"His name was George F. Babbitt. He was 46 years old now, in April 1920, and he made nothing in particular, neither butter nor shoes nor poetry, but he was nimble in the calling of selling houses for more than people could afford to pay."
--"Babbitt" by Sinclair Lewis (1922)
The largest financial bailout in United States history, which some traders are starting to call the ‘Securitized Housing Investment Trust’ (hint: think acronym), is causing an existential crisis amongst those who hold to purest free market ideology. Senator Jim Bunning, Republican of Kentucky, echoed this sentiment when he said, “The free market for all intents and purposes is dead in America.” These ideologues doth protest too much, methinks.
Since the 1929 crash, the last time the nation faced an economic train-wreck of this magnitude, the U.S. Government has effectively been in the insurance business and it has generally served us well. The vast majority of laws and regulations are designed to mitigate risk. Drunk driving laws minimize the number of car wrecks, and the short uptick rule (until recently eliminated) prevented unfettered short-selling from forcing solvent companies into insolvency.
Government institutions enforce these policies. What is the purpose of the military but insurance against an attack from other nations? What is the key purpose of a central bank other than insurance against a run on banks?
In fact, the present-day capital market system, which has been responsible for raising living standards to the highest in world history, relies upon laws and regulations: the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act of 1936, and the Investment Advisers Act of 1940. Although not perfect (and definitely requiring an overhaul), these laws have served Wall Street and LaSalle Street very well over time.
The problem with fundamentalist free market ideology is that it is only theoretical, and ultimately not pragmatic. Truth is, without government establishing the premise of private property enforced through law and justice, contract markets would soon devolve and be quickly replaced by gangster capitalism akin to Putin’s Russia. There is a term for the unfettered combination of concentrated power, ideological adherence and capitalistic greed, it is called “fascism.”
There is another term “beta,” which defines the systematic return/risk of assets. This concept is related to Modern Portfolio Theory and underlies the oft-stated investment strategy of buy-and-hold. What is not well-understood, even by many sophisticated investors, is that this theory is flawed. The issue is benchmark portfolio construction. Accordingly, the definition of “true beta” or “true market portfolio” must be extended to encompass other economic factors.
What academics came to recognize was that approximately one-third of non-governmental tangible assets in the U.S. are owned by the corporate sector, and only one-third of these corporate assets are financed by equity. As a result, Jagannathan and Wang (1993) concluded that assumptions underlying the concept of beta must be altered in order to resolve anomalies in the model. In other words, “true beta” or the “true market portfolio” must include the “aggregate wealth portfolio of all agents in the economy.” This is a revolutionary view with both political and economic ramifications.
Business balance sheets do not in practice reflect public infrastructure assets which businesses are dependent on. For example, a trucking company’s greatest asset is not its fleet of trucks, but the U.S. Highway system. Likewise, public liabilities such as the cost of pollution are also not reflected on corporate balance sheets. This is beginning to change with the idea of integrating regulations into “cap-and-trade” contract markets involving emission allowances.
It is time for a new economic ideology to take hold which adheres to the middle way. Government and free enterprise are actually joint partners in promoting economic growth and well-being. Certainly, political will effects a constant tug-of-war between interests, but this is not unlike the struggle between a sales-trading desk which drive revenues for an investment bank, and internal compliance/risk managers who ensure balance between risk and reward.
The problem with the prevalent populist stream of conversation regarding free markets versus socialism is that such dialogue is anachronistic. Rather, the conversation needs to shift to good versus bad governance, and public policy which enhances the value of the aggregate wealth portfolio of all agents in the economy.
- Mack Frankfurter, Managing Director
Thursday, October 2, 2008
Tuesday, April 29, 2008
1st Qtr 2008 Review and Atypical Markets
THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
Courtesy of the credit mess and massive mispricing of risk that has built up in our system over the past decade, the first quarter of 2008 was for both the fixed income and equity markets one of the worst starts to a year in a rather long time.
The question now being asked, a little over a month after the global economy ‘whistled past’ the Bear Stearns’ run on the bank (which might of resulted in a systemic meltdown), is whether the Federal Reserve’s invocation of emergency powers was the right decision or wrong decision to make. This will remain into perpetuity an unanswered question, but on the morning of March 17th, Fed Chief Bernanke’s decision to finance $30 billion of illiquid Bear assets to secure its takeover by JPMorgan Chase & Co. came as a great relief to a market susceptible to another 1987.
Fortunately for our clients invested in the Diversified Options Strategy, we ended the 1st quarter with a solid 3.64% for the 1X program and 7.90% for the 2X program.
At the end of last year, our 2008 forecast called for continuing high volatility, strength in gold, and propositioned that the controversial idea of nationalizing losses was going to be put on the table in order to “save the markets.” In light of this framework, we traded the Diversified Options Strategy rather conservatively. The systemic risk was never this great and risk management was our main priority.
At the end of February, the odds of a systemic breakdown were, in our analysis, higher than ever and we constructed positions that would have withstood nicely such an event.
This prescience proved fortuitous, and even during the frightful hours around the Bear Stearns’ collapse and MF Global’s rout to a low of 3.64 from the previous day’s close of 17.35 (a 79% drop in price), our positions' volatility remained extremely low and the program was never at serious risk of loss.
Our Diversified Options Strategy’s risk-reward approach is validated by our Top 2 standing in BarclayHedge’s option strategy CTA ranking by Sharpe ratio.
Looking forward for the 2nd quarter, most studies based on sentiment indicators have been illustrating historical levels of negativity, especially when measured from the peak of October 2007 to the bottom of January 2008. This is in line with other recessionary periods. However, this negative sentiment often serves as a contrary indicator of where stock prices may go in the future.
Admittedly, the Damocles sword of additional credit market write-offs remains. This could eventually lead to a more pronounced credit contraction phase, resulting in more retrenchment by an overly leveraged consumer. But for the time being, mean reversion seems to be the leading factor driving the current retracement in stock prices.
For now, our outlook for the securities market in the second quarter of 2008 is more positive, at least in the near term. We expect the longer term will likely produce more disappointments, but the shorter term indicates a reversal to the mean type of action.
While on the subject of mean reversion, we would like to point out what we think are key differences between the capital markets versus the commodity markets. And in the process, also spend a few moments to provide a fresh analysis our trading in the Commodity Options Program.
Securities in general, and certainly stock market indexes, tend to be very mean reverting and therefore they offer numerous opportunities to play contrarian and volatility arbitrage strategies. On the other hand, the leveraged structure, speculative skew and liquidity constraints of commodity markets, as well as sudden changes in supply-demand dynamics, make commodities much more prone to reflexivity.
This state of affairs is due to a number of reasons, some clear cut and some more debatable. In any case, we do not believe one can routinely trade commodity options as you would normally trade stock index options.
Our underlying philosophy for the Commodity Options Program is to integrate income generation strategies with a significant number of directional bets. By definition such an approach will make the program performance more volatile and subject to a number of speculative market calls during the year.
That said, commodities in general have experienced record moves since the beginning of the year. This is a result of a combination of massive speculative inflows, and an inflationary monetary policy put forward by the Fed in response to the systemic risk posed by the credit crisis.
The convergence of these two factors overran our initial thesis that a global slowdown in the economy, and the need for a credit deleveraging, would force the commodity complex into a correction. The resulting situation put the Commodity Options Program into a difficult situation.
This specific program produces results based on a mix of mean reverting trades and directional bets (as opposed to the Diversified Options Strategy which is primarily mean reverting). Mean reversion—selling overbought and buying oversold assets—ended up having a poor risk-reward profile for commodities as three sigma moves became the norm. This was especially true in two markets where we were engaged: wheat and crude oil.
The historical trading anomalies of wheat were enough reason to cause an uproar from the farming industry as the futures-spot price convergence ceased to function properly. Crude has also started to pose valuation problems as it has begun to act more like an inverse dollar proxy than a commodity. In this environment even directional trades were not exhibiting positive risk profiles.
Notwithstanding the headwinds, the majority of our trades in this program were successful, but the poor risk-reward profile produced larger than expected losses in the wheat and oil contracts.
Going forward, we feel that the opportunities for a more rational trading may have finally developed for the Commodity Options Program after the entire commodity complex was hijacked by sheer speculation.
Arrivederci
-Davide Accomazzo, Managing Director
Courtesy of the credit mess and massive mispricing of risk that has built up in our system over the past decade, the first quarter of 2008 was for both the fixed income and equity markets one of the worst starts to a year in a rather long time.
The question now being asked, a little over a month after the global economy ‘whistled past’ the Bear Stearns’ run on the bank (which might of resulted in a systemic meltdown), is whether the Federal Reserve’s invocation of emergency powers was the right decision or wrong decision to make. This will remain into perpetuity an unanswered question, but on the morning of March 17th, Fed Chief Bernanke’s decision to finance $30 billion of illiquid Bear assets to secure its takeover by JPMorgan Chase & Co. came as a great relief to a market susceptible to another 1987.
Fortunately for our clients invested in the Diversified Options Strategy, we ended the 1st quarter with a solid 3.64% for the 1X program and 7.90% for the 2X program.
At the end of last year, our 2008 forecast called for continuing high volatility, strength in gold, and propositioned that the controversial idea of nationalizing losses was going to be put on the table in order to “save the markets.” In light of this framework, we traded the Diversified Options Strategy rather conservatively. The systemic risk was never this great and risk management was our main priority.
At the end of February, the odds of a systemic breakdown were, in our analysis, higher than ever and we constructed positions that would have withstood nicely such an event.
This prescience proved fortuitous, and even during the frightful hours around the Bear Stearns’ collapse and MF Global’s rout to a low of 3.64 from the previous day’s close of 17.35 (a 79% drop in price), our positions' volatility remained extremely low and the program was never at serious risk of loss.
Our Diversified Options Strategy’s risk-reward approach is validated by our Top 2 standing in BarclayHedge’s option strategy CTA ranking by Sharpe ratio.
Looking forward for the 2nd quarter, most studies based on sentiment indicators have been illustrating historical levels of negativity, especially when measured from the peak of October 2007 to the bottom of January 2008. This is in line with other recessionary periods. However, this negative sentiment often serves as a contrary indicator of where stock prices may go in the future.
Admittedly, the Damocles sword of additional credit market write-offs remains. This could eventually lead to a more pronounced credit contraction phase, resulting in more retrenchment by an overly leveraged consumer. But for the time being, mean reversion seems to be the leading factor driving the current retracement in stock prices.
For now, our outlook for the securities market in the second quarter of 2008 is more positive, at least in the near term. We expect the longer term will likely produce more disappointments, but the shorter term indicates a reversal to the mean type of action.
While on the subject of mean reversion, we would like to point out what we think are key differences between the capital markets versus the commodity markets. And in the process, also spend a few moments to provide a fresh analysis our trading in the Commodity Options Program.
Securities in general, and certainly stock market indexes, tend to be very mean reverting and therefore they offer numerous opportunities to play contrarian and volatility arbitrage strategies. On the other hand, the leveraged structure, speculative skew and liquidity constraints of commodity markets, as well as sudden changes in supply-demand dynamics, make commodities much more prone to reflexivity.
This state of affairs is due to a number of reasons, some clear cut and some more debatable. In any case, we do not believe one can routinely trade commodity options as you would normally trade stock index options.
Our underlying philosophy for the Commodity Options Program is to integrate income generation strategies with a significant number of directional bets. By definition such an approach will make the program performance more volatile and subject to a number of speculative market calls during the year.
That said, commodities in general have experienced record moves since the beginning of the year. This is a result of a combination of massive speculative inflows, and an inflationary monetary policy put forward by the Fed in response to the systemic risk posed by the credit crisis.
The convergence of these two factors overran our initial thesis that a global slowdown in the economy, and the need for a credit deleveraging, would force the commodity complex into a correction. The resulting situation put the Commodity Options Program into a difficult situation.
This specific program produces results based on a mix of mean reverting trades and directional bets (as opposed to the Diversified Options Strategy which is primarily mean reverting). Mean reversion—selling overbought and buying oversold assets—ended up having a poor risk-reward profile for commodities as three sigma moves became the norm. This was especially true in two markets where we were engaged: wheat and crude oil.
The historical trading anomalies of wheat were enough reason to cause an uproar from the farming industry as the futures-spot price convergence ceased to function properly. Crude has also started to pose valuation problems as it has begun to act more like an inverse dollar proxy than a commodity. In this environment even directional trades were not exhibiting positive risk profiles.
Notwithstanding the headwinds, the majority of our trades in this program were successful, but the poor risk-reward profile produced larger than expected losses in the wheat and oil contracts.
Going forward, we feel that the opportunities for a more rational trading may have finally developed for the Commodity Options Program after the entire commodity complex was hijacked by sheer speculation.
Arrivederci
-Davide Accomazzo, Managing Director
We Need to Eliminate the Enron Loophole
Excerpt from my article: "The Mysterious Case of the Commodity Conundrum, Securitization of Commodities, and Systemic Concerns."
"The theories which I have expressed there, and which appear to you to be so chimerical, are really extremely practical—so practical that I depend upon them for my bread and cheese."
— Sherlock Holmes, A Study in Scarlet (1888)
The mysterious case of the commodity conundrum is sure to elicit passionate debate on either side of the equation—is the commodity boom due to speculation or fundamentals?
Rising prices and a widespread bull market in commodities should indicate that there is a growing scarcity of hard assets. However, traditional forces of supply and demand cannot fully account for recent prices.
To be precise, the normal price-inventory relationship has been altered. This is the assertion of an expanding list of bona fide hedgers, commodity professionals and economists. Specifically, dynamics have changed because securitized commodity-linked instruments are now considered an investment rather than risk management tools. Of late, this has caused a self-perpetuating feedback loop of ever higher prices.
In a statement to the CFTC, Tom Buis, president of National Farmers Union, testified, “If [farmers] can’t market their crops at these higher prices, we’ve got a train wreck coming that’s going to be greater than anything we’ve ever seen in agriculture.” Billy Dunavant, head of cotton merchant Dunavant Enterprises, was more blunt, “The market is broken, it’s out of whack—someone has to step in and give some relief.”
Even CFTC Commissioner Jill Sommers acknowledged charges that speculators are skewing the market, in an apparent turnaround from the CFTC statement of April 21st which implied that commodity markets are functioning properly. Nevertheless, the official CFTC stance is that speculative trading is not the primary culprit behind surging commodity prices, but other factors such as the declining dollar are contributors.
Yet, it is undeniable that the physical delivery markets for grains, which require that the actual commodity be delivered against expiring futures contracts, are no longer converging. This is probably just the tip of the proverbial iceberg—it is arguable other hard assets are priced “out of whack” for any number of reasons.
For example, public policy plays a role in pricing issues too. For example, continuous accumulation of strategic oil reserves by multiple governments implies rising support levels. In that sense, speculative pressures can expose “bad” application of otherwise well-intentioned government policies, such as subsidies for ethanol production or programs which pay farmers to take erosion-able lands out of production. All the same, governments’ counter-response to excessive speculation can be unhelpful, and shutdowns of free market activities are occurring.
The problem for the public is that theses issues can be complicated, and in a sound bite society which desires easy answers and easier solutions, the predominant view is currently biased to commodities as an investment hedge against inflation and speculators as an easy scapegoat for all the world’s commodity woes.
Unfortunately, this thinking is a self-fulfilling prophecy which ultimately may feed into a negative economic cycle where legitimate commercials are squeezed out of business thereby reducing supply, protectionism gains traction, trade breaks down, hoarding ensues, riots occur and wars erupt over access.
Fact is, the genie is out of the bottle and it is not going to be put back. But the financial services industry also needs to acknowledge the imbalances it has wrought in the commodity markets. The following sets the record straight...
Futures and forward contracts are intrinsically different instruments than securities which are derived from the capital markets (e.g., fixed income or equities). This is underappreciated.
Derivatives are risk management tools, a “zero-sum game,” fundamentally different from the “rising tide raises all ships” concept of the capital formation markets. While, there is an established theoretical basis and considerable empirical evidence that link investment in capital market assets to positive expected returns over time, notwithstanding the recent surge in commodity prices, a legacy of academic disagreement supports the claim that, on an inflation-adjusted basis, the same cannot be said about commodities.
As noted by Greer (1997), the inherent problem is that commodities are not capital assets but instead consumable, transformable and perishable assets with unique attributes. Hence, speculative trading, by definition any commodity trading facilitated for financial rather than commercial reasons, likely results in “zero systematic risk.”
The conundrum for financial “investors” is that for every buyer of a commodity futures contract there is a seller—sine qua non, there is no intrinsic value in futures/forward contracts—they are simply agreements which commit a seller to deliver an asset to a buyer at some place/point in time. Accordingly, the derivatives and securities markets require two different types of regulation. Why?
The percentage of open interest in futures contracts relative to crop size is out of proportion. For some crops, only 10,000 contracts are needed by bona fide hedgers. For comparison, the year-to-date volume of wheat contracts traded through March 2008 is 5.7 million contracts. Meanwhile, the CFTC requires hedgers to provide large trader reporting, but unregulated participants have no such requirements. Further, there are systemic issues with big moves happening overnight and taking place off-exchange.
This is explained in further detailed in more detail in the complete version of this article (to request a PDF version, email: info@cervinocapital.com).
As a CFTC registrant and participant in the managed futures industry, I am personally baffled at our lack of representation regarding the “closing the Enron loophole” issue. Managed futures represent a class of regulated speculators who have traditionally provided liquidity to the bona fide hedgers. Our role is indispensible to the proper balance to commodity trading because we go both long and short commodities. However, if we do not ensure our place at the table, we may lose our rights if not the viability of our industry.
In effect, the “securitization of commodities,” a difficult topic in itself to analyze given the proliferation of different types of securitized commodity instruments, has led to an undermining of the prime economic purpose of the commodity futures market. The primary benefit provided by futures markets is that it allows commercial producers, distributors and consumers of an underlying cash commodity to hedge.
Investors must recognize that risk management markets exist primarily for the benefit of bona fide hedgers. Securitized commodity products are not structured to serve that purpose. Rather, this innovation has allowed money flows to distort price discovery, while at the same time undermine the all-important hedging utility. Further, they are sold as investments, when in fact these products are speculative.
As discussed in detail in the complete version of this article, the “Enron loopholes” within the Commodity Futures Modernization Act have served to undermine the authority of the CFTC, and put the futures industry as well as the economy at risk. It is time to rein in excessive market speculation which is occurring on the “dark exchanges’ and support the transition of unregulated commodity speculation back into the domain of the regulated futures industry.
The Close the Enron Loophole Act (S.2058), introduced by Senator Carl Levin of Michigan, would rearm the CFTC with the tools needed to subject “dark markets” to the same oversight as traditional futures exchanges. Exempt commodity exchanges would be made subject to the same standards as traditional contract markets regarding position limits, large trader reporting and transparency requirements. The proposed Act would also require large-trader reporting for domestic trades on foreign exchanges.
If a facility for trading commodities looks like a futures exchange and acts like a futures exchange, then it should be regulated like a futures exchange.
At the same time, securitized commodity products should come under regulations similar to that which has been imposed on single-stock futures. Recent events reveal that long-bias commodity index funds and commodity-linked ETFs may systemically represent a form of market manipulation.
If investors are interested in investing in commodities on an unleveraged basis, then the futures exchanges should develop “fully-funded” non-leveraged instruments, similar to mini-futures, for investors to trade.
Further, Series 7 securities representatives should be disallowed from marketing commodity-related investment products without also having a Series 3 license and registration as associated persons.
Additionally, commodity-related securities products should be subject to NFA 4-29 marketing rules as is imposed on futures industry registrants. For example, hypothetical concepts such as the roll return should have attendant hypothetical disclosures as would be required of futures professionals.
As to the institutionalization of financial investments in long-biased commodity positions, index funds need to accordingly recognize their inherent responsibility in financing credit lines to utilities which facilitate physical deliveries of commodities. Admittedly, this may be difficult under current law.
These concerns raise a key question for the futures industry, managed futures, and bona fide hedgers. Why are securities professionals allowed to hold themselves out as commodity professionals? The debasing of this core rule has led to confusion in the public's mind and threatens the futures industry profession, thereby undermining the CFTC's authority as granted by the CEA.
Has there been an abrogation of responsibility by the CFTC? Is this regulatory body now beholden to interests other than the constituents it is suppose to serve and regulate?
A key responsibility of the CFTC is to ensure that prices on the futures market reflect the laws of supply and demand rather than manipulative practices or excessive speculation.
The 2006 U.S. Senate Staff Report by the Permanent Subcommittee on Investigations concludes as follows:
“It is critical for U.S. policy makers, analysts, regulators, investors and the public to understand the true reasons for skyrocketing energy prices. If price increases are due to supply and demand imbalances, economic policies can be developed to encourage investments in new energy sources and conservation of existing supplies. If price increases are due to geopolitical factors in producer countries, foreign policies can be developed to mitigate these factors. If price increases are due to hurricane damage, investment s to protect producing and refining facilities from natural disasters may become a priority. To the extent that energy prices are the result of market manipulation or excess speculation, a cop on the beat with both oversight and enforcement authority will be effective.”
Ironically, we’ve been here before... The Commodity Exchange Act of 1936 repeats the same in a more concise fashion, “Excessive speculation in any commodity under contracts of sale of such commodity for future delivery… causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity.”
The more things change, the more things stay the same. “Eliminate all other factors, and the one which remains must be the truth.” Perhaps, we can take heart from Sherlock Holmes in “His Last Bow.”
“Good old Watson! You are the one fixed point in a changing age. There's an east wind coming all the same, such a wind as never blew on England yet. It will be cold and bitter, Watson, and a good many of us may wither before its blast. But it's God's own wind none the less, and a cleaner, better, stronger land will lie in the sunshine when the storm has cleared. Start her up, Watson, for it’s time that we were on our way. I have a check for 500 pounds which should be cashed early, for the drawer is quite capable of stopping it if he can.”
- Mack Frankfurter, Managing Director
"The theories which I have expressed there, and which appear to you to be so chimerical, are really extremely practical—so practical that I depend upon them for my bread and cheese."
— Sherlock Holmes, A Study in Scarlet (1888)
The mysterious case of the commodity conundrum is sure to elicit passionate debate on either side of the equation—is the commodity boom due to speculation or fundamentals?
Rising prices and a widespread bull market in commodities should indicate that there is a growing scarcity of hard assets. However, traditional forces of supply and demand cannot fully account for recent prices.
To be precise, the normal price-inventory relationship has been altered. This is the assertion of an expanding list of bona fide hedgers, commodity professionals and economists. Specifically, dynamics have changed because securitized commodity-linked instruments are now considered an investment rather than risk management tools. Of late, this has caused a self-perpetuating feedback loop of ever higher prices.
In a statement to the CFTC, Tom Buis, president of National Farmers Union, testified, “If [farmers] can’t market their crops at these higher prices, we’ve got a train wreck coming that’s going to be greater than anything we’ve ever seen in agriculture.” Billy Dunavant, head of cotton merchant Dunavant Enterprises, was more blunt, “The market is broken, it’s out of whack—someone has to step in and give some relief.”
Even CFTC Commissioner Jill Sommers acknowledged charges that speculators are skewing the market, in an apparent turnaround from the CFTC statement of April 21st which implied that commodity markets are functioning properly. Nevertheless, the official CFTC stance is that speculative trading is not the primary culprit behind surging commodity prices, but other factors such as the declining dollar are contributors.
Yet, it is undeniable that the physical delivery markets for grains, which require that the actual commodity be delivered against expiring futures contracts, are no longer converging. This is probably just the tip of the proverbial iceberg—it is arguable other hard assets are priced “out of whack” for any number of reasons.
For example, public policy plays a role in pricing issues too. For example, continuous accumulation of strategic oil reserves by multiple governments implies rising support levels. In that sense, speculative pressures can expose “bad” application of otherwise well-intentioned government policies, such as subsidies for ethanol production or programs which pay farmers to take erosion-able lands out of production. All the same, governments’ counter-response to excessive speculation can be unhelpful, and shutdowns of free market activities are occurring.
The problem for the public is that theses issues can be complicated, and in a sound bite society which desires easy answers and easier solutions, the predominant view is currently biased to commodities as an investment hedge against inflation and speculators as an easy scapegoat for all the world’s commodity woes.
Unfortunately, this thinking is a self-fulfilling prophecy which ultimately may feed into a negative economic cycle where legitimate commercials are squeezed out of business thereby reducing supply, protectionism gains traction, trade breaks down, hoarding ensues, riots occur and wars erupt over access.
Fact is, the genie is out of the bottle and it is not going to be put back. But the financial services industry also needs to acknowledge the imbalances it has wrought in the commodity markets. The following sets the record straight...
Futures and forward contracts are intrinsically different instruments than securities which are derived from the capital markets (e.g., fixed income or equities). This is underappreciated.
Derivatives are risk management tools, a “zero-sum game,” fundamentally different from the “rising tide raises all ships” concept of the capital formation markets. While, there is an established theoretical basis and considerable empirical evidence that link investment in capital market assets to positive expected returns over time, notwithstanding the recent surge in commodity prices, a legacy of academic disagreement supports the claim that, on an inflation-adjusted basis, the same cannot be said about commodities.
As noted by Greer (1997), the inherent problem is that commodities are not capital assets but instead consumable, transformable and perishable assets with unique attributes. Hence, speculative trading, by definition any commodity trading facilitated for financial rather than commercial reasons, likely results in “zero systematic risk.”
The conundrum for financial “investors” is that for every buyer of a commodity futures contract there is a seller—sine qua non, there is no intrinsic value in futures/forward contracts—they are simply agreements which commit a seller to deliver an asset to a buyer at some place/point in time. Accordingly, the derivatives and securities markets require two different types of regulation. Why?
The percentage of open interest in futures contracts relative to crop size is out of proportion. For some crops, only 10,000 contracts are needed by bona fide hedgers. For comparison, the year-to-date volume of wheat contracts traded through March 2008 is 5.7 million contracts. Meanwhile, the CFTC requires hedgers to provide large trader reporting, but unregulated participants have no such requirements. Further, there are systemic issues with big moves happening overnight and taking place off-exchange.
This is explained in further detailed in more detail in the complete version of this article (to request a PDF version, email: info@cervinocapital.com).
As a CFTC registrant and participant in the managed futures industry, I am personally baffled at our lack of representation regarding the “closing the Enron loophole” issue. Managed futures represent a class of regulated speculators who have traditionally provided liquidity to the bona fide hedgers. Our role is indispensible to the proper balance to commodity trading because we go both long and short commodities. However, if we do not ensure our place at the table, we may lose our rights if not the viability of our industry.
In effect, the “securitization of commodities,” a difficult topic in itself to analyze given the proliferation of different types of securitized commodity instruments, has led to an undermining of the prime economic purpose of the commodity futures market. The primary benefit provided by futures markets is that it allows commercial producers, distributors and consumers of an underlying cash commodity to hedge.
Investors must recognize that risk management markets exist primarily for the benefit of bona fide hedgers. Securitized commodity products are not structured to serve that purpose. Rather, this innovation has allowed money flows to distort price discovery, while at the same time undermine the all-important hedging utility. Further, they are sold as investments, when in fact these products are speculative.
As discussed in detail in the complete version of this article, the “Enron loopholes” within the Commodity Futures Modernization Act have served to undermine the authority of the CFTC, and put the futures industry as well as the economy at risk. It is time to rein in excessive market speculation which is occurring on the “dark exchanges’ and support the transition of unregulated commodity speculation back into the domain of the regulated futures industry.
The Close the Enron Loophole Act (S.2058), introduced by Senator Carl Levin of Michigan, would rearm the CFTC with the tools needed to subject “dark markets” to the same oversight as traditional futures exchanges. Exempt commodity exchanges would be made subject to the same standards as traditional contract markets regarding position limits, large trader reporting and transparency requirements. The proposed Act would also require large-trader reporting for domestic trades on foreign exchanges.
If a facility for trading commodities looks like a futures exchange and acts like a futures exchange, then it should be regulated like a futures exchange.
At the same time, securitized commodity products should come under regulations similar to that which has been imposed on single-stock futures. Recent events reveal that long-bias commodity index funds and commodity-linked ETFs may systemically represent a form of market manipulation.
If investors are interested in investing in commodities on an unleveraged basis, then the futures exchanges should develop “fully-funded” non-leveraged instruments, similar to mini-futures, for investors to trade.
Further, Series 7 securities representatives should be disallowed from marketing commodity-related investment products without also having a Series 3 license and registration as associated persons.
Additionally, commodity-related securities products should be subject to NFA 4-29 marketing rules as is imposed on futures industry registrants. For example, hypothetical concepts such as the roll return should have attendant hypothetical disclosures as would be required of futures professionals.
As to the institutionalization of financial investments in long-biased commodity positions, index funds need to accordingly recognize their inherent responsibility in financing credit lines to utilities which facilitate physical deliveries of commodities. Admittedly, this may be difficult under current law.
These concerns raise a key question for the futures industry, managed futures, and bona fide hedgers. Why are securities professionals allowed to hold themselves out as commodity professionals? The debasing of this core rule has led to confusion in the public's mind and threatens the futures industry profession, thereby undermining the CFTC's authority as granted by the CEA.
Has there been an abrogation of responsibility by the CFTC? Is this regulatory body now beholden to interests other than the constituents it is suppose to serve and regulate?
A key responsibility of the CFTC is to ensure that prices on the futures market reflect the laws of supply and demand rather than manipulative practices or excessive speculation.
The 2006 U.S. Senate Staff Report by the Permanent Subcommittee on Investigations concludes as follows:
“It is critical for U.S. policy makers, analysts, regulators, investors and the public to understand the true reasons for skyrocketing energy prices. If price increases are due to supply and demand imbalances, economic policies can be developed to encourage investments in new energy sources and conservation of existing supplies. If price increases are due to geopolitical factors in producer countries, foreign policies can be developed to mitigate these factors. If price increases are due to hurricane damage, investment s to protect producing and refining facilities from natural disasters may become a priority. To the extent that energy prices are the result of market manipulation or excess speculation, a cop on the beat with both oversight and enforcement authority will be effective.”
Ironically, we’ve been here before... The Commodity Exchange Act of 1936 repeats the same in a more concise fashion, “Excessive speculation in any commodity under contracts of sale of such commodity for future delivery… causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity.”
The more things change, the more things stay the same. “Eliminate all other factors, and the one which remains must be the truth.” Perhaps, we can take heart from Sherlock Holmes in “His Last Bow.”
“Good old Watson! You are the one fixed point in a changing age. There's an east wind coming all the same, such a wind as never blew on England yet. It will be cold and bitter, Watson, and a good many of us may wither before its blast. But it's God's own wind none the less, and a cleaner, better, stronger land will lie in the sunshine when the storm has cleared. Start her up, Watson, for it’s time that we were on our way. I have a check for 500 pounds which should be cashed early, for the drawer is quite capable of stopping it if he can.”
- Mack Frankfurter, Managing Director
Wednesday, January 16, 2008
2007 Year End Thoughts Going Into 2008
THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
The long and winding year of 2007 has come to a close... In the annals of trading, this is one “vintage” that will be remembered for some time as the year re-introduced the concept of investing risk and volatility. Unfortunately, some trading programs didn’t survive, and surely, the remaining players are breathing a sigh of relief.
Exactly one year ago, we at Cervino Capital were advocating caution and making noise about the badly skewed risk-reward equation, especially in the equity markets. This is documented here in our blog.
In the early part of the year, we traded small and with little conviction, mostly getting frustrated. Such strategic frustration, however, allowed us to overcome the expected change in volatility that started in February and that is still continuing now.
Several other aggressive money managers who also trade options were not so prescient and are no longer managing. We do not say this to “rub it in” but to remind us all, including ourselves, that investing in the futures market is a tricky game.
Leveraged strategies must always be treated with kid gloves, and risk management should be the first priority—that is our philosophy. By sticking to our convictions we believe that, for the prudent and patient, robust investment returns will follow in due course.
At the risk of trying to forecast the future, these are the potential investment themes that we expect may develop in 2008:
US dollar rebound. While the structural weakness of the dollar will be an established theme for some time as a result of numerous bad fiscal decisions made by politicians and consumers alike—when everyone is leaning one way, expect the opposite. The need to repay our debt may spur a rally.
High volatility. Volatility should be here to stay. This measure of risk is cyclical in nature, and as we continue through this period of credit contraction and risk reassessment, it is reasonable to expect a protracted cycle of high volatility.
Energy leadership. Given the continued imbalances of supply and demand, energy will maintain its position of market leadership, with interest in alternatives and carbon allowances continuing to grow too. Even in the event of an economic slowdown, we believe that the price of crude oil will remain high, and energy needs will remain a predominant factor.
Gold strength. With the Fed between a rock and a hard place, and the investment community walking the tightrope between housing/credit deflation and growth stimulation, gold will prove to be the most comfortable “global value benchmark.”
Nationalization of losses. Wall Street’s new credo seems to be: “privatize profits, socialize losses.” We fully expect bail-out plans to be implemented for the ‘rationally irrational’ (or is that, ‘irrationally rational’?) risk takers in the housing market.
Sovereign wealth funds. This is the new significant player in the game, and they are likely to change the market landscape as much if not more than the influence wrought by the hedge funds. Generally, this development is positive, but the markets should demand more transparency.
As a final prognostication, we’re hedging our bets that 2008 will be at minimum another interesting year, and we look forward to trade it. In anticipation, Cervino Capital launched a Commodity Options Program in July 2007, and is now offering a 2X leveraged version of its Diversified Options Strategy.
Our goal is to produce risk-adjusted returns utilizing strategies that enhance portfolio diversification by taking advantage of the situations we highlighted above.
- Davide Accomazzo, Managing Director
The long and winding year of 2007 has come to a close... In the annals of trading, this is one “vintage” that will be remembered for some time as the year re-introduced the concept of investing risk and volatility. Unfortunately, some trading programs didn’t survive, and surely, the remaining players are breathing a sigh of relief.
Exactly one year ago, we at Cervino Capital were advocating caution and making noise about the badly skewed risk-reward equation, especially in the equity markets. This is documented here in our blog.
In the early part of the year, we traded small and with little conviction, mostly getting frustrated. Such strategic frustration, however, allowed us to overcome the expected change in volatility that started in February and that is still continuing now.
Several other aggressive money managers who also trade options were not so prescient and are no longer managing. We do not say this to “rub it in” but to remind us all, including ourselves, that investing in the futures market is a tricky game.
Leveraged strategies must always be treated with kid gloves, and risk management should be the first priority—that is our philosophy. By sticking to our convictions we believe that, for the prudent and patient, robust investment returns will follow in due course.
At the risk of trying to forecast the future, these are the potential investment themes that we expect may develop in 2008:
US dollar rebound. While the structural weakness of the dollar will be an established theme for some time as a result of numerous bad fiscal decisions made by politicians and consumers alike—when everyone is leaning one way, expect the opposite. The need to repay our debt may spur a rally.
High volatility. Volatility should be here to stay. This measure of risk is cyclical in nature, and as we continue through this period of credit contraction and risk reassessment, it is reasonable to expect a protracted cycle of high volatility.
Energy leadership. Given the continued imbalances of supply and demand, energy will maintain its position of market leadership, with interest in alternatives and carbon allowances continuing to grow too. Even in the event of an economic slowdown, we believe that the price of crude oil will remain high, and energy needs will remain a predominant factor.
Gold strength. With the Fed between a rock and a hard place, and the investment community walking the tightrope between housing/credit deflation and growth stimulation, gold will prove to be the most comfortable “global value benchmark.”
Nationalization of losses. Wall Street’s new credo seems to be: “privatize profits, socialize losses.” We fully expect bail-out plans to be implemented for the ‘rationally irrational’ (or is that, ‘irrationally rational’?) risk takers in the housing market.
Sovereign wealth funds. This is the new significant player in the game, and they are likely to change the market landscape as much if not more than the influence wrought by the hedge funds. Generally, this development is positive, but the markets should demand more transparency.
As a final prognostication, we’re hedging our bets that 2008 will be at minimum another interesting year, and we look forward to trade it. In anticipation, Cervino Capital launched a Commodity Options Program in July 2007, and is now offering a 2X leveraged version of its Diversified Options Strategy.
Our goal is to produce risk-adjusted returns utilizing strategies that enhance portfolio diversification by taking advantage of the situations we highlighted above.
- Davide Accomazzo, Managing Director
Prepared Speech on the Subject of Volatility
The following is from a speech prepared by Davide Accomazzo for the quarterly review of the Pepperdine Investment Club, a class which manages real money in a real portfolio.
Let me begin by thanking you for inviting me here tonight; it is an honor and a privilege.
This opportunity you have in running a portfolio with actual money is a great tool to become acquainted with the true meaning of portfolio management. When I took my investment classes in business school, part of the program was to individually manage a $100,000 portfolio for the duration of the class. Whoever had the best performance would win…
Of course, this was not “real” $100,000, which in my case was rather good since after spending about half the class comfortably at number one, I decided to take a leveraged bet on the dollar index just before the U.S. Government shutdown in 1995. From there, I miserably dropped from first place to last place, where I concluded the class.
Later, when I called my professor to tell him that I was going to Wall Street to trade euro convertible bonds for an investment bank, he said, “When I saw you blow it all up with that trade, I knew you were going to go to Wall Street!”
Well… ten years later and after dodging many bullets, with real respect for risk and volatility, and a much better understanding of risk management and discipline, I can say that blowing up that hypothetical portfolio was a worthy experience. Because of this, I would like to touch upon the subject of volatility, and hopefully provoke interest as well as more analysis on your part in your quest to become money managers.
Many years ago, a friend of J. P. Morgan, at the time the most powerful banker and investor in America, if not the world, asked him what his outlook for stocks were for the coming year. The legend states that J. P. answered, “Stocks will go up and stocks will go down.”
Such a seemingly overly-simplistic comment probably disappointed Morgan’s friend but in reality it was the truest analysis Morgan could have given. Even today, with all the advances in quantitative science and the power of technology, the “tea leaf reading” activity in guessing market direction is still, at best, a matter of batting averages and discipline. In other words: stocks will go up and stocks will go down.
What I believe is of utmost importance, and often underestimated, is a clear understanding of the potential violence of those swings; how deep stocks might go down and how high stocks may fly. I am referring to stock market volatility. The process of incorporating volatility analysis and volatility forecasting in portfolio analysis is in my view of paramount importance.
There are many ways to refer to such volatility and one now commonly used benchmark is the VIX, a measure of market volatility calculated by averaging the weighted prices of out-of-the-money puts and calls on the S&P 500 index.
While this benchmark was confined mostly to derivative players for years as an analytical tool, it has recently come to the forefront. I believe that an understanding of how the VIX illustrates and maps market participants’ risk behavior can only improve your portfolio management technique.
There are also lessons to be learned from studying volatility behavior in its historical contexts. One should always be on the lookout for warnings flags as indicated by irrational market behavior—the madness of crowds—as well as disconnections between implied and statistical volatility.
The past is littered with examples: absurdly low volatility levels in 2006, followed by a slew of blow-ups in 2007 including subprime hedge funds, CDO mispricings, and quant hedge funds are recent cases in point. Going just a few years back, there is the 2001-2002 bear market volatility spikes, and before that is the 1998 LTCM volatility convergence trade fiasco.
Consequently, you should imprint onto your psyche the potentially misleading significance of Gaussian calculations in trading, and in turn focus on the importance of volatility cyclicality, the value of common sense, and the need for strategic insurance.
Always ask yourself: Am I being paid enough for the risk I am taking?
Or, on the other side of the coin: Are opportunities undervalued given the market’s structural and behavioral profile, and should I increase exposure?
And always keep in mind the effect of the unforeseen event, now commonly referred to on trading desks as the “Black Swan.” How you can protect your portfolio, or likewise profit from it… because that is or certainly should be, why people pay you to be their money manager.
- Davide Accomazzo, Managing Director
Let me begin by thanking you for inviting me here tonight; it is an honor and a privilege.
This opportunity you have in running a portfolio with actual money is a great tool to become acquainted with the true meaning of portfolio management. When I took my investment classes in business school, part of the program was to individually manage a $100,000 portfolio for the duration of the class. Whoever had the best performance would win…
Of course, this was not “real” $100,000, which in my case was rather good since after spending about half the class comfortably at number one, I decided to take a leveraged bet on the dollar index just before the U.S. Government shutdown in 1995. From there, I miserably dropped from first place to last place, where I concluded the class.
Later, when I called my professor to tell him that I was going to Wall Street to trade euro convertible bonds for an investment bank, he said, “When I saw you blow it all up with that trade, I knew you were going to go to Wall Street!”
Well… ten years later and after dodging many bullets, with real respect for risk and volatility, and a much better understanding of risk management and discipline, I can say that blowing up that hypothetical portfolio was a worthy experience. Because of this, I would like to touch upon the subject of volatility, and hopefully provoke interest as well as more analysis on your part in your quest to become money managers.
Many years ago, a friend of J. P. Morgan, at the time the most powerful banker and investor in America, if not the world, asked him what his outlook for stocks were for the coming year. The legend states that J. P. answered, “Stocks will go up and stocks will go down.”
Such a seemingly overly-simplistic comment probably disappointed Morgan’s friend but in reality it was the truest analysis Morgan could have given. Even today, with all the advances in quantitative science and the power of technology, the “tea leaf reading” activity in guessing market direction is still, at best, a matter of batting averages and discipline. In other words: stocks will go up and stocks will go down.
What I believe is of utmost importance, and often underestimated, is a clear understanding of the potential violence of those swings; how deep stocks might go down and how high stocks may fly. I am referring to stock market volatility. The process of incorporating volatility analysis and volatility forecasting in portfolio analysis is in my view of paramount importance.
There are many ways to refer to such volatility and one now commonly used benchmark is the VIX, a measure of market volatility calculated by averaging the weighted prices of out-of-the-money puts and calls on the S&P 500 index.
While this benchmark was confined mostly to derivative players for years as an analytical tool, it has recently come to the forefront. I believe that an understanding of how the VIX illustrates and maps market participants’ risk behavior can only improve your portfolio management technique.
There are also lessons to be learned from studying volatility behavior in its historical contexts. One should always be on the lookout for warnings flags as indicated by irrational market behavior—the madness of crowds—as well as disconnections between implied and statistical volatility.
The past is littered with examples: absurdly low volatility levels in 2006, followed by a slew of blow-ups in 2007 including subprime hedge funds, CDO mispricings, and quant hedge funds are recent cases in point. Going just a few years back, there is the 2001-2002 bear market volatility spikes, and before that is the 1998 LTCM volatility convergence trade fiasco.
Consequently, you should imprint onto your psyche the potentially misleading significance of Gaussian calculations in trading, and in turn focus on the importance of volatility cyclicality, the value of common sense, and the need for strategic insurance.
Always ask yourself: Am I being paid enough for the risk I am taking?
Or, on the other side of the coin: Are opportunities undervalued given the market’s structural and behavioral profile, and should I increase exposure?
And always keep in mind the effect of the unforeseen event, now commonly referred to on trading desks as the “Black Swan.” How you can protect your portfolio, or likewise profit from it… because that is or certainly should be, why people pay you to be their money manager.
- Davide Accomazzo, Managing Director
Sunday, July 8, 2007
2nd Qtr 2007 Review and Black Swans
THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
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
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
INVESTING IN FUTURES AND OPTIONS INVOLVES RISK AND MAY NOT BE SUITABLE FOR ALL INVESTORS. THEREFORE, INVESTORS SHOULD CAREFULLY CONSIDER THESE RISKS AND DETERMINE WHETHER THEY ARE SUITABLE FOR INVESTING IN LIGHT OF THEIR FINANCIAL CONDITION AND INVESTMENT OBJECTIVES.
"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 www.ma-research.com and www.barclaygrp.com. 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) www.focuspointpress.com. 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.
"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 www.ma-research.com and www.barclaygrp.com. 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
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[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) www.focuspointpress.com. 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.
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