itizations).7See ASIC v. Enterprise Solutions 2000 Pty Ltd (2000), 33 ACSR 620 (where thecourt deemed pooling to have occurred, in relation to individual wagering accountswhose credit balances were held in a common bank account).
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investment returns for the investor and fees for the manager) from the IMA.This interpretation not only renders otiose the requirement for pooling ofinvestor contributions but also means that every financing relationship (i.e.,shareholder-issuer, bondholder-issuer, lender-borrower, depositor-depositholder, as in all these cases both parties expect to derive some profit from therelationship) is potentially a common enterprise and thus a managed investment scheme. (The impact of this categorization is lessened by the exemptionsfor corporations, debentures, and lender-lender/borrower transactions discussed in the context of managed futures funds.)
Registration of Fiduciary Futures ProductsAccording to the Corporations Act 2001 (Cth), sections 601ED(1) and (2),managed futures funds and IMAs, as managed investment schemes, must beregistered with ASIC under Chapter 5C unless the fund or IMA falls withinone of the two categories:1. A wholesale fund or account. A managed futures fund is a wholesalefund and an IMA is a wholesale account where the offer of interests inthe fund or the offer of accounts does not require a product disclosurestatement to be given to investors. Product disclosure statements areonly required in respect of offers to retail clients;8 or2. A private fund or account. A managed futures fund is a private fundand an IMA is a private account where there are fewer than 20 investors in the fund or in a single IMA promoted by the operator (IMAswill invariably have fewer than 20 investors in a single account), andthe fund or account was not promoted to the investors by a professional promoter.The application of Chapter 5C to hedge funds and mutual funds is discussed further by Ali, Stapledon, and Gold (2003) and Baxt, Black, andHanrahan (2003) respectively.8An investor is a “retail client” unless: (a) the minimum subscription price for interests in the managed futures fund or the minimum amount required to open an IMAis A$500,000; (b) the investor has net assets of at least A$2.5 million or has a grossincome of at least A$250,000 for each of the two financial years preceding theinvestment; or (c) is a professional investor (e.g., holders of an Australian financialservices license, pension funds with net assets of at least A$10 million, banks, lifeinsurance companies, general insurance companies): Corporations Act 2001 (Cth),sections 761G(1), (7)(a) and (7)(c); Corporations Regulations 2001 (Cth), regulations 7.1.18(2), 7.1.19(2), and 7.1.28.
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According to section 601ED(5) of the act, failure to register a registrable managed futures fund or IMA will render the fund manager or operator of the account subject to criminal liability (punishable by a fine orimprisonment). In addition, the investors in the fund or account will beentitled to demand the return of the amounts invested by them, or apply tohave the fund or account wound up (sections 601EE(1) and 601MB(1)).The act provides a powerful economic incentive to register unregistrable managed futures funds and IMAs (Ali, Stapledon, and Gold, 2003):According to section 601FC(4), a registered managed investment schemecannot invest in an unregistered scheme. Registration therefore expands theclass of potential investors for unregistrable funds and accounts.Registration imposes seven additional compliance obligations on themanager of the managed futures fund and the operator of the IMA:1. The fund manager or operator (the responsible entity) must be a public company (section 601FA).2. The responsible entity must hold an Australian financial services licensefrom ASIC authorizing it to operate the fund or account (sections601FA and 601FB(1)). The manager of an investment fund will typically be the responsible entity. Alternatively, where the fund has beenstructured as a trust and there is a segregation of the title-repositoryand investment roles, the trustee of the fund may be the responsibleentity with the trustee delegating the selection of investments for thefund to the fund manager (Ali, Stapledon, and Gold 2003).3. The responsible entity is subject to paramount statutory duties in favorof the investors in the fund or account (including duties of care, honesty, and loyalty) (Section 601FC(1) and (3)).4. The responsible entity is deemed to hold the assets in the fund oraccount on trust for the investors in the fund or account (section601FC(2)). The operation of this statutory obligation in the case ofmanaged futures funds (and other investment funds) that have not beenstructured as trusts remains uncertain. Would this provision, in the caseof a fund that has been structured as a limited partnership, for instance,render the general partner (the fund manager) the trustee of the partnership property for the limited partners (the investors)?5. The legal instrument (e.g., the trust deed) governing the operation ofthe fund or account must contain certain stipulated covenants (sections601GA and 601GB, see also ASIC 1998b).6. The fund or account must have an independently audited complianceplan (Corporations Act 2001 (Cth), section 601HA(1); CorporationsRegulations 2001 (Cth), reg. 5C.4.02; see also ASIC 1998a).
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7. If fewer than half of the directors of the responsible entity are externaldirectors, a separate compliance committee with a majority of external members must be established for the fund or account. (Corporations Act 2001 (Cth), sections 601JA(1) and 601JB(1); CorporationsRegulations 2001 (Cth), reg. 5C.5.01).
Fiduciary Futures Products and Financial ProductsThe characterization of a fiduciary futures product as a “financial product” under Chapter 7 of the Corporations Act carries with it two important regulatory consequences. First, the manager of the managed futuresfund or the operator of the IMA will be taken to be conducting a financialservices business in Australia, for which it requires an Australian financial services license from ASIC (sections 911A(1) and 911D).The responsible entity of a registered managed investment scheme alsois required to hold this license by Chapter 5C of the act. A responsibleentity of a registered managed investment scheme is taken to be carryingon a financial services business in Australia (sections 761A, 761C, and766A(1)(d)). The operation of an unregistrable managed investment schemealso will constitute the carrying on of a financial services business in Australia where interests in the scheme are financial products. The issuer ofinterests in the scheme to investors and the party who is responsible for theobligations owed to the investors under the scheme (the fund manager ortrustee of a managed futures fund or the operator of an IMA) will be takento be “dealing” in a financial product and thus carrying on a financial services business (sections 761A, 761C, 761E(1)(b) and (4), and 766A(1)(b)).Second, the offer of a financial product to “retail clients” requires thoseinvestors to be provided with a product disclosure statement at the point ofsale, setting out such information as retail clients would reasonably requireto make a decision on whether to acquire the financial product (sections1011B, 1012B(3) and (4), 1013A(1), 1013C, and 1013D; see also ASIC2001). A product disclosure statement is not required for wholesale managed futures funds and wholesale IMAs, as the investors in such productsare not retail clients.9 Nor is a product disclosure statement required forsmall-scale offers to retail clients.10
9See note 8.10According to Corporations Act 2001 (Cth), section 1012E, a small-scale offer is
one that does not result in more than 20 investors acquiring the financial productor more than A$2 million being raised from investors in a 12-month period.
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Failure to comply with the above licensing and disclosure requirementswill lead to imposition of criminal liability (punishable by a fine or imprisonment) (section 1311).11 In addition, if a product disclosure statement isnot provided or a defective product disclosure statement is provided, theinvestors in the fiduciary futures product will be entitled to recover any lossincurred by them that is attributable to the noncompliance with the act’sdisclosure requirements (section 1022B).Interests in retail managed futures funds and IMAs are financial products (sections 762A(2) and 764A(1)(b)), as are interests in wholesale managed futures funds and IMAs (sections 762A(2) and 764A(1)(ba)).Interests in private managed futures funds and IMAs, in contrast, arenot financial products, and such funds and accounts therefore fall outsidethe scope of Chapter 7 (sections 762A(3) and 765(1)(s)).12 If an IMA is nota managed investment scheme and thus falls outside the scope of Chapter5C, it nonetheless may be regulated as a financial product since the “investment” head of the general definition of “financial product” does not requirethe pooling of investors’ contributions or a common enterprise, in contrast to the definition of “managed investment scheme” (sections 762A(1),763A(1)(a) and 763B).
Individually Managed Futures Accounts—Futures Exchange RequirementsThe Sydney Futures Exchange (SFE) imposes four additional disclosure andtrading requirements on certain IMAs (the term used in the SFE By-laws is“managed discretionary accounts”) promoted by SFE members and thatinvest in SFE-traded futures contracts (By-laws G. 52 and 53; see also SFE2003).1. The operator must ensure that the IMA is suitable for the investor, having regard to the investor’s other investments and the investor’s personal and financial situation.
11The act provides for multiple criminal offenses for failing to provide a product dis-
closure statement or providing a defective product disclosure statement: sections1021C-1021O. In addition, criminal liability may be incurred for making false ormisleading statements in the product disclosure statement to induce persons to subscribe for or buy the financial product: section 1041E(3).12This exception applies only if the IMA can be properly characterized as a managed investment scheme.
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2. A disclosure document containing prescribed particulars must be provided to the investor before the operator can open an IMA for theinvestor or make trades for the IMA.3. The operator must not engage in “churning”—that is, it must ensurethat the trades in futures contracts booked for the IMA are not excessive in size or frequency.4. The operator must not engage in leveraged trading for the IMA; that is,it cannot finance or arrange finance for the positions booked for theIMA.It is, however, difficult to see what scope there is for the application ofthese requirements given the view taken by ASIC of IMAs. According to Bylaw G.1.1., paragraph (ii)(c), Sydney Futures Exchange Corporation(2003b) the SFE managed discretionary accounts By-laws do not apply toan IMA that is a managed investment scheme. (The SFE also, in By-lawG.1.1., paragraphs (ii)(b) and (iii), expressly exempts IMAs that are registered managed investment schemes or unregistrable, wholesale managedinvestment schemes. These two exemptions would seem to be superfluous,given the unqualified exemption for managed investment schemes.) IfASIC’s view is correct that an IMA is a managed investment scheme underthe Corporations Act due to there being a common enterprise between theinvestor and the account operator, this means that the SFE MDA rules areredundant, a view that the SFE and its members do not appear to share.
Regulatory Reform—Individually ManagedFutures AccountsThe Australian Securities and Investments Commission recently hasreleased for public comment proposals to simplify the regulation of retailIMAs. In short, these proposals involve placing retail IMAs outside thescope of Chapter 5C of the Corporations Act and regulating them solelyunder Chapter 7.13 The operators of retail IMAs must still hold an Australian financial services license authorizing them to deal in the IMAs, butthe IMAs will no longer be required to be registered as managed investmentschemes with ASIC (ASIC 2003b pp. 15, 18, 19). The operator of a retail
13These proposals mirror the changes to the regulatory status of Separately Man-
aged Accounts (SMAs) and wrap accounts implemented by ASIC in 2000: see ASIC2003b, pp. 33 and 50.
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IMA also will be exempted from the requirement to provide a product disclosure statement to the investors but instead, will be subject to the lessonerous disclosure requirements in relation to the provision of advice toinvestors about the IMA and the underlying investments of the IMA (ASIC2003b, pp. 15 and 21–22).Despite deeming retail IMAs not to be managed investment schemes,the operator of a retail IMA will, under ASIC’s proposals, continue to besubject to the statutory duties of care, honesty, and loyalty that apply to theresponsible entities of registered managed investment schemes (ASIC2003b, p. 17). In addition, a retail IMA will, in common with registered managed investment schemes, generally be prohibited from investing in managedfutures funds and wholesale IMAs that have not been registered under Part5C (ASIC 2003b, p. 32).The overriding rationale for these reforms seems to be the desire on thepart of the regulator to lower the transaction costs associated with establishing retail IMAs (ASIC 2003b, p. 37). This commercial imperative aside,it is difficult to provide a coherent justification for the reforms. The reformsdraw an artificial distinction between managed investment schemes (wherethe fund manager has the discretion to select investments for the scheme) andretail IMAs, which are deemed not to be managed investment schemes (eventhough it is the operator that has the discretion to select investments for theaccounts). Also, the reforms create an incongruous situation where wholesale IMAs (they are managed investment schemes, albeit unregistrable ones)are subject to more onerous regulatory requirements than retail IMAs.
CONCLUSIONThe regulation of managed futures funds and individually managed futuresaccounts in Australia is characterized by a “bottom-up” approach. Theseinvestment products are subject to the same regulatory regime—a combination of the managed investment and financial product chapters of theAustralian Corporations Act—as all other fiduciary investment products inAustralia, such as hedge funds and mutual funds.This uniform regulation of fiduciary investment products is not, however, without shortcomings. The status of individually managed accounts ina regime designed for pooled investment products, such as managed futuresfunds, hedge funds, and mutual funds, is not free from doubt. It is alsounclear what the regulatory status of a managed fund is, where the fund hasbeen structured as a trust and the investors in the fund have acquired theirexposure to the fund’s investment portfolio via commercial paper, notes, orother capital market debt securities issued by the trustee. This is less of an
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issue for managed futures funds, hedge funds, and mutual funds, where theinterests in the fund held by investors are predominantly equity instrumentssuch as units or shares. It is, however, a major issue for Australian securitization programs, including collateralized synthetic obligations, an innovative investment product very similar to a managed futures fund. It is also amajor issue for collateralized private equity obligations and collateralizedfund of hedge fund obligations, which are securitizations of equity interestsin private equity funds and hedge funds respectively (Ali, Stapledon, andGold 2003).Finally, the current proposals to streamline the regulation of retail individually managed accounts (including retail individually managed futuresaccounts) in Australia will, if implemented, result in the unusual spectacleof a retail investment product being subjected to less onerous regulationthan its wholesale counterparts.
PART
Four
Program Evaluation,Selection, and ReturnsChapter 15 discusses the issues involved in setting up a commodity futurestrading program from start to finish. The chapter covers these areas that anew entrant into the futures markets must consider: trade discovery, tradeconstruction, portfolio construction, risk management, leverage-level determination, and how the trading program will make a unique contribution toan investor’s overall portfolio.Chapter 16 analyzes the ex-post performance of CTA managed fundswith a higher moment-based, contingent-claim replication method. The performance of each managed futures fund is compared to individually createdbenchmark assets having the same risk profile in terms of particular highermoments. Benchmark assets are constructed using the S&P 500, options, andthe risk-free asset. Using these benchmark assets, the author estimates the efficiency gain or loss each CTA produces and analyzes the robustness of thiskind of efficiency measurement with respect to the number of moments used.Chapter 17 aims at providing an overview of the industry and to quantify its added value when included in portfolios (mean/variance optimization). Different statistics and asset allocations studies are displayed withina fixed or dynamic framework. A dynamic framework takes into accounttime evolutions. On the asset allocation side, it then implies working in athree-dimensional environment (mean/variance/time framework) and dealing with efficient surfaces rather than efficient frontiers.Chapter 18 examines whether CTA percent changes in NAVs follow random walks. Monthly data from January 1994 to December 2000 are tested
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for nonstationarity and random walk with drift, using the Augmented DickeyFuller test. All classifications (except the diversified subindex) are found tobehave as random walks, but many of the series show evidence of a positivedrift parameter, an indication that trends could be present in the series. Theeffectiveness of CTAs in enhancing risk-return characteristics of portfolioscould be compromised when pure random walk behavior is identified.Chapter 19 examines the risk and performance characteristics of different strategies involving the trading of commodity futures, financialfutures, and options on futures used by CTAs. The authors rank the returnsof the S&P 500 and MSCI Global Indices from the worst to the bestmonths, and partition the sample into 10 deciles. For each decile, they compute the relationship between the CTA indices and the equity indices, andcompared their risk and return characteristics.Chapter 20 analyzes the risk and return benefits of CTAs, as an alternative investment class. Then it shows, using a modified Value at Risk as amore precise measure of risk, how CTAs can be integrated into existinginvestment strategies and how we can determine the optimal proportion ofassets to invest in such products. Overall, the results of the study show thatan efficiently allocated portfolio consisting of CTA and traditional assetsshould provide a better reward/risk ratio than an investment in traditionalassets only.Chapter 21 uses time series processes to model the return series of the10 largest CTAs from 1996 to 2003. Series are tested for stationarity, andan appropriate ARMA model is applied to each CTA. The authors conducta similar analysis on the excess returns—relative to the CISDM CTA Index.Last, stability tests are performed—through a Chow test—to investigatepossible structural changes in the parameters of the ARMA models.Chapter 22 investigates the risk-adjusted returns of CTAs using themodified Sharpe ratio. Because of the nonnormal returns of this asset class,the traditional Sharpe ratio may not be appropriate. The CTAs are dividedinto three categories in terms of ending millions under management.Chapter 23 examines one of the most important features of managedfutures, their trend-following nature. This topic has been extensivelyexploited to justify the inclusion of managed futures in traditional portfolios, where they act as risk diversifiers during bear markets. However, managed futures still may be risky over short-term horizons. How long does onehave to invest so that it is virtually certain a managed futures portfolio willdo better than cash or bonds? To answer this question, the authors examined monthly holding periods of the CSFB Tremont Managed FuturesIndex. Their conclusion is that although managed futures are relatively safein the long run from a capital preservation perspective, their shortfall riskremains and should not be neglected.
CHAPTER
15
How to Design a CommodityFutures Trading ProgramHilary Till and Joseph Eagleeye
e provide a step-by-step primer on how to design a commodity futurestrading program. A prospective commodity manager not only mustdiscover trading strategies that are expected to be generally profitable, butalso must be careful regarding each strategy’s correlation properties duringdifferent times of the year and during eventful periods. He or she also mustensure that the resulting product has a unique enough return stream that itcan be expected to provide diversification benefits to an investor’s overallportfolio.
W
INTRODUCTIONWhen designing a commodity futures trading program, a commodity manager needs to create an investment process that addresses these issues:Trade discoveryTrade construction■ Portfolio construction■ Risk management■ Leverage level■ How the program will make a unique contribution to the investor’soverall portfolio■■
This chapter covers each of these subjects in succession.
TRADE DISCOVERYThe first step is to discover a number of trades in which it is plausible thatthe investor has an “edge,” or advantage. Although a number of futures
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trading strategies are well known and publicized, commodity managerscontinue to apply them. Three examples of such strategies follow.
Grain ExampleIn discussing consistently profitable grain futures trades, Cootner (1967)stated that the fact that they “persist in the face of such knowledge indicates that the risks involved in taking advantage of them outweigh the gaininvolved. This is further evidence that . . . [commercial participants do] notact on the basis of expected values; that . . . [these participants are] willingto pay premiums to avoid risk” (page 98). Cootner’s article discusseddetectable periods of concentrated hedging pressure by agricultural marketparticipants that lead to “the existence of . . . predictable trends in futureprices.” It provided several empirical examples of this occurrence, including “the effect of occasional long hedging in the July wheat contract.”Noting the tendency of the prices of futures contracts to “fall on averageafter the peak of net long hedging,” Cootner stated that the July wheatcontract should “decline relative to contract months later in the crop yearwhich are less likely to be marked by long hedging.” Table 15.1 summarizes Cootner’s empirical study on a wheat futures spread. The spread onaverage declined by about 2.5 cents over the period. The significant issuefor us is that this phenomenon, which is linked to hedging activity, waspublished in 1967. Does this price pressure effect still exist today? Theshort answer appears to be yes.From 1979 to 2003, on average, this spread declined by 3.8 cents witha Z-statistic of −3.01. Figure 15.1 illustrates the yearly performance of thisspread.TABLE 15.1
Cootner’s Empirical Study on the July versus DecemberWheat Futures Spread1948 to 1966 Average of July Versus DecemberWheat Futures Price on the Indicated DatesJanuary 31February 28March 31April 30May 31June 30
−5.10 cents−5.35 cents−5.62 cents−5.69 cents−6.55 cents−7.55 cents
Source: Paul Cootner, “Speculation and Hedging.” Food ResearchInstitute Studies, Supplement 7, (1967): 100.
279
July Wheat–December Wheat Price Change from January 31 toJune 30, 1979–2003151050–5–100320
0120
9919
9719
9519
9319
9119
8919
8719
8519
8319
19
19
81
–1579
Price Change in Centsper Bushel
How to Design a Commodity Futures Trading Program
Year
FIGURE 15.1 Cootner’s Example Out of SampleSource: Premia Capital Management, LLC.
Frequency
This trade is obviously not riskless. To profit from this trade, a manager generally would short the spread, so it is the positive numbers inFigure 15.1 that would represent losses. Note from the figure the magnitude of potential losses that this trade has incurred over the past 25 years.That said, Cootner’s original point that a profitable trade can persist in theface of knowledge of its existence seems to be borne out 36 years later.Figure 15.2 summarizes the information in Figure 15.1 differently toemphasize the “tail risk” of a July to December wheat spread strategy. If amanager took a short position in this spread, the possible outcomes incorporate losses that are several times the size of the average profit. Again, ina short position, the manager wants the price change to be negative, so thehistorical losses on this trade are represented by the positive numbers in Figure 15.2. A manager might conclude that this trade can continue to exist
14121086420≤ –14.25c
> –14.25c and ≤ –8.5c
> –8.5c and ≤ -2.75c
> –2.75c and ≤ 3c
> 3c and ≤ 8.75c
Price Change Intervals
FIGURE 15.2 Histogram of the Frequency Distribution for the JulyWheat–December Wheat Price Changes, 1979–2003Source: Premia Capital Management, LLC.
> 8.75c
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because of the unpleasant tail risk that must be assumed when putting onthis trade.
Petroleum Complex ExampleAre there any persistent price tendencies that can be linked to structuralaspects of the petroleum market? After examining the activity of commercial participants in the petroleum futures markets, it appears that theirhedging activity is bunched up within certain time frames. These same timeframes also seem to have detectable price trends, reflecting this commercialhedging pressure.Like other commodities, the consumption and production of petroleumproducts are concentrated during certain times of the year, as illustrated inFigure 15.3. This is the underlying reason why commercial hedging pressure also is highly concentrated during certain times of the year.The predictable price trends that result from concentrated hedge pressure may be thought of as a type of premium the commercial market participants are willing to pay. That commercial participants will engage in hedgingduring predictable time frames and thus will pay a premium to do so may becompared to individuals willing to pay higher hotel costs to visit popularlocations during high season. They are paying for this timing convenience.
0.05
0
SalesProduction−0.05Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov Dec
FIGURE 15.3 Petroleum Seasonal Sales and Production PatternsSource: Jeffrey Miron, The Economics of Seasonal Cycles (Cambridge, MA:MIT Press, 1996), p. 118.Note: The seasonal coefficient plotted for each month is the average percentagedifference for that month from a logarithmic time trend.
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Corn ExampleCorn provides another example of a persistent price pressure effect. Thefutures prices of some commodity contracts, including corn, sometimesembed a fear premium due to upcoming, meaningful weather events.According to a Refco (2000) commentary: “The grain markets will alwaysassume the worst when it comes to real or perceived threats to the food supply” (page 1). As a result, coming into the U.S. growing season, grainfutures prices seem to systematically have a premium added into the fairvalue price of the contract. The fact that this premium can be easily washedout if no adverse weather occurs is well known by the trade. Notes aSalomon Smith Barney (2000) commentary: “The bottom line is: any threatof ridging this summer will spur concerns of yield penalties. That meansthe market is likely to keep some ‘weather premium’ built into the price ofkey markets. The higher the markets go near term, the more risk there willbe to the downside if and when good rains fall” (page 1). By the end ofJuly, the weather conditions that are critical for corn yield prospects willhave already occurred. At that point, if weather conditions have not beenadverse, the weather premium in corn futures prices will no longer beneeded. According to the Pool Commodity Trading Service (1999): “In anyweather market there remains the potential for a shift in weather forecaststo immediately shift trends, but it appears as though grains are headed forfurther losses before the end of the week. With 75% of the corn silking, themarket can begin to get comfortable taking some weather premium out”(page 1). Again, this example shows that the commercial trade can be wellaware of a commodity futures price reflecting a biased estimate of futurevaluation, and yet the effect still persisting.
TRADE CONSTRUCTIONExperience in commodity futures trading shows that a trader can have acorrect commodity view, but how he or she constructs the trade to expressthe view can make a large difference in profitability.Outright futures contracts, options, or spreads on futures contracts canbe used to express a commodity view.At times futures spreads are more analytically tractable than tradingoutright. Usually some economic boundary constraint links related commodities, which can (but not always) limit the risk in position taking. Also,a trader hedges out a lot of first-order, exogenous risk by trading spreads.For example, with a heating oil versus crude oil futures spread, each leg ofthe trade is equally affected by unpredictable OPEC shocks. Instead, what
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typically affects the spread is second-order risk factors, such as timingdifferences in inventory changes among the two commodities. It is sometimes easier to make predictions regarding these second-order risk factorsthan the first-order ones.
PORTFOLIO CONSTRU