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Managed Futures Strategy Focus: Agricultural Traders

August 20, 2012

 

With the majority of U.S. farmland located hundreds to thousands of miles away from Wall Street, it is easy to see how the sheer size of the agriculture sector and its impact on the U.S. economy gets overlooked when discussing the American financial machine. Likewise, most discussions related to managed futures revolve around the systematic trend following CTAs, and rarely their lesser known cousins – Agriculture-focused Commodity Trading Advisors, or as we refer to them in our office, Ag Traders.

Just what is an Ag Trader? They focus on the markets which birthed the futures trade, like Corn, Wheat, Soybeans, Soybean Oil, Hogs, and Cattle. Let the Wintons and Transtrends of the world have their fancy algorithms crunching data on financial futures – Ag Traders want to drive to a farm and stick their hand in the dirt to see what the crop is likely to do.

Now, Ag traders have long held a smaller role in the managed futures portfolio, usually being too small in terms of capacity and staff; and too loose in how and why certain trades are put on to be attractive to large institutional investors. But the recent  grain-rallying drought in the U.S. following a similar one in Russia in 2010, and the resulting good performance of Ag Traders during those times (while traditional managed futures programs have mostly struggled) has put the light squarely on these frequently overlooked options. With that enhanced attention has come a slew of inquiries, and we decided it was probably time to take a much deeper look at the Ag Trading strategy within managed futures, breaking down what they look like, what they do, and why you might want to consider an allocation in your current portfolio.

The Programs

While the common theme that binds systematic trend followers together is how they trade the markets, the thing which bonds the Ag Trader space together is which markets they trade.  As the strategy category name suggests, the programs primarily trade agricultural markets, which is a category comprised primarily of grains and livestock futures. These markets found their roots at the Chicago Board of Trade in the mid 1800’s. And wouldn’t you know it? Many of the managers in the Ag Trading space are former CBOT traders who took their skills off the floor when things started to go electronic.

Many of the manager bios in the systematic space read alike: prestigious schools, programming, science, math, engineering and so forth. The same cannot be said of agricultural managers; they’re just a different breed of trader. Many of them come from backgrounds in farming or raw commodities trading. For instance, Jim Green of Rosetta Capital grew up on the family farm, giving him hands-on experience on how certain changes and movements in weather, supply, and demand can impact market movements. Randall Cleland of Tanyard Creek was heavily involved in forecasting meat markets for consumer brands like Sara Lee. David Skudder of Global Ag started out working for Continental Grain Co. in cash operations, embedding him deeply into the world of the cash trade around the globe.

Typically, the programs will have one, maybe two, people at the top who direct the trading, but very few of the managers will tell you they trade alone. However, even their support staff is frequently going to be unconventional. Where trend followers may want to hire a full-time programmer or mathematics scholar, Rosetta has a full-time employee for weather analysis.  While traditional managed futures programs may base their trading on mathematical equations alone, Global Ag turns to a robust network of grain elevators and shipping companies in the U.S. and China for the inside scoop on supply and demand movements. This type of knowledge, and the network it takes to gain it, can’t be bought in hallowed Ivy League halls.

The bulk of these programs are discretionary in nature, meaning the trading is ultimately at the discretion of those in charge of trading. They’ll use a variety of forms of analysis and data to guide the trading, but rely primarily on fundamental analysis to make determinations. What is fundamental analysis? Without getting too involved, at its core the grain markets are driven by supply and demand.  There is either enough crop to meet consumer demand or there isn’t, with prices fluctuating accordingly. The drought of 2012 is a great example of Mother Nature wreaking havoc on commodity markets with grain prices sky rocketing higher throughout the summer due to damaged crops taking a toll on projected supplies. A benign growing season, on the other hand, can cause oversupply, driving prices down.  Fundamental analysis is the study of all of the factors weighing on both the supply and demand side (weather, population, feed patterns, exports, imports, and more).

While the traders playing the game in the 1800’s only had to worry about the crops in their own backyard, today is a much more global game.  The U.S. is the world’s largest grains producer, but the rest of the world is hungry and eager to increase production.  Grain prices are now very much impacted by growing conditions in other nations - think the soybean crop in Brazil or the wheat crop in Russia. Which means a successful Ag CTA needs to have his ear to the ground analyzing imports and exports from around the world.

What does the trading look like? The most straightforward trade you’ll see from an Ag trader is an outright long or short futures position which speculate as to whether markets will be moving higher or lower in the future.  But things are evolving in the space, and trades have become more sophisticated. Today’s toolbox includes options, calendar spreads (long July wheat, Short December wheat for example) or the old crop/new crop spread - a means of following the planting cycle for various markets.

Overall, these programs are difficult to summarize in a single sentence. You can’t put a value on the experience and specialized world view necessary to create a solid agricultural managed futures program. It’s not just anyone who can look at a Brazilian crop report and estimate how it’s going to impact the U.S. futures markets today and three months down the road. That’s insight you can’t program, which is part of the reason that evaluation of discretionary traders, like those found in agricultural programs, can be so difficult. While we may not be able to identify a unifying element in trading strategies, there are two unique components that apply to the programs in this category - market exposure and performance.

The Markets

From a market exposure perspective, in an era of booming populations with greater and greater demand for food, the commodity trade of grains has increased in significance. According to the USDA the net value-added to the U.S. Economy by the agricultural sector via the production of goods and services will total an estimated $145 billion in 2012 including Gross Farm income of $425.5 billion and production expenses of $333.8 billion. It can sometimes be hard to wrap your mind around markets based on intangibles, like interest rate futures, but these are every day products that you and your family interact with regularly, like cattle, corn, eggs, hogs, soybeans, and wheat. One look at volume changes over the past several years gives you a little bit of insight into the trading opportunities manifesting:

 

Supply and demand metrics have significant weight here. The current U.S. drought is just one example of the wide variety of fundamentals that can impact the markets, but the thing that really sets agriculturals aside from the rest of the markets is the responsiveness we see to fundamentals - period.  Over the past several years, the risk on/risk off trade has come to guide much of the movements seen in the markets, but agricultural markets are less likely (at least lately) to get mired in such moves, relying far more often on fundamentals than other sectors. Over the past 18 months, for instance, on days where the full risk on/risk off trade is in session, the grain sector’s correlation to the move is at .43, which, while substantial, pales in comparison to energies, for example, at .63.

This is the kind of exposure most investors salivate over these days, but they have been, as the song goes, “looking for love in all the wrong places.” With the dawn of commodity ETFs, agricultural ETFs, like Corn (CORN) or Wheat (WEAT), have seen massive influxes of assets. This has been particularly true in recent months. With a record drought wreaking havoc on crops across the U.S., prices have been upward bound, attracting even more attention to an already attractive investing space.

Here’s the problem - long only commodity ETFs consistently underperform even a simple strategy of buying the December futures contract and rolling it annually. When compared with the performance of active trading of Corn and Wheat by professional managers – it is, in our opinion, no contest (Disclaimer: past performance is not necessarily indicative of future results).

And that’s what you pay these managers for. They are the ones with connections to vast networks of farmers, producers, policy analysts and more - not you. They are the ones who can describe, in detail, the differences in crop cycles by region, plant and more - also, probably, not you. This is why agricultural managed futures programs have become increasingly popular - they give investors concentrated exposure to an ever expanding chunk of the global markets in a way that diversified trend followers cannot accomplish, in a far more efficient manner (both on the long and short side) than available retail options.

The Performance

As much as market exposure distinguishes these programs from the rest of the managed futures world and the retail options available, it is also their performance profile that makes them stand out in a crowd. This is something that we, as professionals that spend our lives poring over trading and numbers, can say with confidence, but finding an aggregate numerical representation of this distinctive performance is a challenge, to say the least. There really isn’t a truly representative agricultural trader index out there. The closest is a subset of the BarclayHedge CTA Index, and here, the performance is certainly impressive:

 

Disclaimer: Past performance is not necessarily indicative of future results. Indices are imperfect proxies representing groups of assets, may be subject to survivorship and selection biases, and are not inclusive of all investment options within a given space.

That being said, you don’t invest in an index in this space - you invest in a program. So, in our opinion, looking at individual programs - programs we would consider investing with or already have - provides a better idea of what options are out there for a discerning investor and spotlights why performance is such a key element in the defined agricultural trading category of managed futures.

What programs are we talking about?

 

Program

Month

Quarter

YTD

1 Year

3 years

Global Ag, LLC

17.62%

17.62%

43.87%

62.70%

162.90%

Rosetta - Rosetta Program

5.00%

5.00%

20.28%

22.96%

59.81%

M6 Capital - Standard

8.07%

8.07%

16.68%

26.39%

42.94%

Tanyard - Livestock

1.93%

1.93%

12.84%

8.69%

49.53%

 

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

Those numbers are impressive, but chasing returns is a poor decision making calculus for portfolio construction. The really significant aspect of the performance of these programs is their correlation levels, and ability to diversify a portfolio. Consider:

 

Program

Correlation to S&P

Correlation to BarclayHedge CTA Index

Global Ag, LLC

0.025

0.139

Rosetta - Rosetta Program

0.016

0.019

M6 Capital - Standard

0.041

0.094

Tanyard - Livestock

-0.086

-0.148

 

Correlations calculated since program inception for each program. Disclaimer: Past performance is not necessarily indicative of future results.

These correlation levels to both the S&P 500 and BarclayHedge CTA index reflect a large chunk of the reasoning for including agricultural programs in a managed futures portfolio. Their inclusion can help to diversify a portfolio, offering more balanced exposure to the space while maintaining the non-correlation to traditional asset classes that attract so many investors to managed futures to begin with.

But as is the case with any managed futures program, there are going to be losing periods, as well. Agricultural traders are not immune to the dreaded drawdown, and such volatility has to be considered with any allocation. While impressive and consistent performance has been a hallmark of this space, each of these programs differ in realized volatility, and the amount of risk they take in their trading. For many investors, the most important measure here is the max drawdown- or the largest peak to valley loss sustained in the track record.

 

Program

Max Drawdown

Global Ag, LLC

-17.57%

Rosetta - Rosetta Program

-39.67%

M6 Capital - Standard

-15.40%

Tanyard - Livestock

-14.17%

 

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

As you can see, the phrase “no pain, no gain” has merit here. The performance of these programs can be enough to take your breath away, but those highs can be matched by the lows. Even so, it’s not any single component of performance that strikes us as most important, but the combination of these pieces that paints the argument for inclusion of an agricultural program in your managed futures portfolio.

Investing

So let’s assume you’re interested. You like the types of managers available, you want that concentrated market exposure, and the performance profile sits right with you. What do you need to know about these programs before investing?

First, think about how an allocation would interact with the rest of your portfolio. Generally speaking, we recommend looking at the overall performance of the programs in question, their correlation to your overall investment portfolio, and their correlation to your current managed futures holdings. In our opinion, allocations to agricultural traders should be between 10 and 40% of your overall managed futures exposure. Many of these programs have, historically, had lower minimum investments - floating in the $50 to $100k range, and giving investors the ability to more comfortably diversify. However, as demand for access has gone up, so have the minimums (more like $250k to $500k now), making it a little more expensive than it used to be to get that diversification on the cheap.

Second, know what you’re looking for. As is the case with any discretionary trader, a robust risk management infrastructure is the key to identifying investable options. Discretionary traders are the hardest to understand from a due diligence perspective, as we won’t know exactly why a trader decided to put a position on; they basically have free rein. Therefore, it is absolutely necessary that a trader have sound risk management principles and capital protection strategies in play. They will be wrong, and you need to know what that looks like and how big of a hit it could mean for the program.

But beyond that initial selection, you have to know that the ongoing due diligence is what is most important in some ways. With a discretionary trader, style drift becomes much more significant, and the only way to identify that is to watch the trading explicitly. That’s not easy - and that’s where working with a team like Attain comes in handy.

We’re hopeful this newsletter isn’t the contrarian signal marking the top for the Ag Trader space, because it is an increasingly attractive space to investors. The clients we talk to invested in Ag Traders like the simplicity of the strategy. They like actually knowing the markets that are being traded for their account (Corn and Wheat are a lot easier to understand than New Zealand Bank Bills and Spanish Ibex futures). They like that these are hands in the dirt managers who aren’t just relying on a computer algorithm. And they like the ability of the managers to participate in any run up in commodities, while not having the long-only commodity index problems when a pull-back in prices happens.  

At the end of the day, they find it easier to trust a guy who’s actually worked in the fields he’s trading than a slick trader in an expensive suit. Can you blame them?

 

 

IMPORTANT RISK DISCLOSURE


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Feature | Week In Review: The Sounds of Silence

The low-volume, low-volatility of this August continued last week, with very little action in the indices. The Dow was up 0.57%, the S&P 500 rose 0.91%, the Nasdaq gained 2.02%, the S&P Mid-Cap 400 E-mini was up 1.61%, and the Russel 2000 E-mini gained 2.19%. In bonds, US 10-year notes were down -0.92%, and US 30-year bonds fell -1.99%. In currencies, the US Dollar rose 0.04%, the Japanese Yen fell -1.65%, the British Pound gained 0.12%, the Euro gained 0.22%, and the Swiss Franc rose 0.20%.


Metals and energies had a little more excitement, as Platinum, Palladium, and Crude all showed signs of life in a quiet week. Gold was down -0.21%, Silver was down -0.21%, Copper was up 0.80%, Platinum was up 5.23%, and Palladium was up 3.93%. In energies, Crude gained 3.70%, Heating Oil rose 2.39%, RBOB Gasoline gained 0.79%, and Natural Gas lost -1.84%.

The grain markets continued to show calmer behavior absent any major change in the country’s drought status. Corn lost -0.19%, Wheat was down -1.21%, and Soy rose 0.12%. In meats, Live Cattle lost -0.20%, and Live Hogs gained 0.89%. In Softs, Cocoa was down -0.65%, Orange Juice rose 5.97%, Cotton rose 0.38%, Coffee was down -3.63%, and Sugar lost -2.70%.

 

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.