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Where will Managed Futures go from here?

August 15, 2011

 

We ended one of our blog posts last week asking:

Where does volatility go from here? That is the million dollar question? Are we at mid 07, about to see 18 more months of high volatility; or are we at the end of 08, where volatility is about to drop drastically…

This IS the million dollar question. We all know managed futures crisis period performance, but are we at the beginning of the crisis, or the end?  There were a lot of people who got into managed futures at the end of the first credit crisis (around December 2008) who were left with losses and a bitter taste in their mouth after a down year for managed futures in 2009.

Conversely, those who seized upon the first signs of a crisis in early 2007 (remember China being down 5% or so over MLK weekend?) were well rewarded through the rest of 2007 and 2008. So, where are we? Is this volatility spike like early 2007 or late 2008?  

[Disclaimer: Past performance is not necessarily indicative of future results.]

http://www.attaincapital.com/img/newsletters/20110815_Fig1.gif

Note: Managed Futures = Newedge CTA Index

The VIX

Here, there and everywhere, people turn to the VIX as a measure of volatility. As a refresher, the VIX is the ticker symbol for the volatility index that the Chicago Board Options Exchange (CBOE) created to calculate the implied volatility of options on the S&P 500 index (SPX) for the next 30 calendar days. It's typically viewed as a "fear gauge" for the market.

The VIX, recently at about 36, is telling us that options traders are assigning a one sigma (one standard deviation) implied annualized volatility of 36% to the S&P 500 stock index calls and puts they are buying and selling on the Chicago Board Options Exchange (CBOE).  In laymen’s terms, that means traders are pricing in a move of 36% either up or down from current levels over the next 12 months. More technically, that implied volatility level of 36%, in turn, comes out to a move of 10.4% over the next 30 days (the period actually being traded), calculated by dividing 36 by the square root of 12.  This math shows us why a spike from 16 to 36 is such a big deal. We’re talking about the difference between a 4% move over the next 30 days and a 10% move.

To ascertain where the current move up to 40 in the VIX leaves us, a map is needed showing us where we’ve been. First up in that department is a look at the VIX from 2007 to the present. In the words of the Grateful Dead – what a long, strange trip it’s been.  It wasn’t all that long ago (beginning of 2007) that all was well in the world and the VIX sat at the now mind boggling level of 10. A quick 20 months later it was hitting all time highs of over 80.

http://www.attaincapital.com/img/newsletters/20110815_Fig2.gif

In between, Bear Stearns hedge fund blow ups, Madoff, TARP, bailouts,stock routs and the Lehman bankruptcy had the VIX averaging about 35. Cue QE1 and the VIX quickly fell from the dizzying end of 2008 heights all the way back down on the heels of the rally from the March 2009 lows, hitting a low of 15 just over one year later.

From there, we had a brief spike on Version 1.0 of the Euro Crisis when pictures of Greek riots on CNBC and a falling market led to the Flash Crash, and the current spike higher from around 16.50 to a high of 48 just one week ago (8/8).

A different look 

But the level of the VIX (10, 80, 15, 48) often doesn’t matter as much as the change in the VIX.  There were times in 2009 when the VIX was at 35 and it felt like a walk in the park without any volatility at all. Conversely, February 27th 2007 felt like the end of the world shortly when the VIX spiked from 10 to 15. The difference- a move of just 5% or so between readings when it was high in 2009, and a full 50% spike from low levels in 2007.

The spikes are what cause pain more than the absolute level, as the spikes are what catch investors wrong footed and unawares. In that regard, we tweaked the data a little by dividing the daily VIX reading by the average reading over the past 30 days, in order to get a view of the change in volatility.

http://www.attaincapital.com/img/newsletters/20110815_Fig3.gif

Taking this different view, some of the noise of the raw VIX readings gets filtered out and we’re left with four major spikes since that fateful one back in February of 2007.  Interestingly, when looking at how much of a change in volatility there was at these spikes, we quickly see that the move up to 80 in the VIX in October of 2008 is actually the smallest spike by this measure.

And even more interestingly, this recent spike ranks as the highest of the spikes, with volatility spiking 105% above its average over the 30 days preceding August 8th, 2011. For all you cycle fanatics out there (not the Lance Armstrong type), how about the rather regular spacing between these spikes?

The question remains

So now we know where this stacks up against recent volatility moves, but the question remains… Are we looking at more of an October 2008 type volatility spike where the next two years are subpar for managed futures, or a February 2007 type spike where the next two years are above average for managed futures?

[Disclaimer: Past performance is not necessarily indicative of future results.]

 

 Recent VIX Spikes

Feb '07

Sep '08

Jul '11

VIX prev. month

10.42

20.65

16.52

VIX end of spike month

15.42

39.39

25.25

% increase on spike

48%

91%

53%

Max VIX spike above 30day Avg

68%

65%

105%

VIX pre spike relation to 200d MA

Below

Above

Below

Stock trend pre-spike

Up

Down

Flat/Down

Managed Futures Next 22 mos.

23%

5%

??

 

Note: Managed Futures = Newedge CTA Index

Our initial reaction to the question is that this feels a lot more like the spike of 2007, being a reversal of the trend up in stocks and commodities; and coming from a VIX reading of below 20. Hindsight is 20/20 as the old saying goes, and looking back with the perfect vision now – we can see that the 2008 spike was almost too obvious in its profile as an unsustainable panic driven blow off, with the VIX doubling from 40 to 80. There was simply no way the stock market would be moving at an annualized rate of 80% for several years at a time, and the only real way for volatility to go at that point was down. The Sep/Oct of ’08 spike in the VIX was also brought about by a continuation of the down move, not a reversal of the trend, again leaving little room for further downside movement from which managed futures could make further profits.

Further, the 2008 spike was at the end of a year in which 100% of the markets Attain tracks saw their volatility expand. Unless you are in 5th grade with an extra credit question at the end of the quiz, it is impossible to beat 100%, and the likelihood that every market would see volatility expand again in 2009 was remote. See our recent blog post on the managed futures environment for more on the volatility expansion/contraction across markets.

Fast forward to the current volatility spike here in 2011, and we see that it comes from a much better place than the spike in 2008 in terms of ushering in a period of volatility expansion. The VIX was sitting below 20 just as in 2007, and we have just lived through two years of volatility contraction. These factors make it appear to us that this is the beginning of a crisis period, not the end.

So jettison all short volatility programs and flood into the long volatility, traditional managed futures CTAs, right? Not so fast… we do have some reservations about saying the next 22 months will be similar to the 22 months following the Feb ’07 volatility spike.  

For one, the fact that the VIX saw such a huge spike is worrisome. Shooting 105% above its 30 day moving average placed its tops amongst all the volatility spikes; and makes it appear as more of a blow off, one-time thing than the trigger for a volatility expansion.

Secondly, there were some odd circumstances going on throughout 2008 in terms of bailouts and investor panic which aren’t likely to be repeated this time around (we’ve been there, done that before, so people aren’t as likely to get fully spooked).

Third, a rising VIX technically has very little to do with managed futures, with stock index markets a very small portion of most managers portfolios (less than 5% on average would be our guess).  Sure, volatility in stocks usually leads to volatility elsewhere (especially in fixed income and currencies which are big parts of managed futures portfolios), but it doesn’t necessary lead to increased volatility in markets like grains, softs, meats, and so on. And indeed, the reaction of grains during this sell off has been muted.

And finally, the volatility spike in early 2007 occurred when the US yield curve was averaging about 4% to 5%, kicking off a drawn out down trend in rates (up trend in bonds as price and yield move opposite one another).  Today, the yield curve average is maybe 1% with us standing at or very near all time lows in rates (highs in bonds), meaning there isn’t a lot of room left on that trade should this volatility spike usher in a new extended down move in stocks.

Conclusion:

There will be people telling you to jump into managed futures following this most recent crisis, and over the long term that is likely very good advice, but – as always – look before you jump. We have just come through a very beneficial 4 weeks or so for managed futures, and getting involved in a long volatility program right now may be akin to getting in at the highs in 2008.  That worked out fine for those who held on through down periods in 2009, but if you are getting into managed futures as a short term play on volatility, you may very well end up leaving disappointed. Invest in managed futures not for the potential returns amidst increased volatility over the next 3 months, but instead of the next 3 years.

On the flip side – there will also be people telling you to take advantage of this volatility spike to invest in short volatility programs which have just been through the ringer. Again, if you are making that play as a short term play on volatility reverting to the mean – you may end up leaving disappointed again.  Short volatility programs will be selling elevated levels of volatility, but there is at least an even chance that we have just ushered in a new volatility expansion phase (which will cause continued pain for option sellers – as in 2007/2008).

So which is it?  We’ll start by saying that it is impossible to predict the future, and that this is more of an exercise to get possible risks and rewards fleshed out. Then we’ll admittedly cop out a bit and say that our best guess for what last week’s market action portends for managed futures future is that it doesn’t mimic either Feb. ’07 or Sep ’08.

What do we mean by that? Well, if Feb. ‘07 ushered in the perfect conditions for managed futures where nearly all markets saw volatility expansion, and Sep ’08 was the blow off top for the end of those conditions and ushering in (a few months later) a very difficult period for managed futures – then this volatility spike will be neither so awe inspiring or devastating.

The conditions are there for some volatility expansion, but we can’t realistically expect the sort of wild expansion we saw in the 07/08 period as the financial crisis unfolded. And while there is room for some contraction off these recent highs – it isn’t likely to be the sort of massive contraction seen in 2009 (because we’re reversing direction and because we don’t have that far to come down).

So, that leaves us somewhere in the middle, with some poor periods for long volatility managed futures programs in the lulls between storms, followed by quick bursts of profitability upon events such as a failed vote in the US Senate, hurricane, drought, or similar.  

A note on managed futures performance data: 

The mention of specific asset class performance (i.e. +3.2%, -4.6%) is based on the noted source index (i.e. Newedge CTA Index, S&P 500 Index, etc.), and investors should take care to understand that any index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship and self reporting biases, and instant history. 

The mention of general asset class performance (i.e. managed futures did well, stocks were down, bonds were up) is based on Attain’s direct experience in those asset classes, estimates of performance of dozens of CTAs followed by Attain, and averaging of various indices designed to track said asset classes. 

IMPORTANT RISK DISCLOSURE


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Feature | Week In Review: Markets Keeping Investors Guessing

Stocks took everyone for a wild ride last week. Despite starting off down, rocketing up and paring back down, all major U.S. indices finished the week at lows not seen in ten months, including the S&P 500 losing 1.75%, Dow Jones down 1.33%, and Nasdaq falling .43%. Though many were concerned the S&P downgrade would negative impact treasuries, 30 year bonds were up 3.21% and ten year notes up 1.77%- both resting at multi-year highs.

In currencies, losses were seen across the board, including the Swiss Franc- which closed down 1.15% after reaching new all-time highs and seeing government intervention as a result. The Japanese Yen, despite similar interventions by the Japanese government, was up 2.15% to a new multi-year high.

In metals, the main story was gold, which saw an increase of 7.21% to new all time highs. Silver also rose 2.37%, while copper dropped 2.55% to a 9 month low. Energies saw crude fall to its lowest levels in two years, while RBOB gasoline rose slightly- just .61%.

Corn rose 1.24%, while Wheat surged 3.45% and Soybeans fell .10%- despite U.S. reports of lower yields for all three. In softs, cocoa and cotton were down to more than 8 month lows, while Kansas City Wheat was able to rally back from a 7 month low to close up .97%.

Trading Systems

The extreme gyrations during the trading week of August 12th seemed to be a better proposition for day trading systems versus swing traders.  Most swing traders experienced a tough atmosphere as the unnerving situations in the U.S. and Europe led to uncertainty in the marketplace and an environment not conducive to trading systems looking to fade market moves. Only 7 of the 19 swing trading systems came out the of the week in the green with the day trading ratio providing 4 profitable systems out of the 6 that had trades. The severe extremes in the marketplace mostly aided systems trying to catch the breakout looking for follow through activity.

Day trading systems that did have a successful week were Rayo Plus DAX +$13020, PSI ERL +$3414, ATB Trendy Balance v2 +$2977 and Bounce EMD MOC+$1724. The underperformer’s were Bounce ERL MOC -$138 and Upper hand ES -$67.  

Swing trading systems struggled as whole, although there were a few that navigated the extreme volatility to post successful scores. The bright spots included August TD portfolio +$26,210, Bam 90 NQ +$2456, Bam 90 EMD +$2068, August Div. ONE S +$1287 and Money Beans +$290. Strategies that found conditions very treacherous were Strategic SP -$24100, Money Maker ES -$2518, Bam 90 ES -$2740, Bam 90 ES MM -$1573 and Turning Point ES -$1714.

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.