Peering Over the Fiscal Cliff

by Tyler Resch, Portfolio Manager, IASG
Posted October 18th, 2012

As we go into the final few months of the year we are more and more concerned with how we position ourselves going into 2013. A term I am hearing more often from concerned investors is the looming "fiscal cliff." This "fiscal cliff" they are referring to is the predicted reduction in the budget deficit equating tax increases and spending cuts on Jan 1st 2013. The projected outcome of these changes next year are anywhere from a slowdown in the economy to a full double dip recession. As I am sure you all remember the automatic spending cuts were put in place after the current administration and Congress were unable to reach a deal last year. Nearly all proposals to avoid this pending solution involve to some degree extending the 2010 Tax Relief Act or changing the 2011 Budget Control Act or both. There are of course adverse affects to that approach as well. I could easily write an extended essay on these approaches but in the end we are left with the same issue, uncertainty in the markets. There are ways to strategize this burden regardless of the outcome.

In some ways we are privileged to have experienced considerably uncertain and volatile markets in our not so distant past. By privileged I mean that we are able to grade some of our now favorite managers by how they navigated such historical markets. This ability to maneuver becomes paramount in markets where direction is so closely correlated to the fundamental implications of the very near term actions our country is going to be forced to take.

I'll break this down quickly by the few broad strategy titles most CTAs can loosely be grouped under. The first and largest of these categories would be Trend Followers. When I look for an ideal all weather trend follower who tends to deviate from the norm I look at a few years in particular. In other words looking at 2008 where Managed Futures were dominated by the high returns of the "wave riders" is of little help in your search for diversity. I instead like to spend my time looking for those who profited in the years where Trend Following was particularly difficult. In an effort to keep this as relevant as possible I am really only looking over the past five years as my litmus test. The two years where Trend Following CTAs as a class had some difficulty were 2009 and 2011. IASG's Trend Following CTA index was negative both years, -3.72% and -5.02% respectively. A positive performing Trend Follower in those years is an initial indicator that they are doing something different in their strategy and should be examined closer. There are a handful of CTAs in this class that were not only positive both years but also outperformed the group in 2008 and 2010 when times were particularly conducive. Going into 2013 I am trying to encourage clients to learn about these particular managers and consider them as a possible hedge for what could lie ahead.

I am going to stay broad here and group all options traders as simply that, options traders. Regardless of the way they approach derivatives there are a few telling months as to how they manage their risk. With options managers we are focused on individual months rather than collective years. The months I look at are the stock market crash of September and October 2008, the flash crash of May 2010, and the record volatility in August 2011. Each of those months demonstrated conditions that were extremely difficult for an options trader to manage their risk and still find profit. Those moves happened quickly and they happened violently. Those are typically both death sentences for someone holding options. A manager who was able to weather those storms with only a contained draw down or was able to even make profit in those months is a quick determinate for me that they are doing something different and that they have a good handle on their risk in uncertain markets. As with the trend followers, these outliers do exist and I would be happy to discuss them with you.

There are other strategies that can act as havens during these times. Some people tend to prefer shorter term managers because they may be less exposed to after hours risk. Others may look for a mean reversion CTA because they tend to enter the market after these larger moves have already taken place. Others try to park more of their cash in those trading only physical commodities because they seem to have a price floor built in. There are a number of ways to approach this but I think a few parameters to help give your search more direction can prove extremely beneficial to the final product.

A seasoned trader once told me "the market always does what you expect it to, just never when." My portfolios are very much designed with this thought process at the helm. Risk management is my unyielding top priority. I would be happy to discuss the managers referenced above as well as some of these concerns in much greater detail with you as well as how I feel you can best position yourself. For questions regarding this article, a specific CTA or Managed Futures in general, please feel free to contact me by phone (312) 561-3146 or email at tresch@iasg.com.