March 2016 Performance Report

MAR Summary oerformance

Industry Benchmark Performance

March was good for Equities Hedge Funds but poor for futures CTAs. Perhaps that’s the way diversification works, although we’d rather have gains in both. With the major index markets up 6% to 8%, we would expect good returns in equities. On the other size we have the SG CTA Benchmarks all down about 3%. Even with this reversal, Hedge Funds are still down for the year and Futures traders up significantly. Maybe diversification isn’t so bad.

In March, we had a big swing in equity direction and, in all fairness, a Fund Manager can’t both protect you from risk and then turn around and capture every upside move, so returns will lag the market and never be as strong as a good move in the index. Futures were even more erratic, with the US dollar falling from its highs, energy rallying, and interest rate yields dropping again. These were all reversals in the longer-term trend (well, maybe not interest rates).

CTA Benchmark

 

March Overview: Good Returns in Equities, Mostly Losses in Futures

In equities, 14 of 16 of our programs were profitable, but only one program in futures. That’s similar to the industry pattern. Unlike the industry, we remain well ahead of the major index markets year-to-date, with the Trend program up by about 2% and the Timing Program up 5% in the small portfolio.

Futures posted losses in nearly all portfolios, but many remain slightly higher for the year. We’re optimistic that some steady trends will develop now that we’ve seen reversals.

Major ETFs

Once the shining star, now the fallen star: Short-term interest rates at low yields

Keeping Your Portfolio Balanced

Interest rates have been the leading profit sector for futures traders since 1980, and within that group, Eurodollars, short sterling, euribor, and other short-term rates were most often the best performers. It’s not often discussed, but CTAs have faced a serious dilemma since about 2010, and it’s still a problem. Investors who try to keep their portfolios balanced, that is, risk-adjusted, will face the same problems. While this is extreme with futures traders, the same thing can easily happen with stock traders, so let me explain.

The best diversification comes from trading equal risk whenever possible. That means dividing your investment equally among all the stocks or futures markets, then trading the number of shares or contracts that represent the same risk exposure. I’ve written about this before, so I won’t go into the theory. For this example, let’s say we trade $25,000 in Eurodollar risk and the same in S&P risk. We measure risk (we’ll also call this “volatility”) as the 20-day average true range, the method acknowledged as the best.

Calculating the Number of Contracts

To get the number of contracts to trade, we will divide the market investment of $25,000 by the 20-day dollar value of the volatility. Below on the left (Chart 1) are the back-adjusted futures prices for Eurodollars, and on the right the implied yield (1 – price). Because these are back-adjusted the 1980 yield is going to be about 38% rather than around 20%, so we’ve only shown the implied yield (right below) starting in 2000. The current yield is correct.

Eurodollar prices and yield

Chart 1. Back-adjusted Eurodollar futures (left) and implied yield (right).

The problem with low yields is that there is also low volatility, and low volatility means more contracts of Eurodollars are needed to offset the risk of, say, the S&P mini. In Chart 2 below, we show the number of contracts need to keep the risk at $25,000. Note that after 2008, rates and volatility dropped sharply, so the number of contracts needed to trade rose from about 150 to a peak of 1200 and is now back to 200. Now let’s look at the S&P.

Eurodollar contracts

Chart 2. The number of Eurodollar contracts needed to keep the total risk constant at $25,000.

On the left below (Chart 3) are S&P back-adjusted futures price from 1983. The chart looks very much as we would expect it. On the right, the number of contracts needed to have $25,000 in risk has declined steadily because the S&P volatility has increased with price. As of now, we would trade 23 contracts of S&P mini for every 200 contracts of Eurodollars. In 2013, when Eurodollar volatility was at a low, we would have traded 1000 contracts of Eurodollars to only 20 contracts of the S&P.

SP prices and contracts

Chart 3. S&P back-adjusted futures prices (left) and the number of contracts needed to trade (right).

Why is This a Problem?

The most obvious reason is liquidity. If you’re a big trader, then you might have $10 million in Eurodollars, or even $100 million. That could be a lot of contracts. Easy to get in, hard to get out.

Even more important, you are also exposed to event risk, which is no small matter. It may be that Eurodollar prices move only a fraction of a point each day. For example, in 2010 if was common to have a daily range of 0.10 from high to low, equal to $250. Not much compared to the S&P with moves of 23 big points in one day, or $1150. But then a surprise economic event moves prices 0.25 points when the typical move for 2010 was .03, making you position size You have a $25,000 position (200) contracts and normally see a profit or loss of 0.03 points, that’s $15,000, but now you get a 0.25 move worth $125,000. That’s great if it’s a profit, which is not very likely given low yields and a trend towards lower yields, but not so good if it’s a loss.

More Bad News

Is it worth the risk? It may be if the returns justify the risk. There is still profit in short-term interest rate futures even at low yields. When you roll into a new contract, you can capture 90 days of interest, and do that four times each year.

To see what a manager faces, I’ve created a simple 80-day moving average system, long when the trend is up, short when it’s down. I have found that 80 days is the typical period representing the macrotrend used by many CTAs. We enter a trade long or short based on the direction of the trendline, a $25,000 investment, and the current 20-day average true range. No commission costs were charged. Chart 4 below shows the NAV of Eurodollars from inception. Results are very impressive. Except for the past five years.

ED cum PL MA system

Chart 4. Typical cumulative profit from a macrotrend system trading Eurodollar futures.

From 2010 the trading system returned a profit, but if we look closely, the annualized rate of return was less than 10 basis points, without commissions. Before 2010 any trend system did very well: this 80-day simple moving average returned 4.67% per year with volatility of 7.01%, giving a very respectable information ratio of 0.667.

Eurodollar performance table

How Can Equity and Futures Traders Use This?

Not all low volatility periods are bad, but markets that have a concept of “high” and “low,” such as interest rates and commodities, can be very quiet when prices are extremely low. For grains, that means prices below the cost of production. For interest rates, under 1% or 2$ yields. You need much larger positions and take greater risk for a return that turns out to be poor. FX markets have no concept of high or low, so they don’t apply. For markets such as gold, just watch the volatility compared to its history.

For equity traders, low volatility may mean lack of interest in a stock. Along with that goes lower volume and erratic price movement. It is well known that volatility attracts volume in stocks, so lack of volatility will attract disinterest. Even a mean-reverting approach isn’t the solution because the size of the daily price moves many not be enough to overcome the cost of trading. We all need to recognize a change and move on.

Portfolios Selected by Performance are High Beta

As a reminder, our automatic portfolio selection process uses past performance to select stocks and futures. Markets that are outperforming the averages tend to continue to outperform, but they do it with higher volatility than the broad index. Outperformance means that profits on any day are higher, which also means that on a losing day, losses will usually be larger. It’s the basic principle of volatility and risk: you can’t achieve higher returns without higher risk.

Smaller portfolios that are less diverse are more likely to generate higher returns during “good” markets (the ones that work well for the strategy) and larger losses during “bad” markets. More diverse portfolios will have smaller gains and losses. To decide which is best for an investor, you must understand their risk tolerance and their financial well-being.

Trend Strength Index

One measure of market strength is our Trend Strength Index. Our Trend strategy is a composite of many trends, medium term to slow applied to about 250 stocks. When combined, these determine the position size of the current trade. If the faster trends are down but the slower one up, then the position size might be zero. The appearance is that trend positions scale in and out based on the strength of the trend. The Trend Strength Index appears at the bottom of the Trend Stocks All Signals report each day. We’ve tracked it from the beginning of 2014, and the chart below compares it with the SPY. TSI is the Trend Strength Index and SPY is the SPDR ETF. TSI values about zero indicate a positive trend. The range of the TSI is +1 to 1.

The bullish divergence pattern that we saw in the February Trend Strength Index (TSI) turned into a very nice rally. We now have a low in September and a higher low in January, with SPY prices declining. If this proves true, we should see the TSI back up to about zero, wiping out the long-term bear trend in stocks, but only leaving it neutral. Where it goes from there is less certain. We hope this is the beginning of another leg up for the stock market.

Trend strength index

We offer this Index for those investors who select their own trades rather than following our sample portfolios. Daily Index values are available to subscribers.

Strongest and Most Undervalued Sectors

There are two ways to view sector rotation, trade the strongest expecting them to stay strong, or trade the weakest expecting the business cycle to rotate them to the top. We have both. The Trend Rotation trades the strongest and the Timing Rotation trades the weakest. The Trend program may hold positions for a long time, so it’s possible for two ETFs to be in both programs. For example, XOP (Oil and Gas) can be in a long-term uptrend, but a short-term oversold situation.

Strongest

The Trend Sector ETF program buys the 6 strongest sectors of the SPDRs. March started long only Utilities (XLU), a confirmation of a weak market because Utilities have many of the characteristics of bonds.

Beginning of March: Utilities (XLU).

A much stronger market in March put us fully long the maximum of 6 ETFs:

Utilities (XLU), Reits (VNQ), Industrials (XLI), Technology (XLK) Staples (XLP), and Metal & Mining (XME)

Undervalued

The Timing Rotation program buys the 8 ETFs that are weak relative to SPY, but have a history of success. The program began March long the following ETFs:

Technology (XLK), Financials (XLF), and Healthcare (XLV), hedged 33% (2/6) of the risk using SPY:

Even with the strong rally, the long-term trend for equities is still down, and we are hedged 1/6 of our total risk. We removed XLK and XLF, adding Preferred Stocks (PFF), Energy (XLE), Staples (XLP), and Utilities (XLP). Holding the same position in both the Trend and Timing programs means that the trends are strong but the Timing program entered them when they were at a discount to the SPY. We now hold:

Healthcare (XLV), Preferred stocks (PFF), Reits (VNQ), Energy (XLE), Staples (XLP), Utilities (XLU), and hedged 1/6 of the risk using SPY:

When an ETF appears in both the Trend and Timing programs, it means that market is very strong but is in a short-term retracement.

A Standing Note on Short Sales

Note that the “All Signals” reports show short sales in stocks and ETFs, even though short positions are not executed in the portfolios. Our review of using inverse ETFs to hedge stocks during a decline showed that downturns in the stock market are most often short-lived and it is difficult to capture those moves with trend systems. This confirms our approach to the Timing systems, which hedges up to 50% of the long stock risk using multiple trends. In the long run, returns from the hedges are net losses; however, during 2008 the gains were welcomed and reduced losses. In any correction we prefer paying for risk insurance, even without the expectation of a net gain.

Portfolio Methodology in Brief

All of the programs, stocks, ETFs, and futures, use the same basic portfolio technology. They all exploit the persistence of performance, that is, they seek those markets with good long-term and short-term returns, rank them, then choose the best, subject to liquidity, an existing current signal, with limitations on how many can be chosen from each sector. If there are not enough stocks or futures markets that satisfy all the conditions, then the portfolio holds fewer assets. In general, these portfolios are high beta, showing higher returns and higher risk, but have had a history of consistently out-performing the broad market index in all traditional measures.

 PERFORMANCE BY GROUP

NOTE that the charts show below represent performance “tracking,” that is, the oldest results are simulated but the newer returns are the systematic daily performance added day by day. Any changes to the strategies do not affect the past performance, unless noted.

Groups DE1 and WE1: Daily and Weekly Trend Program for Stocks and ETFs

The Trend program seeks long-term directional changes in markets and the portfolios choose stocks and ETFs that have realized profitable performance over many years combined with good short-term returns.

The Equity Trend portfolios jumped 5% in March, not far behind the major index markets. They are now up about 2% for the year, ahead of the index markets. The chart below on the left shows that the smaller 10-stock portfolio is positioned to make new highs, always a welcome event.

The two standard ETF portfolios did not fare as well, posting fractional losses but remaining in line with major index returns for the year. The Sector ETFs, which buy the 6 strongest sectors, gained nearly 3% and are profitable for the year.

Trend equities

 

Weekly Equities had been doing better than the daily program and both 10- and 30-stock portfolio are still doing well, but is now more in line with the Daily Equity Trend. In the left chart below, we see a similar pattern for both portfolios. The ETF program is still in a sideways pattern, even though both portfolios were profitable in March. We’re overdue for a rally.

Weekly Equities

 Sector Rotation

The Sector Rotation Program has switched back and forth from the strongest sectors to interest rates as the overall equity market trends flopped around in March. It did gain about 1.4% in March. During the last week of March, the program was long bonds and we know (although it is not reflected in these returns) that it benefited from Chairman Yellen’s statement about keeping rates low. As of today, the program has switched back to the strongest sectors, including XME which has shown extreme strength in the past few weeks.

 Weekly Sector Rotation

  

Group DE2: Divergence Program for Stocks and ETFs

The Divergence program looks for patterns where price and momentum diverge, then takes a position in anticipation of the pattern resolving itself in a predictable direction, often the way prices had moved before the period of uncertainty.

NOTE: WE HAVE CORRECTED A DATA ERROR IN THE ROLL FOR EUROBUNDS AND EUROBOBL, AS WELLL AS THE AUSTRALIAN INTEREST RATES. THE RESULT IS A BETTER HISTORIC PERFORMANCE, AND WE HOPE BETTER FUTURE PERFORMANCE, SHOWN IN THE LEFT CHART BELOW.

The Divergence programs for stocks gained from 4% to 5% in March and is keeping its long-term pattern intact. Even though its expected returns are far lower than the Trend Program, it has proved to be a steady performer. Even more reliable is the ETF program, which has expectations of only 5¼% but has suffered very little in the way of drawdowns. It returned move than 3% in March, a big number for that program.

Divergence Equities

 

Group DE3: Timing Program for Stocks and ETF Rotation

The Timing program is a relative-value arbitrage, taking advantage of undervalued stocks relative to its index. Its primary advantage is that it doesn’t depend on market direction for profits, although these portfolios are long-only because they are most often used in retirement accounts. When the broad market index turns down this program hedges part of the portfolio risk. The ETF Rotation program buys undervalued sectors, expecting them to outperform the other sectors over the short-term.

The Timing Program buys undervalued stocks so that it will buy the weakest even in a declining market until that stock shows that it is not expected to rally. Risk is protected with an absolute stop of 15% and also by hedging the broad index.

The Timing Program was another pleasant surprise. The smaller 15-stock portfolio, which has been steadier than the larger one, gained over 4% in March and now shows signs of life. The 30-stock program, which gained about 2.7%, still has to recover from its drawdown. The Sector ETF program also had a rare positive month; a few more and we will raise our expectations of a recovery.

Timing Equities

 

FUTURES PROGRAMS

Groups DF1 and WF1: Daily and Weekly Trend Programs for Futures

Futures allow both high leverage and true diversification. The larger portfolios, such as $1million, are diversified into both commodities and world index and interest rate markets, in addition to foreign exchange. Its performance is not expected to track the U.S. stock market and is a hedge in every sense because it is uncorrelated. As the portfolio becomes more diversified its returns are more stable.

The leverage available in futures markets allows us to manage the risk in the portfolio, something not possible to the same degree with stocks. This portfolio targets 14% volatility. Investors interested in lower leverage can simply scale all positions equally in proportion to their volatility preference. Note that these portfolios do not trade Asian futures, which we believe are more difficult for U.S. investors to execute.

Using the same strategy and portfolio logic, the Weekly Trend Program for Futures has the added smoothing resulting from looking only at Friday prices. While it will show a larger loss when the trend actually turns, most price moves are varying degrees of noise which this method can overlook.

Please read the new report describing our revised portfolio allocation methodology. It can be found in the drop-down menu under “Articles.”

PLEASE NOTE: LAST MONTH THE COLORS ON THE WEEKLY NAVS CHANGED DUE TO TRANSFERRING THEM FROM ONE SPREADSHEET TO ANOTHER. IT SHOWED THAT THE BEST WEEKLY PERFORMANCE WAS THE 1M PORTFOLIO, WHEN IT WAS ACTUALLY THE 250K PORTFOLIO, AS SHOWN BELOW.

Trend Futures lost in March, in-line with the CTA industry. Both the daily and weekly program look as though they are consolidating after the extreme gains two years ago. These changes take time. While profits made from extreme bull markets may then turn and produce profits in a sharp decline, a falling market, such as crude oil, is much less likely to rebound from its lows without time to consolidate.

There are signs that new trends are forming. The dollar has been steadily weakening, despite the expectation of higher rates, energy has been creeping up and is 25% above its lows, and gold is looking better, with XME (Metals & Mining) now one of the strongest of the ETFs. We just never know when a new major trend will happen, but we do know that that it occurs when least expected.

Weekly Futures

 

Group DF2: Daily Divergence Portfolio for Futures

The Divergence Program posted mixed results in March, with only the $250K portfolio showing a gain and all three portfolios slightly down for the year. In the chart below, the March returns look part of the continuing upward pattern.

Divergence Fuitures

 

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