Cranwood Capital Management

Cranwood’s butterflies generate Treasuries futures alpha

Originally published in the May/June 2009 issue

Even the most liquid strategies have suffered from the more difficult trading conditions arising from the upheaval in volatility that has swept global markets. Curve trading in US Treasuries futures has proven to be no exception.

This tricky backdrop underscores the careful risk management and close focus on capital preservation at Cranwood Capital Management, a futures hedge fund specialising in US Treasuries ‘butterfly’ trades, which is based in Rocky River, on the outskirts of Cleveland, Ohio. It may not be the most auspicious location, but the unconventional locale lets the firm operate with a reduced cost base compared to firms located in the US hedge fund corridor of New York/Greenwich.

“Our whole trading programme is alpha,” says Peter Powers, Cranwood’s chief executive officer and founder. “The tools behind our methodology are backed by a discretionary bias. If something looks too good to be true, it usually is. Long Term Capital Management was a huge reversion to mean strategy that blew up. The discretionary bias keeps us out of a knock-out blow. A machine that is taught to look at levels that are attractive can get caught out because they just keep getting more attractive as the spread moves.”

Like other trading-based strategies, Cranwood has grappled with the surges in volatility. The fund has a strong track record, though in the last quarter of 2008 and the first quarter of 2009, returns have edged lower. The chief reason is that Cranwood have cut daily risk budgets and sought to conserve capital.

“We have done a decent job of not getting wiped out,” says Powers. “I see things getting back to normal. As far as the current market environment is concerned, we are seeing volume coming back into the market. Bid/offers are growing. Eventually we are going to get back to the days of 20,000 (contracts) on the bid side and 20,000 on the offer. In short, a lot more depth in the market and it should also dampen volatility.”

Butterfly trade rationale
Cranwood’s bread and butter play is the NOB Butterfly trade. It is a combination of the FYT spread (five-year Treasuries versus 10-year Treasuries) and the NOB spread (notes over bonds or 10-year Treasuries vs. 30-year Treasuries). Using the NOB butterfly trade, Cranwood seeks to exploit short-term disequilibrium in the relationships among five-year, 10-year and 30-year Treasury securities.

The trading opportunity for each spread may last from a few seconds to several hours. It is quantifiable and it is where the trading team aims to generate returns. This is possible as the yield curve, while efficient over timeframes greater than one day, typically experiences brief distortions over the course of a day. And that is because supply and demand factors for each instrument, while correlated, are not identical.

There is no black box to the trading of each butterfly; rather a disciplined execution approach. Proprietary software helps the team identify spread trading ranges for a given day, and positions are typically scaled into and cut out in small size. What’s more, the whole portfolio goes flat every day at 3.00pm EST.

Fed policy is trading challenge
The recent stimulus and dramatic loosening of Fed policy affects how Cranwood trades through the strategy. Most of the volume is in the five and 10 year futures. Usually, the two year Treasury is the most sensitive to Fed policy changes but the slashing of the Fed funds rate of 0-0.25% means that, for now, there is effectively no policy. This unusual environment makes the 2-5-10 butterfly more challenging.

Before the credit crunch the bid/offer volumes of 10 year futures would typically be 4,000 contracts. Now that amount has shrunk to about 800 contracts. With liquidity lower, the fund’s risk budget has also been correspondingly dialled down.

“We position our trades on the volatility of the environment we are in,” Powers says. “We have a daily approach to trading, if it is not there today you don’t push. It is easy to take care of yourself in good times, but it is how you do in the bad times that differentiates you from everyone else.”

“I like to tell people that if things get better in the economy and the credit crisis eases, we are going to get back to making 1–2% per month,” says Powers. “However, if things don’t improve we are not going to lose you money.”

The introduction of a three-year Treasury future in March should help Cranwood find more profitable trades. Powers’ initial assessment is that it will act more like the five year Treasury future than its two year counterpart and will offer opportunities to construct butterflies.

Cranwood trades a 22.5 hour day tapping Treasuries futures markets worldwide from its Rocky River base using daytime and overnight trading teams. The fund has assets under management of $117 million. It has a 1% capital risk budget per day and ideally tries to put on five butterflies over the course of the one global daily session. There is a typical 10-30 basis point risk per trade and the night traders have a maximum 30 basis point total risk allotment, though even that has been scaled back due to the market volatility.

Trading teams but one P&L
The trading team numbers 12. But each trader works for the same profit and loss statement. Powers likens it to an assembly line. Each portion of the butterfly will have a trader, one executing the buy and the other two the short positions. The team work is meant to avoid slippage in bid/offer spreads, thus tying in more profitable trades.

“Every trade has a discretionary bias,” Powers says. “By automating the system you buy offers and sell bids. We make the same trade over and over and over. Ideally we would get 10 chances (over the extended day) but now we get four or five. Our trading volume is down about 50% from a year ago.”

The performance record of the strategy used by the Cranwood International Fund dates back to July 2005. From then until March 2008, the performance measures the actual trading results, net of fees, for a Chicago Board of Trade (CBOT) proprietary trading firm with a strategy identical to the fund, which launched in April 2008.

The strategy’s best month was November 2005 when it returned 10.41%. “What happens in our good months is the lack of a bad day,” Powers says. “If you put up 50 basis points (daily) for 22 days that’s how a good month would look.” A more typical outcome, he says, would be 10 winning days, 10 scratches and a losing day or two.

But in the current volatile environment reaching for 50 bps in a trade is judged too risky, so trades seldom reach for more than 10 bps. The fund was largely flat over the final quarter of 2008. During the first four months of 2009 it gained +0.48% net of fees.

“To aim to make 1% in that kind of environment would have risked a drawdown which we aren’t ready to take on,” says Powers. “The opportunities on a risk reward basis have not been there for us.”

In November, the fee schedule changed from a flat 25% performance fee to the conventional 2% management and 20% performancefee. Powers says the impetus for change came from investors who were considering allocations but didn’t like how the fee arrangement could bias managers to take outsized risk. “They wanted us to be able to pay our bills, rather than swing for the fences during the last few days of the month,” he says. Some institutional early investors have opted to retain the 25% performance fee but all investors will be on the 2% and 20% scheme in 2010.
The entire team, except for two of the night traders and Ferenc Sanderson, the chief operating officer, have been together since 2002. Management put up $5 million when the fund began trading with launch capital of nearly $10 million.

Early experience at CBOT
Powers traces the changes in the futures market that allow a fund to be based outside of Chicago, or almost anywhere, to 1999-2000 when electronic trading volumes grew to match the pit, and floor trading started to dry up. “Once that happened, it became transportable,” he says. “It was a new era.” Powers has been a member of CBOT since 1998 and the firm bought a seat on the exchange in 2003.

He first worked as a runner and then as a clerk on the CBOT floor with broker SSS Commodities, spending three months in each post. “I realised that the people who have been there the longest were Tee spreaders, so I became a spreader,” Powers says. “I was in the 10 year pit. Scalping was going well but the lease was $5,000 a month. It was a tough business.”

Powers’ maturity and the firm’s steady development from scratch means that Cranwood and chief risk officer Joe Radostitz have adopted an increasingly conservative risk budget in recent quarters. “Our philosophy is that we shouldn’t lose more in one day than we can get back in two days,” Powers says. “That’s what’s kept us in the game. We’ve avoided the blow-ups.” Records dating from 2002 show a
70-30 success/failure rate in trades.

“It takes all four markets in all four time zones to blow out for us to lose our 1%,” Powers says, adding that this happened once in June 2007. The result was a 3.68% drawdown, the worst monthly result for the strategy.

Typically, the fund is flat ahead of what is expected to be key policy or data announcements. This served investors well on March 18 when the US authorities unveiled the $1 trillion quantitative easing plans and new non-farm payrolls data was published.

“We knew the announcements were coming,” Powers says. “But we didn’t know what was coming. So we were flat.” Subsequently, the volatility for the five, 10 and 30 butterfly hit record levels – the 30 year bond had an eight point move – and spreads went to 10 times the normal volatility range.

“I just hope the investment community sees things in the way we do,” Powers says. “It is my first time around so I don’t know whether they will or not.” He notes that there are a couple of equity long/short managers and funds of funds in Cleveland, but adds: “There is no one else like us.”