Sunday, July 8, 2007

2nd Qtr 2007 Review and Black Swans


My business partner and I have recently discussed at length the anti-probabilistic theories and philosophical musings based on a book we both recently read, “The Black Swan; The Impact of the Highly Improbable” by Nassim Nicholas Taleb.

This book has recently made the rounds quite extensively in the hedge fund community because of its caustic approach about life and trading, and for having been written by one of us.

One of the points I had been making to friends and colleagues before the book came out—and ‘corroborated’ (pun intended) to a certain extent by Taleb’s thought process—is the increasing cosmogonic awareness of uncontrolled chaos around us.

This is not a soul searching exercise but part of an ongoing discussion in the intellectual vanguard of market analysis; that is, the impact that acute random events as well as seemingly trivial random events may have on the markets, and by implication on the highly leveraged trading environment we find ourselves managing.

Long-held ideas and passed-down wisdom teaches us to explain markets based on likely relationships between certain cause and effect dynamics. In the case of option theory, traders also utilize quantitative calculations based on the Black-Scholes model, Cox-Ross-Rubinstein binomial tree, and/or Monte Carlo simulations, all which stand solidly on the shoulders of conventional statistics and probability assumptions.

Taleb, however, puts forward that ‘we’ live in an increasingly complex world of unpredictability and inequality resulting in situations of huge disparity between efforts and rewards; accordingly, Gaussian bell curves are “intellectual frauds.” My contention is that ‘we’ live and trade in a world of “self-fulfilling prophecy,” until one day ‘we’ wake up to find long-held assumptions are turned upside down (‘the trend is your friend until it ends).

Regardless, this past year has certainly increased my awareness, as well as in others, of a disruption in traditionally-understood economic relationships: “When America sneezes, the rest of the world's economies may no longer catch a cold” (The Economist, “The Alternative Engine,” October 19, 2006).

Philosophy aside, our performance has been less than stellar in the first part of this year, but I do not want to sound defensive by claiming randomness as an excuse—I’m not. However, knowing that smart traders like Taleb are buying the insurance we’re selling (and for which we receive premiums) induces us in turn to prudently reinsure some of our positions.

Appropriately we have increased our S&P hedges and also made our trading more diversified than last year as a proactive way to deal with hurtful “grey swans” that may be potentially overlooked by our models. At the same time, the increase in volatility from the doldrums last year and earlier this year is generally welcomed, and we have made adjustments to capture the upside in this new environment within reasonable risk parameters.

With respect to market fundamentals, my thesis is bullish on energy, while remaining short term cautious in equities where I have assumed a more benign outlook for the intermediate term. One of the reasons for such an intermediate bullish outlook resides with the attitude of the ‘smart money.’ A number of studies tracking large commercial players show a fairly bullish set up; history has taught us that betting against these investors may be a mistake.

We are a bit disappointed with silver and gold; especially since the latter seems to trade mostly on physical demand while investment demand has waned. I also question gold’s reflection of the inflationary environment which I still believe is miserably (or should I say self-servingly?) misrepresented by the official statistics.

In conclusion, we expect volatile waters to navigate going forward but think we have trimmed our sails accordingly and look forward to the second half of 2007. Having set our compass, should we see a black swan we will kindly remind him of Black-Scholes’ greeks.

- Davide Accomazzo, Managing Director

Saturday, July 7, 2007

Managed Futures and Incubating Talent


"Managed Futures: A Model for Incubating Talent" was originally published by Focus Point Press, Inc. (Emerging Manager Focus) on June 18, 2007.

“Until lions have their historians, tales of the hunt shall always glorify the hunters.” --African Proverb

The idea of traders staking other traders for a slice of profits is probably as old as trading itself. Fast forward to the late 1970s and one unearths Commodity Corp. which is remembered for launching the renown careers of Michael Marcus and Bruce Kovner. And in 1983 Richard Dennis is legendary for having made a bet with William Eckhardt which led to his recruiting and training the “turtles.”

One of Richard Dennis’ earliest if not first client was Bradley N. Rotter,[1] who established a successful track record by investing early with traders like Joe and Bob Hickey, Willis-Jenkins, Mississippi River, EMC Capital and Hawksbill Capital. In 1990 Rotter founded a company called The Echelon Group with the idea of forming joint ventures with talented traders and then helping them grow into niche money management firms.

Then there is Arpad “Arki” Busson, who began his career raising capital for Paul Tudor Jones and is the founder of EIM Group with $8bn in assets.[2] Busson made his name betting not in stocks, bonds or derivatives, but rather in upstart managers some who became hedge fund titans.

The common thread between these trailblazers is the niche segment of the alternative investments industry they got their start in—managed futures.

Managed futures has always been the little kid brother to the hedge fund juggernaut. Nonetheless its impact upon the industry is writ large in two significant and related ways: first, the managed futures industry unlike its brethren hedge funds operate in a highly regulated environment; second, this same regulated environment which imposes disclosure and reporting requirements lends itself to fomenting lower barriers of entry for new talent to evolve.

Money managers within the futures industry operate under registrations either as Commodity Trading Advisors (CTA) or Commodity Pool Operators (CPO). The latter in practice is a regulated hedge fund,[3] but it is the CTA structure we’re most interested here.

Key to the development of any emerging trader is the ability to establish a legitimate performance record and quickly raise assets. Managed futures addresses both of these concerns.

With respect to raising client investments, managed accounts are an established and widely accepted vehicle within the managed futures industry. This arrangement provides a variety of benefits from the investors’ perspective. Advantages include the fact that futures accounts are mark-to-market daily, transparent and easy to monitor, and most importantly liquid in the sense that an investor can easily fire a CTA (as a matter of practice CTAs usually liquidate positions on instruction in 24-48 hours or even less). On this basis it can be argued that the managed account structure is a more attractive vehicle for investors who focus on emerging traders, especially when compared to concerns about hedge funds’ delay in performance reporting (often it is quarterly), lack of transparency, as well as investment lock-ups and redemption cycles.

Sophisticated investors in managed futures utilize what is known as the cross-margin account structure where a cash account is capitalized and collateralizes trading accounts traded on a nominal or notional basis. The result is a customized multi-advisor portfolio with the ability, at least hypothetically, to control the leverage utilized by CTAs that capital is allocated to.

Managed accounts provide several advantages for emerging traders too. The legal, administrative and audit costs in setting up a hedge fund can be prohibitive and requires traders to try and raise at least $5 to $10 million in client assets before they commence trading. Meanwhile, it is not uncommon for CTAs to establish themselves starting with $100k in assets. Minimum account sizes within the industry range from $25k (exception rather than the rule) to $5 million, with smaller minimums making it easier to attract clients.

The other advantage managed futures provides emerging traders—a regulated environment for establishing a money management business—is exactly that aspect which many traders perceive as a major disadvantage. It is in actuality quite the opposite situation.

The Commodity Futures Trading Commission and the industry’s self regulatory organization, the National Futures Association, have set forth clear accounting and disclosure guidelines with respect to CTA managed account composite performance reporting. The rules are also well established in regards to disclosure of client trading versus proprietary trading as well as hypothetical presentations.

There are too many nuances for this article to delve into a detailed examination of certain issues regarding reported CTA performance data. Suffice it to say that the formalized composite methodology and the ability to publicly disseminate composite performance on managed accounts, something which is a significant regulatory constraint for private placements, is a great boon to emerging CTAs in terms of their ability to publicly market their track record.[4]

In fact, the only consistently reported data in the early days of alternative investments initially came from CTAs, not hedge funds. This data became the basis for an academic body of research on managed futures which includes studies by Lintner (1983), Baratz and Eresian (1985, 1989), Oberuc (1990) and Schneeweis (1996).

One can point to the beginning of the institutionalization of alternative investments as partly a result of CTA performance tracking databases such as Managed Account Reports which grew into MAR/Hedge, and TASS Management which is now Lipper/TASS. These organizations, like many focused on managed futures in the 1980s and 1990s, subsequently evolved from boutique businesses to industry insiders within the hedge fund universe.

This returns us to the original idea that managed futures is and has always been a fertile area of the industry for developing emerging talent apart from those with institutional pedigree.

Managed futures remains mainly a boutique shop industry. Start-up costs are relatively immaterial and many CTAs are or began as one-man shops by leveraging proprietary track records, registering with the NFA and filing a disclosure document. Established industry databases collect and present CTA performance via websites such as and At the same time, there is an established network of Introducing Brokers (IBs) and Associated Persons who focus primarily on marketing CTA programs.

There are pitfalls, however. Due diligence on many of these operations would reveal that they are light on the operational side. While certain administrative activities can be outsourced, it still remains the trader’s responsibility to establish sound practices and comply with the ever-expanding burden of rules and regulations. Yet a trader focused on operations and marketing is not focused on the markets, research and trading.

Another approach to starting up a CTA is partnering with operationally minded personnel that can relieve many of the administrative requirements from the trader’s shoulders.

This is the approach my business partner and I took when we established Cervino Capital Management LLC, a CTA and RIA. Leveraging my background with Rotter in the 1990s incubating emerging traders and then running the operations-side, I co-founded Cervino with Davide Accomazzo. Davide also has prior experience in managed futures previously running a CTA as a one-man operation as well as an offshore hedge fund.

Besides the segregation of duties—Davide is Cervino Capital’s principal trader and concentrates his attention on the markets—development of our trading program began by first considering how we would differentiate our product from competitor programs. We achieved this by creating a well-defined yet robust mandate in which the trading program operates. This was done in view of what we thought prospective clients would desire in terms of various factors including but not limited to performance objectives versus equity volatility, margin-to-equity utilization which allows leverage through notional funding, and a best practices approach to operations.

This is atypical of how many CTAs get their start, and reveals other questions for investors to consider when allocating to an emerging CTA program, including: applicability of proprietary results as representative of prospective trading in client accounts; amount of leverage used to generate returns, serious consideration and commitment by trader as to the program’s capacity limitations; as well as accessibility and organizational professionalism.

Unfortunately, while “past performance is not necessarily indicative of past results,” there is a tendency with many who invest in managed futures to chase hot performance. Rather, what should take priority in investor’s thinking is the robustness of the underlying trading strategy as it pertains to varying market environments—when does an approach work best, when does it not work and how does the CTA manage risk and drawdowns during such periods?

Investors who invest with emerging CTAs (and the same applies to investing in established CTAs) should seek to develop robust multi-advisor portfolios with these questions in mind.

Likewise, if making allocations to emerging CTAs is considered an attractive investment, then what about the business model of incubating CTAs? The economies of scale that derive from leveraging standardized and professional operations with multiple sources of trading talent, has from my experience, always been an attractive opportunity.

- Mack Frankfurter, Managing Director

[1] Futures Magazine, “Rotter thrives on investing from the gut” by Staff, February 1991
[2] Financial Times, “To live and dream hedge funds” by Stephen Schurr, March 29, 2006
[3] Report of The President’s Working Group on Financial Markets, “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” April 1999
[4] Note: This is not necessarily applicable to CPOs, most which are structured as limited partnership private placements (or other similar entity based on jurisdiction) and if domiciled in the U.S. concurrently operate under the same SEC exemption rules as hedge funds; CTAs, on the other hand, are generally not subject to certain exemption rules which limit marketing to the public because they trade managed accounts.

This article was first published by Focus Point Press, Inc. (Emerging Manager Focus) It is republished here by permission. Every effort has been made to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete. There is no guarantee that the forecasts made, if any, will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. This material does not constitute a solicitation to invest in any program offered by Cervino Capital Management LLC which may only be made upon receipt of its Disclosure Document. Past performance is not necessarily indicative of future results. Investment involves risk. Investing in foreign markets involves currency and political risks. The risk of loss in trading commodities can be substantial.