Best Ways to Maximize Increased Market Volatility

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The agricultural commodity funds have a number of investors scratching their heads. With a backdrop of commodity prices reaching new heights -- wheat is up 92% year to date, for instance -- the Barclay Agricultural CTA index, a measure of professional Managed Futures fund trading, is up a paltry 1.2% year to date. 

But this should come as no surprise to professional futures investors and those familiar with the emerging asset class that is Managed Futures. 

Managed Futures offers investors structure a similar to a stock mutual fund. Professional traders -- some would say the best traders in the world -- manage client assets through a system that provides investors unique transparency, providing investors a direct glimpse into sophisticated and often secretive futures and options trading strategies.

There are several factors to consider with the "Ag" Commodity Trading Advisors, commonly known as CTAs. 

The primary issue with professional trading of the Ag markets has been "unusual" market forces creating what some consider abnormal volatility and market conditions. To illustrate the difficulty, even when a CTA makes the correct call on market direction, the extreme volatility produces such wild price fluctuations that they get stopped out before the trade has a chance to profitably mature.  

Plagued by the forces of globalization, new environmental demand such as bio fuels and the unusual influence of "outside" markets, the top Agricultural CTAs have been forced to contend with new and often surprising market forces -- and have suffered as a result.

Two primary new forces are driving this year of adjustment and difficulty for Ag funds: The globalization of supply and demand has taken center stage, and the heavy influence of outside markets such as crude and Forex have contributed to unusual market volatility. 

Many AG CTAs are accustomed to focusing on US-based supply and demand analysis and seasonal forecasting. However, focusing on domestic balance sheets gives the wrong answer to the supply/demand equation. With a very weak US dollar and global weather problems, the need to watch global offtake is clear. For instance, with a record US corn crop in 2007 a Ag trader would normally think $3.50 corn is too high -- as the stocks/use ratio would never justify such a price for corn. However, that looks at the Ag markets only though traditional measures of the US balance sheet. When global factors are applied -- something not typically done by many Ag traders -- the real answer becomes clear.

In Europe, skyrocketing prices made it too expensive to use wheat to feed livestock, and thus the global demand for corn increased. Add to this a weak US dollar -- which motivated European buyers to gobble up American corn stock -- and the bio-fuel craze, and Ag funds were found contending with new data and market forces to which they were not accustomed. 

As is often the case, there are CTAs outperforming the index benchmark. For instance, the Strategic Ag Grains program is up over 25% and Four Seasons Commodities Hawkeye program is up over 12% year to date. These nimble CTAs, which can invest both long and short commodities, have found methods to profit in what some consider a difficult market. 

For instance, the Four Seasons Commodities Hawkeye program is primarily engaged in a spread trading strategy. An example of a spread strategy is what is known as the "crush" spread in the soybean market. With this strategy, the CTA simultaneously purchases soybean futures and sells soybean meal futures, attempting to establish a position in the processing of soybeans, created through the spread.

At times such spread trading can make for interesting results. For instance, in 2004 Chicago Capital Management posted powerful 344% annualized return from a spread trade. During that year the CTA was long near month cattle during a mad cow scare and short the far month. When mad cow sent near month cattle prices limit up several days in a row, the spread between the near and far month ultimately widened, creating a trade to remember. 

While 344% is strong and powerful, Managed Futures investors should maintain realistic expectations when investing in the asset class. As a rule, I consider "conservative" programs to maintain past returns from 15% to 25% on an annualized basis -- after fees and expenses. Such conservative programs might have limited drawdowns and equally attractive risk measures, such as their Sharpe and Calmer ratios. "Moderate" Managed Futures programs might typically post past returns of 25% to 35% with a slightly higher risk profile. "Aggressive" programs might post past returns from 35% to 60%. However, hang on to your hat with the Aggressive programs, as the investor should be prepared for wild volatility on their investing path. 

While it is tempting to consider CTAs simply based on their absolute returns, the entire CTA package needs to be considered. This includes risk / reward measures, Alpha, Beta and R Squared analysis. But perhaps the most significant key to success with CTA investing, in my opinion, is proper diversification. 

When building a Managed Futures portfolio, we strongly consider the correlation the components of the portfolio have to one another as well as to outside investments, such as the stock market at large and other investments. Not only do we conduct a standard, return-based correlation analysis, but we also consider a strategy correlation analysis. This is where the CTA’s strategy is regression tested against various market conditions and markets, Ags being one such market category. 

Ideally, the Managed Futures investor creates a well diversified portfolio that includes an Ag strategy along with other appropriate strategies.

Complimentary Managed Futures CD-ROM

See how professional investors profit from the futures and options markets. With managed futures a professional money manager with a past track record trades your account. Register for a complimentary Managed Futures CD-ROM produced by the Chicago Board of Trade and a portfolio recommendation report with rankings and returns of top managers. Learn more!