Archives for May 2024

• As Q2 of 2024 unfolds, the geopolitical environment is as dynamic as ever. But if you’re a systematic trader, chances are the whims of current markets aren’t part of your calculus.
• Aspect Capital cofounder Anthony Todd says that his firm’s investment decisions are strictly based on its models and research, not on prevailing economic conditions or market sentiment.
• How is Aspect Capital taking trend following into the mid-2020s and beyond? What’s Anthony’s take on the mood of 2024 so far?

“Bear in mind, we’re not economists. Everything we do is entirely consistent and static,” says Anthony Todd, cofounder of Aspect Capital, a systematic investment management firm based in the U.K. with offices in London and Stamford, Connecticut.

Founded in 1997 by Anthony and his partner Martin Lueck (a repeat guest on our show), Aspect Capital manages over $9 billion in a range of systematic investment solutions, including trend following, macro/currency and multi-strategy/customized solutions. Its approach is both “scientific and creative,” with an emphasis on research.

“If you ask anybody in the company, we’ll all have a view about what’s happening in terms of the global economy,” Anthony says. “But it has no bearing on our models, on our research, on the positions we’re taking at the moment.”

Why isn’t the current economic milieu part of Aspect’s methodology?

Anthony joined Alan Dunne and me for a Top Traders Unplugged episode to answer that question, and discuss the role of systematic trading and trend following in today’s economy, including the rise of AI in the space. Read on for highlights of their wide-ranging conversation.

The most dangerous words in finance

Anthony says that during the “tough period of performance between 2009 and 2018,” a number of investors, commentators and Aspect’s competitors took the view that market behavior itself had changed — that since the markets became faster to respond to market news, the right thing to do was to take in-kind action with lightning-fast responses in the form of trading.

“We looked at that in extensive detail,” he adds. “And we could not reach that same conclusion. The most dangerous words in finance are this time is different. We cannot actually see any evidence of that market behavior change. So we retained our aggregate level of responsiveness but did a lot of work trying to identify ways of repeatedly improving our responsiveness at those turning points.”

However, Anthony says, we’ve seen “a complete seismic shift in the market environment.”

“If you look at the period post-global financial crisis, we saw an extended period of coordinated central bank intervention, quantitative easing on a global basis and a zero-interest-rate kind of policy — significant levels of government intervention,” he explains. “And it was that significant government [and] central bank intervention in the markets that distorted market price behavior and limited the ability for markets to trend effectively across multiple fronts.”

Consider the alternative

Alternative data and machine learning have been significant areas of investment for Aspect Capital over the last seven or eight years — “particularly in our systematic global macro program, but also elsewhere,” Anthony explains.

In the context of investment management, “alternative data” is non-traditional data that can provide investors with insights beyond the conventional financial statements and economic indicators. Asset managers and hedge funds often use alternative data to gain an edge over the competition, make better investment decisions and produce astute predictions about the financial markets.

At Aspect Capital, alternative data include non-pure, price-based data like “nowcasting … more instantaneous measures of certain key economic indicators,” as well as flow data that “provide valuable additional sources of return,” says Anthony.

‘Intuitive and explicable’

Aspect Capital runs a “sleeve of 24 machine learning models” in its “mousetrap” program.

But those models are “constrained” by the firm’s central tenets: everything should be hypothesis-driven; intuitive and explicable to clients; and consistent in style (“avoiding style drift”).

“We don’t undertake research on the basis of just trusting the data,” he notes. “Any [economic] effect we’re trying to identify in the first place has to be backed up by a hypothesis about market behavior.”

That’s a very different strategy from the typical “data-driven approach” many firms use — which is essentially the idea that “if you have enough data and are strong enough … because statistics, then you can just trust the results.”

“We don’t work on that basis,” he argues.

“We see huge advantages in the application of AI, particularly in relation to increasing productivity in research and … in terms of coding. But we’re moving cautiously. … We need to actually make sure that the work we do using AI is hypothesis-driven. We’re not just asking AI for a solution.”

Although Aspect’s team pride themselves on providing a high degree of transparency to its investors, “we’re highly protective of our IP,” Anthony says.

Sophistication and diversification

In terms of the investment philosophy, Aspect Capital has been consistent with their approach for 25 years.

Looking back on the early days of Aspect Capital back in the late ‘90s, “our aim was to build a medium term trend-following program, capturing trends over a period of two to three months over a broad set of diversifying markets,” Anthony explains. “And at the highest level, that’s exactly what we’re trying to do today.”

What has changed is the “level of sophistication” of those models — today’s are much more complex and diverse than they were 25 years ago.

That’s due to a number of factors, the most obvious being the number of markets that Aspect trades. When the firm launched in December 1998, its portfolio consisted of 64 markets. Today, the company trades in 180 markets, many with multiple contracts — so its portfolio trades more than 240 contracts overall.

Machine learning

In its early years, Aspect Capital primarily used daily cut-price data. But the level of data granularity it uses today is “significantly finer.”

Anthony and his team’s filters for identifying uptrends or downtrends in each market are considerably more advanced than they were a quarter century years ago.

“If you translate that trend strength into a position in the markets — we talk about the application of a position function — that’s the way we translate a trend signal into a position in the market,” he says. “A significant amount of work and research has gone into refining those position functions. Over the course of the last five years, a significant focus of research has been put into trying to improve our responsiveness at turning points in markets.”

“We’re very excited,” Anthony says of the rise of AI in trading. “But we move carefully … and make sure our approach is consistent with our central tenets.”

Amid the rapid advancements in AI, we should all remember to remain this steadfast in our commitment to our guiding principles.

This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes. 

• Pension plans have gradually moved assets away from equity and into debt and cash investments over the past few years. Ontario’s University Pension Plan (UPP) uses a diverse allocation strategy focused on absolute returns.
• When equity beta — a measure of a stock’s volatility — increases in a stressed market, managed futures can contribute to a positive return known as “crisis alpha.” A balanced portfolio can perform well throughout market cycles.
• Why UPP recommends choosing managers based on a belief in their investment processes rather than their historical returns.

Pension plans are supposed to offer financial security after retirement, but in the past several years, employees have had reason to doubt they’ll see their full benefits.

Headlines about underfunded pension plans and market volatility have been particularly concerning for public sector employees, including city workers, emergency responders and educators. In 2021, in response to the funding crisis, Ontario’s provincial government created a jointly sponsored pension plan for eligible university employees.

University Pension Plan Ontario (UPP) now has approximately 39,000 members and 11 billion Canadian dollars ($8.1 billion) in assets under management. UPP’s Managing Director, Head of Public Markets Christophe L’Ahelec is responsible for a global investment strategy delivering stable retirement income regardless of uncertainty in the financial markets. For Christophe, the focus is on sustainable growth.

“Our ambition is to attract all the universities in Ontario,” he says. “We invest across all asset classes, including public and private equity, the fixed income sector and real estate.”

Christophe joined host Alan Dunne for a Top Traders Unplugged Allocator episode to further discuss how UPP pursues absolute returns in a volatile market. The conversation also touched on Christophe’s philosophy for investment manager selection. For investors committed to sustainable long-term growth, strategy matters more than recent portfolio performance.

The main objective

In the decade following the global financial crisis of 2007-2009, central banks did just about everything they could to stimulate economic growth through loose financial policies and low interest rates. It was one of the greatest bull markets in recent memory, a decade that some analysts termed a golden age for growth stock investment. Frankly, passive management had great returns, so investors didn’t need to be particularly strategic.

“We believe that this era is over,” Christophe says, “and that the next few years will be characterized by heightened levels of volatility.” This calls for more active hedge fund management and diversification with a focus on absolute returns in the short term. Especially in the context of a pension plan, consistent income is the primary goal.

“Our main objective is to remain fully funded and to manage the funding ratio to mitigate its volatility,” Christophe adds. A pension’s funding ratio is a comparison of the plan’s assets to its obligations — essentially, a 100% funded plan has enough assets to pay the full retirement benefits to all plan members.

To satisfy this objective, UPP pursues high-quality assets with risk-adjusted value. In other words, the fund seeks investments with a high expected return relative to the risk associated with it. The plan also considers environmental, social and governance (ESG) factors in asset selection for ethical, sustainable investments for their members. Last year, UPP committed to invest CA$1.2 billion in climate solutions by 2030.

Member-focused allocation

In terms of allocation, what does this ESG-conscious absolute return plan look like? Christophe breaks it down:

• 52% to equities, credit and absolute returns
• 32% to government and inflation-linked bonds
• 16% to real estate and infrastructure

It’s a traditional 60/40 portfolio with an 8% slice carved out from both stocks and bonds to fund the real estate and infrastructure investments. Alan asks, “Is that based on research that these are the most durable kind of assets to withstand inflation?”

Christophe explains that because inflation indexing is a core characteristic of the pension plan, the fund has to account for it. “It’s very important to be able to hedge that inflation indexing by investing into assets that will provide some kind of inflation protection,” he says.

An inflation-indexed pension will periodically increase retiree payouts relative to changes in the consumer price index. If inflation is up 3%, the pension plan can mitigate risk by holding assets that are likely to rise in value with inflation.

Alongside property and utilities, commodities are often suggested as an asset class to hedge against inflation, but Christophe notes that holding certain commodity futures, such as fossil fuels, could conflict with the fund’s ESG goals.

“We ultimately want to build a framework that will be focused on risk factors,” Christophe adds, but also manage a portfolio that reflects the expectations and values of UPP’s members.

Trading convergence

Once the allocation is decided, how does the fund pursue its goal of absolute returns? For Christophe, the underlying principle is a convergence strategy.

A convergent investment strategy perform best in normal times, when fundamentals prevail and investors act rationally. Expecting mean reversion, traders act on mispricing and deviations from fair value, arbitraging away inefficiencies and profiting handsomely in the process.

Divergent strategies, on the other hand, perform best in turbulent times, when uncertainty prevails and investor psychology tramples fundamentals. Instead of reverting back to intrinsic value, price deviations develop into full-fledged and well pronounced trends. Traders who successfully anticipate and ride these trends deliver outstanding performance, both in absolute terms and relative to convergent strategies. An example is the so-called crisis alpha, referring to a positive return in a period of market stress.

Here’s how it works. In a sharp market decline, beta (a measure of volatility) usually increases. But if investors are holding highly liquid, opportunistic positions, they can exploit this downward trend for a profit. Managed futures, for instance, tend to do well in periods of high volatility because active traders can capitalize on the trend movements.

Trend following isn’t foolproof, however. “And a good example is March 2020,” Christophe notes. “The market reaction [to COVID-19] was so sudden and so sharp, that the managed future and trend following strategy didn’t do well because it was a very short period of time,” not long enough or slow enough to find opportunities on the trend line.

Still, an outlier event such as the COVID-19 pandemic isn’t a reason to dismiss the approach. Christophe explains the importance of choosing a long-term strategy rather than focusing on recent market performance.

Buy the process

UPP has a large enough principal to invest in a variety of niche strategies to maintain liquidity and diversification. Christophe is in conversation with managers every week, some of whom he meets through banks or at conferences, and some who reach out to UPP directly. The fund maintains a database to quickly reference how a new risk-return profile is different from those strategies already in the portfolio. It’s a mindset of always looking for new opportunities.

Alan asks about manager evaluation and selection. “There’s always that temptation to be heavily influenced by their track record,” he says. Are the best fund managers the ones with the strongest recent performance? Christophe disagrees.

“You’re not buying a track record. You are buying an investment process that you believe will produce a risk-return profile for your portfolio going forward,” he says.

Christophe wants to avoid alpha decay, a nickname borrowed from nuclear physics that refers to a strategy’s gradual breakdown in its ability to outperform the market. “A manager should have the capacity to adapt to an ever-changing market environment,” he adds, without staying stuck in a singular mindset. Successful managers are agile and forward-thinking.

Of course, it’s much easier to look at historical rates of return than to make an informed assessment of a strategy’s potential in current market conditions. Christophe acknowledges that UPP’s selection philosophy requires a deep understanding of investment technicalities and market fundamentals.

A little T.L.C.C.C.

It’s fair to wonder, is active management worth the additional effort? Many pension plans use passive strategies such as investing primarily in index funds. But in support of UPP’s objectives to remain fully funded, diversified and capable of absolute returns, Christophe names five benefits of managed accounts.

1. Transparency

Transparency isn’t in reference to a fund manager’s trades, open orders or portfolio holdings. “It’s about being able to aggregate [all the risk exposure] across your hedge fund portfolio,” Christophe explains. It goes back to diversification. Even if active managers are beating their benchmarks, if there’s too much strategic overlap in the different slices of UPP’s portfolio, the pension plan could be overexposed to a particular risk.

2. Liquidity

A convergent, trend-following strategy relies on liquidity. Christophe notes that commingled funds — those mixing assets from several accounts — typically have limitations in terms of liquidity. By using managed accounts, UPP can maintain agility during market swings, ultimately preserving capital for clients. To that end, any managed strategy needs to have enough trading volume for quickly resizing a position.

3. Control

Managed accounts give the fund manager control of their assets, but the managers also have more direct contact with third parties such as audit firms or prime brokers. In many cases, this can simplify the auditing process and expedite any necessary changes.

4. Customization

“Being able to customize a strategy with the manager so that it will meet your needs for a given risk-return profile within your portfolio is very important,” Christophe explains. Related to the idea of transparency, sometimes changes need to happen in a few managed accounts to meet the risk tolerance of the portfolio as a whole.

5. Cash efficiency

Lastly, individually managed accounts don’t need to be fully funded. For example, a manager trading long-dated options doesn’t need the full amount of cash to cover those contracts, provided the cash is available elsewhere in the portfolio. With managed accounts, UPP can preserve cash on certain strategies and instead deploy it in other opportunities.

Never stop learning

Christophe’s advice to traders is to be curious and embrace the ever-changing investing landscape. Geopolitical shifts; the increased attention on sustainability and ESG issues; and the prevalence of automation and machine learning in investing tools will likely redefine best practices in the coming years.

“There are always new financial instruments, new ways to implement a given strategy and new tools at our disposal,” he says. Successful investors will be the ones looking ahead.

This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes. 

• Evolving trading systems along with technology is always essential to maintain competitiveness, particularly in short-term trading.
• Tony Kaiser says that some strategies are classics for a reason, but they’re definitely not one-size-fits-all.
• Why are some trading tactics suited to certain market environments and not others? What are the short-term strategies that work best today? Tony weighs in with his investment philosophies — and some hot takes as well.

In a world where the only constant is change, especially in the high-stakes game of short-term trading, wisdom comes not only from the hard data but also from the nuanced understanding of market dynamics.

“One of the benefits of being in markets for so long … is the intuitive feel,” says Tony Kaiser, the CEO and founder of Kaiser Trading Group, a short-term systematic fund based in Melbourne, Australia.

He can definitely describe what doesn’t work in today’s era of algorithms: thinking, I’ve got a model, and I'm going to run it on 50-odd markets, and it’s going to work all the time.

“That’s not true. That model [only] works when the market dynamics suit it. Therefore, the smarter thing is [to] understand what market dynamics suit the characteristics of the model. That’s the million-dollar question.”

Tony joined host Moritz Seibert on an Open Interest episode of Top Traders Unplugged to discuss how the short-term trading space has evolved over the years, why short-term models are even shorter than the ones he traded decades ago — and how his firm leverages technology to “harvest the noise.” Read on for highlights of their conversation.

Models and market dynamics

Adaptability and specificity have always been key for Tony. After all, trading models are not universally effective across all time periods or market conditions. They’re contingent upon the presence of certain market dynamics.

A volatility (vol) breakout trading model is predicated on the assumption that after a period of compression, the market is poised for a significant movement (breakout). Capitalizing on the sudden increase in price movement is the whole point.

But the effectiveness of this model is inherently linked to the market, specifically a “moving state environment,” Tony says. The potential for volatility has to exist. Consider a stagnant market like Japanese government bonds, which became “untradeable” when interest rates fell to zero. So even if a trade meets the theoretical criteria put forth in the model, it’s unlikely to succeed. The essential dynamic — the breakout — just isn’t there. That’s why frequent evolution is a priority for Kaiser Trading.

‘Harvesting the noise’

Certain trading strategies will always have limitations in the face of long-term market trends, particularly short selling, which is unlikely to be successful in a predominantly bullish market.

“It doesn’t matter how much you want to be a short seller, it’s not going to work … because of the bias of the data,” says Tony. So while many hedge funds rely on historical data and use those trends to predict future market dynamics, that’s only a viable strategy if the model they use is appropriate for the current market environment. He cautions against relying too much on history when considering potential unforeseen market shifts. For Kaiser Trading, adjusting trading models is vital in response to changing economic winds, like interest rates.

“The effect of carry on any asset class is huge. So if you’ve got 7% or 8% on a model, and you’ve got negative carry of 3% or 4%, there’s not much edge on that model left,” Tony notes.

But there are plenty of small gains to win — at scale.

“There’s so much information in the minutes to ticks to sub-daily [minute-by-minute fluctuations and individual transaction data, in very short time frames] that we are now very invested in harvesting that noise in our models,” he says. “Why do we do that? I think the answer is: I like it.”

Mean reversion and the modern trading landscape

Moritz asks Tony whether “harvesting the noise” — that is, actively incorporating the random or unexplained variations in stock prices as valuable data — is essentially a mean reversion style of trading.

“Yes and no,” Tony replies. “I always say … if you stand in front of a train, you’re gonna get run over. The reality is, if you’ve got to try the noise, you’ve [got to be] meaner.”

However, “trading mean reversion into even short-term momentum or strong momentum, you’re gonna get slaughtered,” he adds. “It’s really a case of putting all those pieces together.”

In other words, trying to apply a mean reversion strategy during a period of strong short-term momentum can lead to significant losses because prices might continue to move away from the mean for longer than the investor can remain solvent. Integrating several strategies requires a sophisticated understanding of the market conditions under which each strategy is likely to succeed or fail. And after more than 30 years in trading, Tony has that in abundance.

Endurance and adaptation

Moritz wonders whether the models Tony uses today are mostly unchanged since the beginning of his career, or whether technology has required him to reinvent the wheel.

Again, the answer is a bit of both. Certain trading strategies continue to be effective as long as we apply them in a suitable market environment. That’s true for both short-term and long-term strategies, including one of our favorites here at Top Traders, trend following.

But in Tony’s estimation, the markets have become less conducive to trend following in recent years compared to previous decades, when we saw much more pronounced trends. Why? More market noise, for one. And there are also more frequent V-shaped (sharp reversal) and W-shaped (double bottom) price actions.

(“I wonder if that’s because … there’s more players in the system [who] are trying to do the same thing,” he muses.)

Tony uses the U.S. dollar/Japanese yen currency pair as an example. Specific market conditions, such as a significant interest rate differential between the two countries, can create favorable conditions for certain trading models. But the same conditions aren’t present all the time, making it challenging to consistently profit from the same strategy without adapting to the current state of the market.

“When [dollar/yen trading] took off a couple of years ago on the fact that U.S. rates were 5% and USD/yen rates were at nothing … any model at all would perform well, because it was in a highly moving state. If you looked at dollar/yen for the preceding years, you would have had a pretty tough time making money out of that market.”

The more things change, the more they stay the same

Is what Kaiser Trading does proprietary?

Not exactly — the secret sauce, so to speak, is simply Tony’s extensive experience and understanding of the markets, although “a lot of the ideas come from discretionary thought process[es] that we code up and then try and prove [out] the dynamics,” he says.

“Hindsight is a wonderful tool,” Tony adds. He notes that from 2009 onward, market dynamics have radically changed several times. During the era of zero-percent interest rates, “the impact on the markets for that extended period — we still made money, but not as much — was huge,” he says. “Now, the fundamental dynamics since ’22 have changed. So I think you would expect to see market behavior more similar to the 1990s and early 2000s than what we’ve experienced in the past 12 or 14 years.”

Does that mean today’s market environment is good for longer-term trend following traders? Moritz notes that “recently, they’ve hit it out of the park.”

“No doubt,” Tony replies. “I think the move last year, and [the] first quarter of this year has been really good for long-term trend followers. But the question I would ask is, How much are they going to give back on the reversal of trend in equities? Potentially starting from now … the good thing for them is they will readjust.”

That’s the name of the game, isn’t it? Always adjusting as needed.

Trading is always unpredictable, so let’s keep our eyes open, our models flexible and our spirits high. Who’s to say what thrilling plot twists lie ahead?

This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes. 

• Commodities can be volatile, subject to political decisions, weather patterns and cost of production. KLI Asset Management, commodities-focused hedge fund, uses a fundamental analysis framework to generate absolute returns regardless of pricing swings.
• Mismatched commodity fundamentals often take several months to realign. By maintaining a wide portfolio diversification, KLI avoids overleveraging on positions while waiting to realize a gain.
• Despite recent bearish signals, copper, crude oil and European carbon allowances (EUAs) are among the commodities with long-term upside based on current global supply and demand.

Investing in commodities has been a roller coaster for the last few years. As many analysts predicted a rapid acceleration in raw material consumption in the post-pandemic economic recovery, commodity prices have taken wild pendulum swings that feel impossible to time. So how does a commodities-focused hedge fund navigate these choppy waters?

For KLI Asset Management, the answer is a strong reliance on fundamental analysis and broad diversification. The UK-based fund manages about $400 million — a large portion of which is internal capital — and has a proven track record of absolute returns in a volatile space.

“We’re not short-term traders,” says KLI Chief Investment Officer and founding partner Ricardo Leiman. “We are really focused on the fundamentals and where we can get it right.”

Lately, the short-term commodities market has been full of slow growth and bad news. The Bloomberg Commodity Index is down 25% from its June 2022 high with energy, agricultural products and base metals headlining the disappointment. Yet the KLI team expects a correction based on fundamental supply and demand, a prediction informed by extensive internal analysis and their close contacts with merchants in the physical trading space.

Ricardo and his KLI co-founder Pedro Marion spoke with host Moritz Seibert on an Open Interest episode of Top Traders Unplugged to explain their approach to commodities trading and where they see opportunities in the next 12 to 18 months. Here’s what to look for.

Elements of a strong commodities position

“The interesting thing about commodities,” says Ricardo, “is that nothing happens in the medium term.” Typically, commodity traders are looking months out on futures contracts, but prices can move suddenly due to fluctuations in the physical market — more so than with financial assets, including stocks and bonds. To manage this volatility, KLI balances three factors in its commodities positions.

1. Supply and demand

Most importantly, KLI focuses on fundamental analysis — how do supply and demand impact price? Through a combination of internal research and consultations with merchants and buyers in the physical markets, KLI identifies the best pricing opportunities. “[Networking] gives us an edge in understanding all the price points and elasticity of supply and demand,” Ricardo notes.

Patience is the trick. If a commodity price is misaligned based on actual demand, it will rarely correct overnight. Pedro estimates that KLI holds long positions for six to 12 months on average, waiting for market realignment.

“It usually takes quite a bit of time for the market to come back to reality,” Pedro says. “But because it’s commodities — tangible assets — the fundamentals will always win.” If manufacturers or consumers need a particular commodity and global supplies dip too low, eventually the price will go up until storehouses can restock.

2. Portfolio diversification

In this sense, waiting becomes a matter of position sizing. “If you have too much level leverage [in a single commodity], you can’t hold the position long enough,” Pedro explains. “If you have too little leverage, then you don’t have the right-sized position to make the money that you should have made.”

For this reason, KLI’s portfolio includes a wide range of energies, metals and agricultural products, never exceeding a 35% concentration in a single commodity. Approximately 20% to 25% of the portfolio consists of commodity equities, offering some hedge against sudden price drops and a positive carry through dividends.

“[Diversification] gives us the ability to hold positions when the market goes against us,” Ricardo says. If the fundamental analysis supports a long-term hold of a particular commodity, the firm can ride out a few tough months without impacting the absolute return.

3. Liquidity

Of course, when they’re ready to exit a position, the fund managers need enough liquidity in the market to do so. How liquid? Ricardo’s goal is to be in or out of a position within 24 hours.

“That’s the nature of commodities. Suddenly, everything happens, and the market is really not prepared or paying attention,” Ricardo says. These parabolic moves can go down as quickly as they skyrocket, emphasizing the importance of a short-term trade window, even if KLI has held the position for a year or longer. 

Ricardo gives examples of crude oil, natural gas and base metals such as copper and aluminum as high-volume markets with constant open interest. Conversely, bulk freight fluids such as industrial chemicals or cooking oil are among the items that don’t meet the trading liquidity criteria.

Spotting the trends

Trading high volatility without overleveraging capital — why not use options? Moritz asks, “Do you think about buying a long-dated call on copper or a call spread? Or does selling a put play a role in your book?”

Despite the occasional advantage of buying a call when he views a price that might move quickly, Ricardo generally prefers to stay away from options. “Because of the drawdown of the supply chain, [the timing of commodities] is more unpredictable,” he says.

Instead, KLI focuses on directional movements based on commodity trading advisor (CTA) trends. These CTA models can help forecast commodity flows and highlight buying opportunities.

“We look at the short-term CTAs, which are basically trading moving averages. They’re simple to track, very fast and very active,” Ricardo explains. He compares this analysis with longer-term CTAs — those tracking momentum or the shape of the commodity’s futures curve — to inform the timing of when to get in or out of a position.

Yet Ricardo offers a word of caution. A KLI analysis was inconclusive as to whether or not solely following CTA trend models resulted in higher profits. “In the end, the fundamentals are what really drives local [metal] miners,” Ricardo says.

Fundamentals always win

From a consumer perspective, supply and demand is simple. As more people travel in the summer, gasoline prices go up. When it’s a mild winter with less demand for natural gas heating, energy prices go down.

But because commodities traders are usually looking at futures contracts rather than the actual price of the commodity in today’s market — often called the spot price — the fundamental impact isn’t always apparent in long-dated trades.

Take coal, for instance. Coal prices fell in 2023, despite global demand reaching record levels. As Europe and the United States shut down coal plants and push toward renewable energy sources, there’s a perception among investors that the green energy transition will result in a plunging demand for coal. The reality, however, is a different story.

“Asia is burning coal like there’s no tomorrow,” Ricardo says. “You have increasing demand in China, increasing demand in India and the continuous building of coal-burning plants across Asia. So despite the West declining in terms of coal demand, we continue to see that Asia is picking up.“ Fundamentally, a higher demand suggests a correction is coming to the downward price trend.

Commodities to watch in 2024

Pedro’s one concern with coal is that the market doesn’t have the liquidity KLI normally looks for. “With all the negative publicity [around burning coal], all the banks have had to pull out of it,” he says. At least for now, Ricardo and Pedro see stronger buy opportunities in other commodities.

Copper

Opposite coal on the clean energy spectrum is copper, a primary component in solar panels, wind turbines and other electrical systems. China, quickly becoming the world’s leader in electric vehicle production, has skyrocketing demand for copper and other so-called green metals, and global stockpiles are shrinking.

“​​The price of copper has gone down [alongside] a massive drawdown in global inventories, which is pretty difficult to put together,” Ricardo says. Once again, prices have the potential to go higher, only this time in a commodity market with more global liquidity.

Oil

Speaking of clean energy, Ricardo forecasts that we’ll still live in a both/and world for quite some time — fossil fuel consumption and electrification. That puts all eyes on oil.

“I think that the green transition will take a lot longer than the politicians have estimated,” he says. As long as consumers drive gas-engine cars, diesel powers farm equipment and jet fuel fills the tanks on planes, crude oil demand will stick around for the foreseeable future.

EUAs

In our energy-conscious geopolitical climate, emissions are an intriguing commodity play. European Union Allowance (EUA) futures have trended downward since summer 2023, largely attributed to less energy usage in a mild winter and falling gas prices. Supply is harder to calculate as emissions caps are based on political decisions, but upticks in industrial production or power consumption will likely increase demand.

“Right now, we think that emissions could easily double in price from today's numbers,” Pedro says. “It depends on what your horizon is. In two to three months, I can’t tell you where emissions will be. Maybe nine or 15 months ahead, it is getting quite compelling to be long on emissions.”

What to avoid

On the flip side, Ricard and Pedro find other commodities less interesting for a long-term investment. The first on the list is one making headlines in 2024.

Cocoa

Cocoa prices have gone stratospheric, up over 130% year to date at the time of this writing. Poor harvests in West Africa have dwindled global supply, creating a parabolic rally as importers scramble to fill their stores. Although Ricardo acknowledges this kind of situation would normally be a good market opportunity, he isn’t interested in cocoa as a long-term play.

“Cocoa is dependent on two countries that manage 70% of the global supply. We [at KLI] think that doesn't really fit our category of risk diversification because it has a lot of political risks associated with it,” he says.

Grains

Conversely, favorable weather conditions in the U.S. could lead to a bumper crop. When combined with falling global demand for U.S. grain exports, there may not be enough demand for the supply, pushing the price down.

“Our view has been we’ve been negative on corn and soybeans for a few months,” Pedro says. Ricardo further predicts that an overabundance of grain could drive prices below the cost of production for U.S. farmers — not an ideal situation for investors.

Closing thoughts

In any case, KLI’s approach is that that reward is worth the wait. “We’re more like investors on the commodity spectrum, waiting for fundamentals to take place, than the short-term traders trying to make a quick buck in and out of positions,” Ricardo says.

Perhaps the most valuable commodity in the market is patience.

This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.