue higher. Insurance via alternative investments does not have to be a wasting asset as it can actually make money even if nothing happens.

That’s the beauty of managed futures….they aren’t like dedicated short funds which will, by definition, struggle when the market goes up. Futures investing carries the risk of substantial losses, meaning they of course can lose money when the market goes up, as they have done so far this year, but that hasn’t always been the scenario in the past. In fact, managed futures tend to hold their own in boom times for stocks. See here.

How does this work? It works because managed futures are NON correlated with stocks and bonds. Since 1994, the S&P 500 and CSFB/Tremont’s managed futures index have a correlation of -0.15.  So, managed futures have proven to be non correlated in the past, versus negatively correlated, meaning they move independently of the stock and bond markets. This means a strong stock market isn’t necessarily a bad thing for managed futures. It also means a big sell off in stocks won’t necessarily result in big returns for managed futures, but the past history has shown managed futures to outperform during times of market stress.

How can I diversify:

We have touched on this in a past newsletter, and it bears repeating here. When looking for the stress period performance of managed futures – it doesn’t do to diversify into just any managed futures program. You want a managed futures program which tracks the managed futures index as closely as possible, and not one which may actually end up increasing your stock index exposure.

So, the first step is finding a program you are comfortable will be diversifying you away from stock market exposure, not adding to it. The next is figuring out how much, and when – to allocate to managed futures.

History shows us that managed futures are the place to be during bear markets and crises situations. Futures based investments are often viewed as a way to generate oversized returns due to the leverage built into futures contracts [the use of increased leverage can substantially increase the risk of loss] and potential for large moves, but it is their low correlation with traditional markets which causes managed futures investments to be volatility reducers and portfolio diversifies during the bad times.

Walter Gallwas

IMPORTANT RISK DISCLOSURE


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Feature | Week In Review: Dow loses 700 points in 15 minutes, while Oil and Euro down significantly

Energy futures showed the largest sector decline due to the European turmoil last week as worries of weaker demand in the face of current adequate supply weighed heavily on prices. Crude Oil -12.81% led the complex lower followed by RBOB Gasoline -11.43% and Heating Oil -10.20%. Natural Gas +2.42% posted a rally with spread trading versus other energy contracts the main feature.  

The Stock Index sector fell victim to a worldwide investor purge of stocks due to European liquidity issues and ideas on how the sovereign debt issues could hamper the recent economic turnaround. The weakness was heaviest in the S&P 500 futures -9.16% followed by Russell 2000 futures -8.90%, Mid-Cap 400 futures -8.18%, NASDAQ futures -7.41% and Dow futures -5.70%.

Industrial metals were weaker on ideas that demand growth would be curtailed not only by European issues, but ideas that Far East purchasing would slow after China again increased their lending reserve policy for banks. Palladium -8.20% led price declines followed by Copper -6.23%, Platinum -4.54% and Silver -1.01%.    

The balance of Currency activity last week was under the weather with European turmoil and elections making for a very sensitive environment. For the week Euro Currency fell -4.02% followed by the British Pound -3.05% and Swiss Franc -2.70%.      

Commodity and Food products were mostly lower last week, although demand and weather aided rallies in Live Cattle +1.62% and Wheat +1.47%.  The balance of the complex was hampered by weakness in the financials and ideas that better crop weather could aid in bigger supplies for the current growing year. Sugar -9.24% had the largest decline followed by Cocoa -6.88%, Cotton -4.07%, Lean Hogs -1.35%, OJ -1.27% and Coffee -1.03%.  

Managed Futures

Specialty market manager, 2100 Xenon Fixed Income Program, was last week’s top single sector program earning +2.08%.  For those investors who have been tracking the program since our  4/12/10 newsletter (http://www.attaincapital.com/managed_futures_newsletter/379) you’ll note that last week was one of the prime reasons to have active exposure to the fixed income markets – bond yields fell, along with stocks, sending futures prices higher globally which allowed 2100 Xenon to capitalize. 

Other Specialty manager May estimates are as follows: Emil Van Essen Low Minimum Spread Program +1.77%, NDX Abednego -0.15%, NDX Shadrach -0.04%, and Rosetta +0.08%.

Multi Market:

Futures Truth has the early lead for May in the multi-market sector.  The Futures Truth MS4 program +6.14% est. is the top performer thus far, while is close behind at Futures Truth SAM 101 at +4.37%. Clarke Capital has started May off on the right foot with estimated returns of +8.06% for the Global Magnum Program, +3.54% for the Worldwide Program, and +0.03% for Global Basic.   The 2100 Xenon Managed Futures Program (2X) also had a great start to May at +3.30%.  The only other manager in the black thus far is Dominion Capital Management at +0.15%.  APA Modified, DMH, Mesirow Financial Commodities Low Volatility, and Quantum Leap Capital are at breakeven. 

Multi-Market Programs in the red include Sequential Capital Management -0.25%, GT Capital -0.45%, Robinson Langley -0.92%, APA Strategic Diversification -1.24%, Integrated Managed Futures -2.25%,  Hoffman Asset Management -2.75%, HB Capital -1.49%, Applied Capital Systems -1.93%, Covenant Capital Aggressive -2.86%, Accela Capital Management -3.23%, and Dighton Capital USA Aggressive Futures Trading -7.70%.

Short Term Index trader Paskewitz Asset Management Contrarian 3X Stock Index is at -7.56% after reversing long.

As volatility rose exponentially last week, Option traders were truly tested for the first time since October 2008.  The end result (today’s huge recovery) was more of a non event (so far) as equity markets recovered; however the following numbers do give us a sense of what could have been had equities continued lower and also gives us a sense of what we can expect to see out of short volatility traders from time to time.

Index Option managers were the most affected by the volatility increase and closed Friday with the following estimates for the month: ACE SIPC -14.31%, Cervino 1x -5.58%, Cervino 2x -12.53%, Clarity Capital -6.89%, Crescent Bay PSI -8.07%, and Crescent Bay BVP -11.59%. 

As we would have expected, Diversified Option managers handled the volatility better than their Index Option counter parts.  The current May estimates are as follows: ACE DCP -5.43%, FCI OSS +0.39%, FCI CPP +3.95%, and HB Capital -1.49%.

Trading Systems

Last week was a difficult week for most of the trading systems as the volatility spiked upwards and the markets moved erratically due to the European Union debt crisis and the pricing error that took place at the NYSE. However, the day trading systems handled the erratic moves well and posted some nice results. Rayo Plus DAX led the way with a return of +$4,720.00 , Beta–DT eRL at +$3,249.17, Waugh eRL at +$2,240.00, Clipper eRL at +$1,930.00, Upperhand ES at +$790.00, Compass SP at +$325.00, ViperIIA EMD at +$185.58, and Compass ES at +$20.

Unfortunately, the swing trading systems couldn’t handle the volatility as well as the day trading systems. Waugh Swing ES finished the week at -$17.50, BetaCon 4/1 EX at -$40.00, MoneyBeans S at -$47.50, AG Xtreme2 ES at -$441.76, Ultramini ES at -$492.50, Bam 90 Single Contract ES at -$655.00, Polaris ES at -$680.00, Strategic NQ at -$695.00, Strategic ES at -$1,052.50, Waugh CTO eRL at -$1,080.00, AG Xtreme2 SP at -$1,875.00, Moneymaker ES at -$2,210.00, AG Mechwarrior ES at -$2,377.50, Tzar ES at -$4, 489.17, Strategic SP at -$4,950.00, and Bam 90 ES at -$9,303.06.

IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.

Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.

Please read carefully the CFTC required disclaimer regarding hypothetical results below.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.