U.S. Natural Gas Towards an advanced Strategy
by Patrick Oberhaensli, on Jun 24, 2019 2:12:00 PM
When a market traded asset is highly volatile with a sharp or very sharp maximum drawdown within just a few years, only an attentive active strategy will allow the achievement of a sufficient high risk-adjusted performance. We will discuss in this article uncommon and advanced approaches to exploit the possibilities of Natural Gas as a (financial) investment via futures.
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Examining Characteristic Moves
An immediate observation is that it is not possible for us to make a similar parallel as we had made in our Evaluating Bitcoin Investment eBook with Oil and Bitcoin in terms of behavior. Natural Gas doesn't have those sharp combined up-and-down (or the inverse) trends that last long enough to utilize them. Let’s take the example of the characteristic moves in 2007-2008: we could indeed argue that Oil could have “predicted” the up move in Natural Gas.
Starting on December 26th of 2007, the up-move topped on July 1st 2008 which was an increase of more than 80% but natural gas was below that December level by early September 2008, and it had lost more than 60% from the peak by the end of the year. Natural Gas’ up move was followed by a down move that was so quick and in no comparison with Oil’s, meaning that to extrapolate behavioral parallels here is simply too risky.
What is possible to propose, in this context, is to make risks the source of return - this is especially attractive in terms of return characteristics in the case of highly or extremely volatile assets with a good market liquidity available. One of the fundamental laws in finance is that risk drives return (you take risks... you don't take returns) and it is of course not the opposite (returns driving risks).
Using risks as the sources of returns, hence the name “risk-based” has also the expected advantage of strongly reducing the long-term maximum drawdown when compared to a long-only investment. Moreover, the beta to the long-only market is well below 1 and depending on the risk-model applied, it can even be close to zero or (well) negative.
The implementation using futures allows one to benefit from several of their key advantages: easy-way-to-go short, possibility to leverage, liquidity (where the underlying is liquid itself) and low-costs. Tax matters are of course of individual nature but also need to be considered in the context of an Investment Policy Statement (IPS). There is as well the alpha(s)-beta(s) separation via an overlay advantage: the alpha coming from the risk-based strategy.
Now what are the relevant risks (in terms of active risk taking) when it comes to a risk-based approach for a managed futures strategy? The answer is market risk, which can be measured in many different ways. The next question being then: Does market risk properly reflect the fundamentals related to supply and demand of the commodity - in that case Natural Gas? The Technical Analyst would say that the price action of the commodity tells it all (eventually including volume information). In our opinion, risk information is much more relevant and inclusive – there is simply nothing more fundamental than risk.
The key difficulty is of course to understand what measures are effectively relevant in which contexts. Should statistical analysis really be the essence of the research efforts? Or, at least, be the only methodology used? We clearly disagree with the latter.
Simple Risk-Based Approach
Let’s start with the improvements due to the use of a simple Natural Gas long/short risk-based approach a.o. gross of a larger part of the costs and with no slippage. It considers a specific form of Natural Gas’ risk we won’t detail here: the period considered starts in June 2007 and continues up to the 31st of May 2019.
This particular improvement alone allows remarkable change to the profile of the investment – a long-only investment having a Compounded Annual Return worse than -30% during that period.
Multiple Risks-Based Approach
If we were to use a more advanced technique for a truly multiple risks-based long/short approach applied with conditions, we can obtain even (much) better results – just below we have a representative case with figures on the same trading basis as above.
For a period starting in June 2007 up to the 31st of May 2019, we have in terms of results for illustration purposes using our own proprietary technology:
The result is a Compounded Annual Return that is just short of +60%: This means that a return target of annually compounded +50% - to be obtained over a complete market cycle, could be taken as the benchmark in terms of strategy development. The long-term maximum drawdown could be reduced here by more than half (this wouldn’t be an unexpected result)! And if we look at the beta versus the long-only exposure, it is with -0.29 even negative.
A risk-based strategy is typically well diversifying and, in this case, it is strongly diversifying. The Information Ratio, which is the average excess return versus the long-only exposure divided by the variability of that excess return (also called the tracking-error), is here equal to 1.43 which means that the risk-adjusted alpha is unusually high. A value of 0.50 is generally considered as (very) good.
A successful Natural Gas investment strategy as a single market requires a sustained effort in research and development given its particularly high level of risk. On the other hand, these risk characteristics allow for above or well above average returns – even when compared to Equities (even though they are typically less risky). A differentiated approach would be risk-based, putting risk at the heart of the generation of returns.
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EVOLIDS FINANCE LLC, Disclaimer:
- This content is not intended to be a solicitation nor an offer
- The preparation of the information provided herein is done with a high level of care. Nevertheless, errors are possible