Final Report Summary - FUTURES (The Efficiency of Futures Markets)
The project focuses on the analysis of alternative investments active in futures markets. In particular, we investigate the effects of the expanding speculative trading for the price formation and the efficiency of financial markets. It is precisely the lack of knowledge of this impact that might have amplified the scale of the current global financial crisis.
Alternative investments refer to investments other than ‘classical’ investments in bonds or long stocks. They are mainly divided into directional (e.g. managed futures) and non-directional strategies (mostly hedge funds) and have experienced a solid growth during the last decade. Financial development has led to a rapid expansion of futures markets, its global volume tripled between 1998 and 2008 from $1.3 billion to $4.2 billion (Source: Futures Industry Association). RPM is specialized in the investment in managed futures, performed by specialized and professional managers, so called commodity trading advisors (hereafter: CTAs). These invest not exclusively in commodities, but nowadays to the major extent in pure financial assets.
Traditionally, commodity markets were dominated by mostly commercial traders with commodity risk management needs (hedgers) and a small group of (market making) specialized commodity traders. But along with the generalization of electronic trading, broadening of market access and the decrease in transaction costs, future markets have mutated into a new investment option for a much wider public including pension funds, index tracking commodity funds, and a much larger group of financial commodity speculators.
The expansion of market access is often referred to as financialization of futures and commodity trading. The project has analyzed the role of futures traders and their contribution to (in-)efficiency. The research aimed at answering the question what role this new market architecture plays for the futures market itself as well as for the underlying spot market. Do futures prices become more informative about future resource scarcity and therefore contribute to better production and allocation decisions for the underlying commodity? Or is market entry of a broader class of financial investors (including pension funds and index tracking funds) a step towards more non-fundamental commodity price volatility as sometimes alleged? What role do the more sophisticated investors like hedge funds and CTAs play in the price process?
Knowledge of these issues is sadly lacking, not just in Europe but globally. Our proposed project gives Europe a competitive edge in the understanding the role of alternative investments. The financial crisis has shown us the consequences of ignorance in this area. This research has trained a cohort of experts in this field and disseminated its critically important results for the future of Europe, and particularly the euro.
Results of the Project
The results of the project help to better understand the role of CTAs. A first block of results deals with potential benefits of CTAs for investors: In fact CTAs are highly beneficial for investors: We find that they are useful instruments for diversification, in the sense that they do provide some market timing abilities, i.e. they know when to enter or leave the market. While this result has been partially confirmed in the previous literature, we have found much stronger evidence due to methodological improvements to these tests. Furthermore, CTAs cannot even time trend, but also provide what is called a ‘crisis alpha’, i.e. they outperform – like an insurance – classical investments particularly during those periods when markets are in stress, thus when it is most needed from the perspective of an investor. We further find the reason for their outperformance: They do NOT predict or forecast crises, but achieve their crisis alpha by diversification over several markets and by quick adjustment to crises. We therefore suggest that CTAs (and in more general alternative investments) should be part of portfolios that require more stable returns than a classical bond/equity investment, i.e. pension and retirement plans.
A second result, which is more important for the fund industry itself is that the so-called cristallization frequency, at which the high-water mark determining the performance fee of CTAs is updated, strongly affects the fee effectively paid by the investor. The result is therefore of major importance for investors negotiating with CTAs.
A third block of results covers the role of CTAs for financial markets and its interdependence with monetary policy and regulation. It seems that over the recent period of ultra-loose US monetary policy, traders had the tendency to engage in USD carry trading against emerging-market currencies but not against developed-market currencies, where they are found to follow a completely different trading style. One of the most important implications of currency carry trades is their effect on the stability of the foreign exchange market, especially in times of unwinding carry positions. So, tracking carry trades is important because it can provide us with a better understanding of the foreign exchange market volatility dynamics. Moreover, tracking carry trades is relevant to potential target countries that usually tend to take actions against the undesirable influences of such speculative activities. These actions may include capital flow restrictions, taxation of foreign investments and limitations on foreign holdings. Besides that we analyzed the impact of a potential EU financial transaction tax on CTAs. While our results do not suggest a deterioration of CTAs profitability, the trading volume is expected to decline, which may lead to a drying out market during certain periods and may result in difficulties by hedgers to find counterparts for their needs.
The work on this project will go on after the official end of the project. Details and published work can be found on the project website (www.futuresproject.eu) or requested from:
Prof. Michael Frömmel, Ghent University Belgium, Michael.froemmel@UGent.be
Dr. Alexander Mende, RPM Risk & Portfolio Management AB, Stockholm, alexander.mende@rpm.se
Alternative investments refer to investments other than ‘classical’ investments in bonds or long stocks. They are mainly divided into directional (e.g. managed futures) and non-directional strategies (mostly hedge funds) and have experienced a solid growth during the last decade. Financial development has led to a rapid expansion of futures markets, its global volume tripled between 1998 and 2008 from $1.3 billion to $4.2 billion (Source: Futures Industry Association). RPM is specialized in the investment in managed futures, performed by specialized and professional managers, so called commodity trading advisors (hereafter: CTAs). These invest not exclusively in commodities, but nowadays to the major extent in pure financial assets.
Traditionally, commodity markets were dominated by mostly commercial traders with commodity risk management needs (hedgers) and a small group of (market making) specialized commodity traders. But along with the generalization of electronic trading, broadening of market access and the decrease in transaction costs, future markets have mutated into a new investment option for a much wider public including pension funds, index tracking commodity funds, and a much larger group of financial commodity speculators.
The expansion of market access is often referred to as financialization of futures and commodity trading. The project has analyzed the role of futures traders and their contribution to (in-)efficiency. The research aimed at answering the question what role this new market architecture plays for the futures market itself as well as for the underlying spot market. Do futures prices become more informative about future resource scarcity and therefore contribute to better production and allocation decisions for the underlying commodity? Or is market entry of a broader class of financial investors (including pension funds and index tracking funds) a step towards more non-fundamental commodity price volatility as sometimes alleged? What role do the more sophisticated investors like hedge funds and CTAs play in the price process?
Knowledge of these issues is sadly lacking, not just in Europe but globally. Our proposed project gives Europe a competitive edge in the understanding the role of alternative investments. The financial crisis has shown us the consequences of ignorance in this area. This research has trained a cohort of experts in this field and disseminated its critically important results for the future of Europe, and particularly the euro.
Results of the Project
The results of the project help to better understand the role of CTAs. A first block of results deals with potential benefits of CTAs for investors: In fact CTAs are highly beneficial for investors: We find that they are useful instruments for diversification, in the sense that they do provide some market timing abilities, i.e. they know when to enter or leave the market. While this result has been partially confirmed in the previous literature, we have found much stronger evidence due to methodological improvements to these tests. Furthermore, CTAs cannot even time trend, but also provide what is called a ‘crisis alpha’, i.e. they outperform – like an insurance – classical investments particularly during those periods when markets are in stress, thus when it is most needed from the perspective of an investor. We further find the reason for their outperformance: They do NOT predict or forecast crises, but achieve their crisis alpha by diversification over several markets and by quick adjustment to crises. We therefore suggest that CTAs (and in more general alternative investments) should be part of portfolios that require more stable returns than a classical bond/equity investment, i.e. pension and retirement plans.
A second result, which is more important for the fund industry itself is that the so-called cristallization frequency, at which the high-water mark determining the performance fee of CTAs is updated, strongly affects the fee effectively paid by the investor. The result is therefore of major importance for investors negotiating with CTAs.
A third block of results covers the role of CTAs for financial markets and its interdependence with monetary policy and regulation. It seems that over the recent period of ultra-loose US monetary policy, traders had the tendency to engage in USD carry trading against emerging-market currencies but not against developed-market currencies, where they are found to follow a completely different trading style. One of the most important implications of currency carry trades is their effect on the stability of the foreign exchange market, especially in times of unwinding carry positions. So, tracking carry trades is important because it can provide us with a better understanding of the foreign exchange market volatility dynamics. Moreover, tracking carry trades is relevant to potential target countries that usually tend to take actions against the undesirable influences of such speculative activities. These actions may include capital flow restrictions, taxation of foreign investments and limitations on foreign holdings. Besides that we analyzed the impact of a potential EU financial transaction tax on CTAs. While our results do not suggest a deterioration of CTAs profitability, the trading volume is expected to decline, which may lead to a drying out market during certain periods and may result in difficulties by hedgers to find counterparts for their needs.
The work on this project will go on after the official end of the project. Details and published work can be found on the project website (www.futuresproject.eu) or requested from:
Prof. Michael Frömmel, Ghent University Belgium, Michael.froemmel@UGent.be
Dr. Alexander Mende, RPM Risk & Portfolio Management AB, Stockholm, alexander.mende@rpm.se