One of the many exhilarating experiences about our daily blog writing is the ability to receive feedback from our dedicated readers, which in turn prompts more discussions and questions about the managed futures industry. The latest question asked is, “Do CTA’s with AUM’s over $1 Billion have the ability to trade grain markets?” The simple answer is yes, but the long answer; most of them don’t.
First, on an elementary level, you won’t find anything on the CME website detailing a restriction on managers exceeding an arbitrary assets under management, from entering into a position into any market, nevertheless any of the grain markets. That’s not to say the question is entirely off; the root of the question, and in our opinion, the far more intriguing factor is not that they can’t but that they mostly don’t.
1. Sheer Size
The answer as to why a billion dollar manager doesn’t invest in grains are three and one in the same. From a macro level, it’s simply that CTA’s are charged with generating the best possible risk adjusted returns as possible for clients; in other words they go where they can get the most bang for the buck. We love soybeans, Corn, and Wheat just as much as the next futures enthusiast, but with the massive amount of funds flowing into various futures markets, the grains probably wouldn’t make enough impact on their strategy compared to say a stock futures market or interest rate market. But how can that be? Can’t you enter as many trades as you want, as long you have the money to back it up? Not quite.
2. Position Limits
Position limits stop this from happening. The idea is so no one person has too much control over one individual market. Take corn for instance, the CME (formerly CBOT) dictates that no person shall have more than 600 corn positions (or 33,000 futures-equivalent contracts) at any given time. If you’re doing the math at home, yes that in fact does equate to 3 million bushels of Corn (5,000 bushels per contract). This means managers can have 12.54 Million in exposure ($50 per point * 418 = 20,900 * 600 contracts). How can that not be enough? Let’s compare to the S&P 500.. Just a couple months ago, the CME ruled to expand and raise the position limits on both the E-mini and full S&P 500 futures contracts. Say the manager maxes out their position with 140,000 E-Minis * $50 per point *1806 = 12 Billion in exposure. At an average move of 9.63 points per day in the S&P 500 futures prices over the past 50 days, a maxed out position limit trader would stand to make/lose around 67.4 million per day.
3. Volume / Liquidity
Now we return to not controlling too much of one market. These positions reduce the possibility of liquidity size, and therefore reduce managers of that stature from investing in such a market, because it might not be advantageous to hold such a large investment in an illiquid market. It’s not so much that Corn is an illiquid market; it’s that it appears to be less liquid when comparing it to the E-mini-S&P 500. For instance, the Volume of Dec Corn today is 107,000 contracts, compared to the Emini, where we’ll typically see volumes between 2 and 3 million contracts a day.
This is where “slippage” becomes a concern. In trading vernacular slippage is the difference between the traders (or system’s) desired market entry/exit price and where the trade was actually successfully executed. Slippage is a cost of trading (along with commissions and fees) that ultimately detracts from a strategies profit potential..and as a program grows it can become much more difficult to execute effectively in commodity markets. This is why large CTA’s tend to overweight their portfolio exposure to stock index, fixed income, and currency sectors where the equivalent of billions to trillions of dollars exchange hands each day and slippage can be kept to a minimum.
Now we can hear the cries, what about diversification? Aren’t CTA’s supposed to be trading hundreds of markets worldwide? This is where the largest CTAs have become a victim of their own success so to speak.. as assets roll in the door it becomes much harder to trade in the same manner that one would have with $10 million, 100 million, $500 million, etc. In other words if you’re seeking true managed futures exposure, the biggest program might not necessarily be the best.