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Four important thoughts for a -500 point Dow day

September 15, 2008

 

Unless you are one of the lucky few who is cruising the Caribbean, without power, or otherwise disconnected from the world today – you have no doubt heard of the financial hurricane surrounding Lehman Bros, Merrill Lynch, and AIG today, and resulting market activity: Dow down -504 pts (-4.42%), Nasdaq down 81 points (-3.60%), S&P down 59 points (-4.71%) while 30 year bonds rallied over 4 basis points.

A few comments on today’s action:

1.  The safety and liquidity of your funds in a futures account should be the last of your worries…..thanks to the segregated account structure of the futures industry.

The segregated account structure of futures trading accounts protects customers from incurring losses should the brokerage firm, clearing firm, or the clearing firm’s bank go bankrupt.

This segregated structure means that client funds on deposit are not subject to any offset, indebtedness, obligation, or liabilities of any entity besides the customers themselves. These regulations are in place so that the clearing firm can not dip into the customer funds to offset losses elsewhere. The futures industry is a model of transparency, as well, with clearing firms required to submit a daily segregation computation to the National Futures Association.

This is one of the major differences from a Broker/Dealer firm (i.e Bear, Lehman, Merrill, etc) Those firms can borrow money (and say, invest it in sub prime mortgages) based off the amount of customer assets they have, and they can lend money and securities based off the amount owned by their customers.

One of the main problems going on right now with several of these investment banks failing is that they not only borrowed money to spice up trading returns, but that they leveraged that borrowing by a large amount. This leverage caused just a small move lower in the price of the mortgage backed securities they owned to feel like a loss up to 20 times that bad.

With the banks usually many times the size of the individual clearing firms (usually tens to hundreds of times as large), clients have rarely, if ever (until now) been concerned about the possibility of the bank the clearing firm holds its money in going bankrupt. Usually a client is concerned about the brokerage firm they are using or the clearing firm that produces their daily statements, but thinks little of the bank the clearing firm uses (and rarely even knows what bank the clearing firm is using unless wiring funds to their account and listing the bank’s details).

But with today’s activity, and general feeling that the financial system is not what it should be in the US, a new concern has emerged. What if the bank that holds the segregated funds goes under?

We put this question to our attorneys and a senior officer of one of our clearing firms, to double check our knowledge on it, and they confirmed that our understanding is correct.

And that understanding is that the customer segregated account structure carries all the way through to the bank level. In fact, the bank must issue a letter to the clearing firm stating they are aware of the “segregated account” status of the deposit, and will treat it accordingly. And only certain banks are allowed to carry clearing firm’s segregated accounts.

Finally, even if a clearing firm’s bank failed and the funds were not provided the segregated protection for whatever reason, the full capital of the clearing firm is between you and the failed bank. That is, you deposited your money with the clearing firm, and they have the obligation to return that money to you if you desire it. In a way, the bank failing is more the clearing firm’s problem rather than your own.

There are regulations in place for how much capital an FCM must have on hand to meet such circumstances, and that capital amount must be reported and is transparent in much the same way the segregated customer funds numbers are.

It is important to note that Forex accounts do not have the same segregated account structure, and are at risk of being used as firm capital. That is, forex accounts are at risk of being used in the very manner the government has protected futures customers from via the segregated account structure. We saw this in the Refco bankruptcy – with no futures clients we know of losing any money, yet many Forex clients losing money.

Another important note,  Treasury Bills held in your account are afforded the same segregated account protection, being viewed by the bank as customer property belonging to the customer segregated account.

In closing, we think it is more important to be worried about if you’ll ever be able to sell your house, your portfolio composition, putting your kids through college, or your future asset allocation percentages at this time rather than the safety and liquidity of your futures account.

2. At times like these, managed futures are the place to be…..

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 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.

But what does low correlation really mean to an individual investor. Saying non correlated investments are better than highly correlated ones is fine, but how does it play out in real hard earned money. To see this, we looked at how the asset class managed futures reacts to different stress periods as compared with the stock market (as measured by the S&P 500 index).

To accomplish this, we compared the performance of the CSFB/Tremont managed futures index versus that of the S&P 500 during the following five market crisis periods. You’ll notice the last one is the current crisis we’re in, the credit crisis.

1. 1994 - the surprise Fed rate hike in February 1994 sent stocks reeling, and caused the S&L crisis, Orange County bankruptcy, and Mexican Peso devaluation. (Mgd fut = +11.95%, S&P 500 = +1.32%)

2. 1998 - This year saw post-Communist Russia default on its debt, causing widening credit spreads across the globe. The widening spreads caused severe losses for several hedge funds, including Long Term Capital Management, which was eventually bailed out by a consortium of banks fearing a LTCM default would result in a severe shock to financial markets. (Mgd fut = +20.64%, S&P 500 = +28.58%)

3. 2000, 2001, 2002 - The much ballyhooed Internet bubble burst - tech crash, which began in March of 2000, and depending on who you speak to either ended in 2002 or remains unfinished. (Mgd fut = +8.16%, S&P 500 = -14.36%)

4. September 2001 - The 9/11 tragedy saw US markets closed several days, with major liquidity and backup fears realized instantly, sending global markets to fresh lows once markets reopened. (Mgd fut = +3.65%, S&P 500 = -8.08%)

5. October 2007 to present - Credit Crunch, Liquidity Crisis – The current market crisis brought on by a dip in housing prices and collapse in the sub prime mortgage market, has seen hedge fund failures, bank collapses, unprecendented action by the US Fed, and a global stock sell off. (Mgd fut = +10.95%, S&P 500 = -13.69%)

The stress period analysis starts to show a clearer picture of what low correlation actually looks like. The lowly correlated managed futures index performed very well during periods of overall market stress, showing positive performance in all five incidences, and averaging over 11% higher performance than the S&P 500 stock index across those periods. (and nearly 20% higher if removing the 1998 period)

Click here to view the chart/table below

The reason for this is that the drivers of managed futures returns are not the same drivers as those for the stock markets. In fact, they are often opposite, as increases in commodity prices, for example, can have a negative impact on corporate growth and therefore stock prices while adding to the returns of a managed futures program.

3. How did stock option sellers perform today….

The last time we saw a big sell off like this, in February 2007; the stock index option sellers took a pretty big hit. But that was due to not just to the movement in prices, but also the large spike in volatility – which rose over 80%.

This time around, the price move was just as substantial, but volatility only rose 24% (just a ¼ of the Feb spike), as volatility has remained higher since that Feb 2007 spike. This means the losses during today’s spike were not as severe for stock index option sellers, and the time to recovery could be much shorter.

Sep. 15^th estimated losses (stock index option sellers)

ACE………………..………………………………-10.5%

Crescent Bay PSI………………………………-3.0%

Crescent Bay BVP………………………………-9.5%

Cervino 2x…………………………………………+3.9%

Zenith Index………………………………………-1.1%

Zephyr Aggr………………………………………-7.4%

>please note that Cervino 2x is not a typo above, and actually profited today, thanks in part  to long bear put spreads.

4. if worried there is more of this ahead – maybe look to add a managed futures program not tied to stock market

While you can use a lot of fancy efficient frontier analysis, correlation coefficients, and Sharpe ratios to construct the “perfect” portfolio – we’ve found that good old common sense usually prevails in times like these.

The issue is that in market stress periods, investments tend to become more highly correlated than their past performance would suggest. There’s an old saying on Wall Street, “the only thing that rises in a falling market is correlation”

To combat this phenomenon, it pays to make sure your managed futures investment which is supposedly not correlated to the stock market – actually doesn’t trade any stock indices. This seems like a no brainer, but a lot of managed futures investments are actually performing their trading on stock index futures and options. There are some very good programs who do just fine on those stock index products, but if you are looking to reduce stock index exposure, the best way to do that is to trade something which doesn’t have any direct stock index exposure. Sounds simple enough, right.

Here’s a listing of our top rated managers who don’t have any direct stock index exposure, meaning they rarely, if ever trade stock index futures or options. Click on the link for performance details and more information.

Listed alphabetically:

Clarke Capital (Global Basic) – shorter term trend follower

DMH Futures – discretionary trader

Dighton Capital – discretionary trader

Financial Commodity Investments (FCI) – commodity market option seller

NDX Shadrach – spread trading meat markets

Rosetta – directional and spread trading agriculture markets

 

Feel free to call or email us with questions on any of the programs above.

And as for the rest of it - the best advice we can give is to not do what everyone else does and panic.  This stress period will subside like all the rest, and those with cooler heads who are looking for ways to profit from this, rather than run from it, are likely the ones who will prevail. 

- Jeff Malec