Volatility Is Back… Embrace It!
Over the past few years, the U.S. Central Bank served as a calming drug by forcing both fundamentals and technicals to take a backseat.
One side effect?
Markets became lazy and complacent. Traders sat in their chaise lounges as phases of quantitative easing came and went.
Volatility plummeted as a result.
Trends in liquid markets became short-lived and experienced sharp reversals, making it hard for trend followers to capture moves.
But now, after all of the Fed’s tactics have run their course, volatility is back – and the commodities sector is once again supporting trend followers. Here’s how you can benefit…
Pain Management Comes to an End
There’s no question that recent years have created a challenging environment for managed futures traders and commodity trading advisors (CTAs).
With volatility low, the returns of systematic traders and trend followers suffered. This is reflected in the Barclay CTA Index, which experienced three consecutive negative years from 2011 to 2013.
What made this latest trend so intriguing was its length. Since its launch in 1980, the Barclay CTA Index never had consecutive negative years.
As you would expect, assets under management in this class exited, seeking returns mostly in safer sectors, such as bonds.
But history dictates that markets are cyclical, and we all knew this phase would pass. The only question was timing…
The Turning Tide
In Q3 of 2013, the anticipation of Federal Reserve tapering roiled the markets, and opened the doors to a previously uninvited guest – volatility.
The market went from lots of “crowded” trades (long bonds and short mostly everything else) to, in 2014, an ideal market for the trend-following crowd: market de-correlation.
By October of 2014, quantitative easing in the United States had run its course, and global markets were on edge as an interest rate hike by the Federal Reserve seemed probable.
Thus, 2014 turned out to be a good year for managed futures and CTAs. The period of low volatility in both the commodities and certain currency markets had finally come to an end.
Energy markets collapsed in the second half of the year, much to the surprise of many on Wall Street, who were expecting West Texas Intermediate to close out around $85 to $90 per barrel, rather than $45. Futures, such as meats and milk, turned out to be great plays, as well. And equity markets began their long, upwards slope, as did the 10-year note.
Today’s markets face the anticipation of a rate hike. This would equate to a higher U.S. dollar and even lower commodity prices, barring any unexpected systemic or geopolitical events.
Slower growth in Europe, Japan, and many emerging markets is creating a divergence in fixed income… and an equity market in the United States that cannot stop climbing.
Many believe that 2015 could see the kind of returns that mirror 2008, which history deemed the “perfect” year for trend followers.
According to Kim Bang, the Portfolio Manager for the Prolific Swiss Fund, the markets are cooperating and are on track to produce attractive returns.
“We believe the recent sharp dollar appreciation is a precursor to more volatility to come in the global equities and rates markets,” says Bang. “With geopolitical and economic divergences afoot, the rise in volatility in the financial markets has just begun. As the equity markets trade at historical highs, and the VIX and rates at historical lows, investor complacency is about to burst when the [Fed] curtails the low interest rate ‘put option,’ provided since the financial crisis in 2008.”
2015 Ripe for Trend Followers
If you’re new to this sector, it’s advisable to check out BarclayHedge, which publishes results for the best-performing CTAs. The company offers the Barclay Systematic Traders Index, which is an equal-weighted composite of managed programs, currently holding approximately 457 programs.
If you embrace volatility more than larger institutions do, you may want to stick with smaller managers who can be more nimble. They can trade the less-liquid markets that larger macro traders tend to avoid, such as cotton or steel.
Larger managers are also forced to tone down volatility to serve their pension fund and sovereign wealth government investors who aim to keep volatility in check.
Bottom line: Investors should aim to diversify some of their core investments into non-correlated products, such as managed futures and CTAs.