February 5, 2013

In our Semi-Annual CTA Rankings. we try to answer the age old investor question of which managed futures program is the best, and end up with our unique Top 15 ranking which incorporates dozens of different statistical measures rather than just looking at which program made the most money last year.

Traditionally, we highlight the top program in that list in this newsletter one week later. But this time around, it wasnt so straightforward. At the top of the focus list rankings was Tanyard Creek. Its certainly a quality program from our view and traded by many of our clients, but theyre closed to new investors, making a spotlight for new investors pretty pointless. Then came Briarwood. Covenant and Mesirow — three programs weve already done relatively recent spotlights on.While its good to know our top ranked managers have been ranked highly so consistently that weve already profiled them in the past, we thought our readers could benefit from seeing a fresh face. So today, we will take a look at #5 ranked M6 Capital — what is, in our opinion, a strong, unique agricultural program worth considering.

M6 Capital is run by Chris Myers, who, despite his proclivity for numbers and trading, is a master story teller. Chris eats, lives, and breathes the stuff he trades. He was born and raised on a sprawling family farm that worked in grains, cattle, and, most notably, catfish. Catfish? Yes, their 2000 acre property boasted over 400 acres of catfish ponds, along with a family-owned hatchery, feed mill, processing plants and rails for transport.

As he made his own way in life, he didnt stray too far from the family interests, receiving a Masters in Agri-Business Management from Mississippi State University. He then went on to work for a contact from the family business — Willard Sparks. In the 70s, 80s and 90s, Sparks was considered by many to be a guru in agricultural research and trading, making him a more than fitting mentor for Mr. Myers. With Sparks Companies, Myers traveled throughout North and South America, analyzing crops and estimating production for the traders back home.

In a pre-digital era, this was not as simple as it sounds. They were asking questions like whether the farmers financial circumstances would necessitate a quick or below market sale, or whether the supply and demand dynamics of the region would lead to higher or lower exports, and what that might do to crop markets in other regions. This information was not as easily accessed as it would be today, meaning every scrap of information could turn into an edge for the well-researched trader. Myers left Sparks Companies in 2001 to join Cattlco, the Sparks family cattle feeding operation and 7 th largest cattle feeder in the world. There Myers worked under Willard Sparks researching grains and livestock markets and conducting hedging and trading activities.

Willard Sparks knew early on that Myers wanted to trade as a CTA, and spent years teaching him the ropes. This tutoring, paired with the support and instruction of Sparks crop estimation wizard Hosea Harkness, fostered a dedication and discipline in research that has shaped Myers as a trader today.

Sparks passed away in early 2005, speeding up Myers’ timeline for entering the managed futures space. He registered as a CTA later that year, using the fundamental analysis tools hed picked up from his years with Sparks to craft a discretionary program that specialized in Agriculture markets. A family man through and through, Myers named the program M6 as an homage to his last name, plus the six members (him, his wife and four children) of his household.

The M6 Capital program is the definition of an agricultural market, focusing on the agricultural markets that Myers grew up studying — in his mind, the only logical route. As he puts it, I dont know anything about Crude, Natural Gas, the S&P pits. I know about Grains and Livestock. Im sticking with what I know. I not only know the ins and outs of the industry — I have the contacts, I have the people, and I have the day to day information flow.

In an era where farmers are tweeting about their crops from combines, and USDA reports are broadcast around the world, just how valuable can this kind of information be? Apparently, quite valuable. Myers argues, Technology has made information more accessible — but that doesnt mean that people know how to interpret it.

Interpreting the information is not as easy as taking a glance at a number. Indeed, this is part of the reason adequately describing the trading methodology of a discretionary program can be so difficult. When the edge is the trader’s head, how do you help investors understand what theyre getting into? When conversing with Meyers, he doesnt claim that HE is the edge. No, he attributes the success of the program to the prolific research and preparation that goes into placing any trade on any given day.

I do ludicrous amounts of research — I couldnt even tell you how many hours. We buy research from others, as well. We do as much research, if not more, than the vast majority of people out there as far as identifying potential trades.

But simply being well-researched does not make one a trader, and Myers is simply being humble. It really isnt just about compiling information; its the ability and experience required to effectively contextualize and sort through that information that really makes a discretionary trader, and in the case of M6, the process of digesting the information is a long one indeed.

Before I ever enter a trade, I am a ridiculously patient person, Myers explains.

Patience would have to be a pre-requisite. Before any trade is placed, Myers and his team spend countless hours identifying the set-up. The first thing theyre looking for is the potential for a trade opportunity to open up. Are supply and demand metrics evolving in a given market in such a way that significant price movement can be expected? Just because its expected doesnt mean the movements will come to fruition, though, so the next thing hes looking for is the anticipated price movements of a market based on its behavior in recent and similar circumstances. The goal is to determine whether the trade has enough upside potential to be worthy of further consideration.

Lets say you want to go long on the soybeans trade at $14.90, for instance, Myers says. If I think upside is $15.50, and downside is $14.50, that means placing a trade at that point has a potential 60 cent upside and 40 cent downside. Thats a flip a coin type of trade. Were not flipping coins.

But its not just about looking for theoretical upside. Its also about finding the trade opportunities where you can adequately monitor factors which could significantly impact the dynamics of the trade. For M6, because of the markets they trade, these factors are largely fundamental. They answer questions like what the average cattle weights are in a given time period, and how that might impact demand for feed, which in turn might impact the price of a crop. While any Joe on the street might be able to draw out some of these connections, M6 is picky about what theyll pay attention to, and when. For them, its about whether you can monitor the factors in play, as these elements will play into how much risk youre putting on your plate.

If you cannot monitor your factors on a live basis, you cannot realistically calculate risk versus reward, Myers explains.

But even if all the pieces fall into place, it still might not be enough to trigger a trade for M6. Theyre also paying close attention to market reactions and price movements.

What new pieces of information are coming into a market, and how is the market behaving with that information? If I want to be long Corn, Myers says, and the cash price is going up, were getting export demand, your Hog numbers are big, your Cattle numbers are big, and the corn market is sitting still, and the March contract is losing on the May somethings not adding up.

In other words — is the market behaving rationally? This has become a unique challenge in recent years. In fact, he points to 2008 as a shining example of the kinds of climates hes become wary of.

Sometimes correlations get messed up. When that happens, wed simply be trading the S&P in the Corn pit. Were not going to play that game.

But the risk on/risk off trade isnt the only market behavior Myers keeps an eye out for. Is the USDA Crop Report due out tomorrow? If so, you shouldnt expect Myers to have substantial positions in any market. The rise of algorithmic traders has made these days perilous. Sometimes theres no reaction. Sometimes, the market goes haywire. Sometimes, the algorithmic traders read a headline about one crop, and extend the logic to the rest of grains. These are the warning signs hes looking for.

Myers is also paying attention to larger trends, and the way those trends might alter the structure of a market. One example of this is the long-only commodity fund. While some managers have seen their presence as a trading opportunity, given their frequently predictable roll, Myers is wary of their influence, and monitors the climates they create vigilantly.

Take wheat, for instance, he says. Last summer, Wheat was a significant short for speculators, but when the markets started going up, the speculators had to cover their shorts. But the funds arent about to sell, are they? Unfortunately, that meant there was no natural seller to act as a governor on the markets, and they were going up 20-30 cents a day.The seller used to be farmer, but now I believe long-only funds are around 25% of the Wheat open interest. At this point, you just have to learn how to work with it this is sink or swim.

Assuming all of the data is pointing to a solid trade, Myers then has to decide the appropriate trading vehicle to attain the desired goal. This might range from a traditional long or short position to options and calendar spreads — two tools that M6 has used more frequently as the years have gone by. For Myers, its about appropriate and acceptable volatility.

When money flows into the markets, it often times creates interesting dynamics in calendar spreads. Theres a fair amount of implied volatility in options, too. There have been some massive swings over the past several years. At one point, we were long way out of money calls in Soybeans. It started with low volatility — around 19 or 20 — and jumped up to around 36.5. We were right directionally, and made money off the volatility, he explains. Personally, I like being able to sleep at night. I like being able to calculate my risk. When you have a large futures only position thats a lot of overnight risk. In volatile markets, you better know your stuff!

Even after all that, the trade may never get placed. Thats where we get into the programs risk management.

Risk Management

Lets imagine a world where a trade qualifies by all of Myers standards. Before it gets executed, Myers takes a step back to ensure the trade fits within the parameters of his risk management.

Most trades dont go through, he admits. Were not doing 10 things at once — throwing spaghetti against the wall and hoping it sticks.

Indeed, the program typically ranges between having 1-3 open trades on any day, and Myers is demonstrably uncomfortable with the idea of having more than 4 open trades at any given point in time. This piqued our curiosity a bit — what if there were five or six trades that more than qualified for execution under his standards? Then, he argues, it comes back to correlation concerns.

You pick the best story among the markets. If youve got bullish stories in four correlated markets, and something rattles them, you could be losing on four separate trades instead of one, he pointed out.

Hes also very diligent about managing risk in terms of position sizing, commoditizing risk relative to account equity. He defines a unit of risk as 1/3 of 1% of equity in an account. This is held relative to the market price and the way that it moves, so the risk is calculated on a fluid basis. On any given trade, M6 will typically accept 1 to 3 units of risk. On occasion, there will be a 4 unit trade, but thats maybe a couple times a year.

If its a 4 unit trade, youre willing to bet the farm, the wife — everything — on it, Myers chuckled.

But they dont really bet the farm. In fact, the margin-to-equity ratio on the M6 program is statistically very low, averaging 2.3%.

More importantly — you remember that incredibly involved research process they go through before they place the trade? That doesnt stop once the trade goes through — it continues throughout the life of the trade. If at any point the fundamentals or market behavior begins to change, thats a cue for M6 to begin scaling down the position or exit, depending on the strength and speed of the changes. If the fundamentals they were tracking suddenly become unreliable? Same cue. It doesnt matter if the untrackable fundamentals arent changing the market movement; for Myers and M6, its about logical calculation of risk, and they wont risk trading blind.

Thats a lot of work going on behind the scenes, you might be thinking. But what has it yielded?

Were glad you asked.

Since launching in 2005, M6 has had only two down years — 2008 and 2009. The rise of risk on/risk off trading during the time period certainly contributed, and M6 has since adapted their trading style to be far more cognizant of market correlations. Their max drawdown of -15.40% may make some investors uneasy, but the duration of the drawdown was far shorter than even some of our systematic programs, at a mere 16 months. Past performance is not necessarily indicative of future results, and we often advise investors to expect 1.5 to 2x the level of the prior max drawdown to occur at some point in the future, but we are heartened by the way the program has handled negative performance in the past.

Why? Because it makes M6 very different. Not only does it boast the typical non-correlation to stocks, it also has a very low correlation to the BarclayHedge CTA Index. For a managed futures investor seeking a diversifier for their managed futures portfolio, thats a metric they want to see. Not so sure? Take a look at their performance over the past several years relative to managed futures as a whole.