Commodity trend funds need end to market volatility

NEW YORK (Reuters) - A steady economic rebound that sparks a big rally in commodities and stocks, or a deeper recession that pushes prices further down, is what trend-following commodity hedge funds need to reprise last year's heady run.

These funds thrived through most of 2008, buying oil, metals, grains and equities as they rose and selling them as they plunged. They have not done well lately due to volatility in markets they trade in, including currencies and bonds.

But the so-called Commodity Trading Advisors, or CTAs, could have big gains again this year if global economic recovery strengthens and financial and raw materials markets start surging again.

They could profit handsomely too if markets trend sharply the other way, if investors are unconvinced the recession has hit bottom.

"I think commodities could start to trend here...some of the indicators I'm watching are pointing in that direction," said Mark Melin, who oversees CTA programs for clients of Chicago broker Alaron Trading.

"I have not recommended to our clients that we move into trend-following programs at this time. But I'm keeping an eye on the trend followers because I think the second half of 2009 could be a big year for them," said Melin, who is also writing a book on CTAs.

Prices of various commodities, including oil, copper, soybeans, sugar and cocoa have bounced to multi-month highs from last year's recession lows. But the rebound has not been even, with on-off economic worries leading to intermittent selloffs in those markets.

Likewise, U.S. stocks .DJI have shown encouraging signs of recovery but are still down about 5 percent from last year.

"The trend followers get their bang for the buck when a market takes off and continues moving in one direction," Melin said. "When a market is moving sideways, they get mixed signals to buy or sell and ultimately, the market can move against them and they take losses. That's typically how it works."

Investors in CTAs lost more than 2 percent on the average in the first four months of this year, versus the average gain of 14 percent for the whole 2008, data compiled by BarclayHedge, an industry database, shows.

Investors in hedge funds have done better.

The average hedge fund returned more than 5 percent year-to-date, after being down more than 20 percent last year as the credit crisis unfolded, BarclayHedge numbers show.

Hedge funds are loosely policed and can trade in any type of market or strategy. The highly regulated CTAs operate only on financial and commodity futures exchanges, and are alternatively known as managed futures firms.

Another difference between the two is that hedge funds usually employ discretion in their search for alpha, or extraordinary gains, and will not be long, or bullish, on two markets at the same time if their fundamentals clash. CTAs, in contrast, can be simultaneously long on bonds and commodities if their computer-plotted trading models tell them to.

Such a fundamentals-free approach, and use of little borrowed money except for client funds, helped CTAs miss few market moves in 2008. Some returned as much as 60 percent to investors. Dozens of hedge funds went bust, bridled by market fundamentals and the financial crisis which impeded their heavily geared operations.

But CTAs remain a small part of the hedge fund universe, accounting for only about 5 percent of the $1.3 trillion managed by the industry.

Analysts say this is because the early in-roads hedge funds had made with investors have yet to be conquered by CTAs.

Celent, an international consultancy, said in a recent report that CTAs also need to constantly upgrade their computer-trading models.

"Viable technologies need to be developed to accommodate alternative trading systems," the company said.

Those in the business say they aware of the challenges.

"We're working with people to make sure they understand our strategy and that it has some volatility," said Paul Wigdor, president at Superfund US, a managed futures firm in New York.

Superfund had its third negative month in April and one of its two flagship funds is down almost 27 percent year-to-date.

But Wigdor says the declines aren't worrying as the fund returned about 46 percent in 2008 despite losing 21 percent between July and August.

"Drawdowns are normal with trend-following strategies. Our average drawdown period is three months and our average recovery is five months. Since 1996, we've had 14 drawdowns of greater than 10 percent and we've bounced back with 22 percent returns six months after that," Wigdor said.

Despite the equity and commodity markets seeming in better shape now than six months ago, Superfund is still "short", or betting on lower prices, in some energy, metals, grains contracts as well as stocks.

"We have certainly been reducing our positions as the market has moved against us," Wigdor said. "If you believe in our strategy, now is a great entry point."

(Editing by David Gregorio; Editing by David Gregorio)