Andrew Abraham

andy-0101 My name in Andrew Abraham. I have been investing in commodities and managed futures since 1994. I adhere to the philosophy of trend following. Trend following stresses a disciplined approach to commodity/ futures trading. Successful trend following and commodity futures investing requires patience, discipline and actively managing the risk. What sets me apart from other traders is that I am not only concerned about the return on investment but how much risk I will have to tolerate to achieve my goals.

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Futures and commodity trading involve substantial risk. The evaluations of futures and commodities may fluctuate and as a result, clients may lose more than their original investment. In no event should the content of this website be construed as an express or an implied promise, guarantee or implication by, that you will profit, or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance. Information provided on this website is intended solely for informative purposes and is obtained from sources believed to be reliable. Information is in no way guaranteed. No guarantee of any kind is implied or possible, where projections of future conditions are attempted.



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Managed futures on the rise as investors chase diversification

Wanted to share this article that was on Hedge Fund Review.

Managed futures on the rise as investors chase diversification

Probable future

Author: Kris Devasabai

Source: Hedge Funds Review | 04 Apr 2011

Managed futures has grown to become the single largest strategy in the hedge fund universe. Strong inflows and performance have helped make it a popular diversifier for many portfolios.

In 1983 Harvard professor John Lintner published a seminal paper illustrating how an allocation to managed futures could dramatically improve the risk adjusted returns of an investment portfolio. Twenty-seven years later managed futures have become an investment vogue and allocations to the strategy are growing at a startling pace.

Commodity trading advisers (CTAs) running managed futures programs experienced record inflows in 2010, according to data from BarclayHedge. Combined assets managed by CTAs reached $267.6 billion at the end of 2010, an increase of over 25% from $213.6 billion in 2009. That makes managed futures the single-largest strategy in the hedge fund universe, representing almost 15% of industry assets, according to BarclayHedge numbers.

This is not simply a case of investors chasing performance. CTAs generated only modest returns of around 7% last year and were broadly flat in 2009 when most other strategies posted large gains on the back of the powerful rally in equities.

Instead, the focus is on managed futures as a source of uncorrelated returns that can help diversify a broader portfolio. These properties came to the fore in 2008 when managed futures programs returned over 14% on average despite large declines in global markets.

The contrarian performance of managed futures is the key to its value as a diversifier. A study by the CME Group and AlphaMetrix in 2009 revisiting Lintner’s original paper found the BarclayHedge CTA Index had positive returns in 12 of the 15 worst months for equities since 1987.

The diversification properties of managed futures come into sharper focus when viewed in relation to the performance of other investments.

A recent research paper by Welton Investment Corporation examined the correlation of various asset classes and strategies over the past decade. It found that 15 of the 24 most common investments in institutional portfolios, including eight of the 10 main alternative investment strategies, had a correlation to the S&P 500 index of 0.65 on average.

Over the same period, the Newedge CTA Index had a correlation of -0.16 to equities.

“We found that investments which provide truly uncorrelated sources of return are extremely scarce. Of the 24 indices we examined, managed futures had the lowest correlation to equities and offers the greatest diversification benefits for investors,” says Patrick Welton, founder and CEO of Welton Investment Corporation.

Despite its value as a diversifier and a return driver, managed futures has always been a thorn in the side of conventional portfolio theories based on the capital asset pricing model or the efficient market hypothesis (EMH).

CTAs seek to identify recurring trends in financial markets which they exploit through a systematic, rules based approach to trading. For all their powerful computers and complex algorithms, the basic strategy of most CTAs comes down to some form of trend following: essentially buying markets that are rising and selling those that are falling.

This type of momentum-based investing is incompatible with EMH which holds that market prices move in a series of random steps. EMH further states that current market prices already reflect all available information, including past prices, meaning that strategies which claim to forecast future prices moves by analysing historic data are doomed to fail in the long term.

The mistake CTAs make is believing they can anticipate trends. The future is unknowable and no amount of historical data analysis can change that. The real strength of CTAs is their ability to manage the risk of the unknown future.

Patrick Welton has an elegant theory on what drives the returns of managed futures. He argues that CTAs make the bulk of their returns by harnessing capital flows across and within major financial markets. “Price trends are essentially a reflection of capital moving between various asset classes, instruments and geographies. Managed futures should be seen as a long/short capital flows strategy,” he says.

Capital flows can be driven by a variety of inputs. Changes in central bank policy or an increase in new issues in a particular country will rationally induce or restrict capital flows around the world with different lag times and varying degrees of magnitude.

CTAs are relatively unique in their ability to capture these movements, says Welton. Global macro funds operate on a similar principle, but the systematic approach and sheer diversification of CTAs provides more reliable exposure to capital flows as a return driver, Welton argues.

The capital flows theory is not widely accepted in the managed futures community.

CTAs commonly attribute the existence of price trends to information asymmetry and irrational behaviour among market participants. “If everyone behaved rationally, the markets would be efficient and no strategy could outperform,” says Keith Balmer, a portfolio manager at AHL, the world’s largest CTA with around $23 billion in assets.

“EMH hinges on perfect information and rational behaviour. The reality is human beings are far from rational. We sell winners too early and hold losers too long. We pile into trades that are doing well and rush out of those that are doing poorly. This type of behaviour creates trends which can be exploited through a systematic process,” admits Balmer.

The behavioural biases most often cited by CTAs are anchoring and herding. The anchoring argument links the emergence of trends to the tendency of some market participants to respond more slowly than they should to market developments because of some attachment to a past reference point.

For instance, bearish investors may dismiss positive news as a blip and refuse to change their position, causing prices to rise more gradually than they would in a truly efficient market.

Once a trend is established, the herding instinct takes over and investors begin rushing into trades that are doing well. This bandwagon effect sustains trends over time and often drives prices beyond rational levels.

The information asymmetry argument highlights inefficiencies in the way news and data is consumed and digested by market participants. “The market does not assimilate and act on information in an instantaneous or uniform manner. Investors analyse and respond to events over different time horizons, especially if that information relates to macro changes,” says Ted Frith, head of UK sales at Aspect Capital, a $5 billion CTA based in London.

For instance, the full implications of near-zero interest rates and the quantitative easing programmes in the aftermath of the financial crisis were not immediately apparent to all market participants. Over time, however, these policies were the catalyst for persistent directional moves in equities, currencies and the fixed income markets. CTAs profited from many of these trends in 2010.

EMH suggests inefficiencies of this nature will be arbitraged away. To some extent this has been the case. The original trend following systems developed by US-based CTAs in the 1970s and 1980s experienced severe performance degradation in the late 1990s and 2000s, prompting many observers to proclaim the death of managed futures. However, a second generation of research-driven CTAs like AHL, Aspect and Winton Capital which emerged in the 1990s have found new ways to exploit the persistence of trends in the futures markets.

One reason trends have not been arbitraged away is because they are extremely difficult to exploit on a consistent basis. “If it was easy, everyone would be doing it. It requires a huge investment in research and technology to capture markets trends profitably over the long term,” says AHL’s Balmer.

CTAs can be highly volatile. A study by Mila Getmansky, Andrew Lo and Shauna Mei in 2004 found that managed futures funds had the highest attrition rate at 14.4% and volatility (18.55%) of any hedge fund strategy.

“A basic approach to trend following can be very risky,” says Aspect’s Frith. “There is a high probability of getting into loss-making positions. The better CTAs have developed various techniques and signals which allow them to be smarter trend followers.”

CTAs have sought to temper the inherent volatility of the strategy through greater diversification, expanding the number of markets they trade and running their models over different time frames. However, even the most sophisticated trend-following programs tend to lose money on around half of all trades.

The Newedge CTA Index showed a positive return on 53.97% of trading days since January 2000 and negative performance on 45.89% of days (with several days of zero returns), according to analysis by the research group of the Newedge prime brokerage division. The average return on positive trading days was 0.39% compared with -0.4% on losing days.

CTAs concede their models give them only a small edge in predicting future market direction.

“We look to make a forecast that is ever so slightly better than random,” says Matthew Beddall, chief investment officer at Winton Capital Management, a $19 billion CTA based in London. “That doesn’t provide much of a trading edge in an individual market, but the power of diversification translates this into a very credible performance over the long run,” he says.

Winton’s Diversified Program trades over 100 futures markets employing a variety of models over multiple time frames. The program, like the Newedge CTA Index, has been profitable on only 54% of trading days and its emphasis on longer-term trends means the probability of large one-day losses is greater than large one-day gains. Yet the program has generated annualised returns of almost 17% since 1997 with only one losing year.

“We are able to translate a small edge into consistent returns by keeping transaction costs low and adhering to a disciplined and systematic approach to trading and risk management,” says Beddall.

The outsize returns of the top CTAs is partly attributable to superior risk management and trading efficiency. CTAs spend significant time analysing the transaction costs, liquidity profile, volatility and correlations of the markets they trade. These inputs are fed into computer models which determine position sizes, stop losses and other variables.

“If you look at the way CTAs weight markets, size positions, forecast volatility and correlations, measure market capacity, that’s where the real science comes in. Risk management and portfolio construction is where CTAs really excel,” says Ryan Duncan, co-head of research in Newedge’s prime brokerage group, which has conducted multiple studies on the performance of managed futures.

The sophistication of risk management in the managed futures industry is illustrated by AHL. Its systems sample the price action and volatility in the markets around 4,000 times each day – or once every 21 seconds. Trading positions are opened, closed or resized based on these inputs. “We end up trading about 3,000 times a day on average,” says Balmer.

Managed futures is first and foremost a risk management strategy, says Peter Matthews, founder and managing partner of PJM Capital, a $350 million CTA based in Northern Virginia. Matthews, a veteran of the managed futures industry who co-founded Mint Investments with Larry Hite in 1981, has an interesting theory on the capital markets and why managed futures has proven to be successful over the years.

He argues financial markets are “complex adaptive systems” where outcomes are a function of the dynamic interactions between heterogeneous participants competing for limited resources. Complex adaptive systems theory has been used to describe a host of natural and social phenomena and is starting to gain acceptance as a framework for understanding capital markets activity.

The behaviour of complex adaptive systems reflects the totality of the interactions between participants. At times the system may appear efficient because the interactions between participants cancel each other out. At other times a self-reinforcing positive feedback loop grips the marketplace, resulting in the emergence of trends.

“The markets are not efficient or orderly. They are an endless battleground,” says Matthews. Capital markets activity is characterised by groups of participants with opposing views fighting each other to a standstill until one side eventually prevails and surges ahead. “The emergence of price trends often reflects the end of a battle in the markets,” says Matthews.

That does not mean trends are necessarily forecastable. Complex adaptive systems are non-linear and the outcomes at the aggregate levels are often more complicated than the sum of the interactions between participants. This explains the difficulty of predicting the periodic booms and busts in financial markets as these are often the result of a series of innocuous events.

The central conclusion of complex adaptive systems theory is that the future is entirely unpredictable. “The mistake CTAs make is believing they can anticipate trends. The future is unknowable and no amount of historical data analysis can change that. The real strength of CTAs is their ability to manage the risk of the unknown future,” says Matthews.

The success of managed futures is baked into its risk management DNA, says Matthews. CTAs trade highly liquid futures contracts, diversify across multiple markets, keep position sizes small and are quick to exit losing trades. “If the future is unknown, then all we can do is measure and minimise the risks associated with the decisions we make. That’s what CTAs do better than anyone else,” concludes Matthews.

The recent growth in allocations to managed futures raises the obvious question of whether CTAs can continue to profit from their small edge as more capital flows into the sector. Matthews thinks this could be a problem, particularly as around 20% of managed futures assets are controlled by a handful of CTAs – AHL, Altis Partners, Aspect, BlueCrest Capital Management and Winton – which employ a broadly similar trend following strategy. The growth in capital chasing trends could cause them to be less persistent and chip away the profits of CTAs, Matthews says.

For Winton, this is an area that requires further research. “We don’t know to what extend the strong inflows into trend following strategies will affect their future performance,” says Beddall. “It seems likely that it will make the strategy less profitable. Our real fear is if the CTA industry starts to create trends rather than just follow them. This is one of the key issues we’re focusing on,” he says.

Past performance is not indicative of future performance
Futures trading involves risk. People can and do lose money

Andrew Abraham

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