Volatility Index (AIMFV)

Transcription

1 A.I.. Managed aged Futures Volatility Index (AIMFV) Methodology and Maintenance v

2 Table of Contents Executive Summary 3 Introduction 4 Description of the A.I. Managed Futures Volatility Index 5 Sectors/Components 6 Selection Criteria 7 Initial Weightings 8 Rebalancing 9 Position Determination 10 Contract Maintenance 11 Index Committee 12 2

3 Executive Summary The A.I. Managed Futures Volatility Index (AIMFV) is a diversified composite index of global commodity, financial and volatility futures instruments with long/short/flat diversified managed futures exposures. The index is both systematically and quantitatively based index of numerous components that serve as a proxy for exposures to economic sectors related to financial futures, commodity and volatility futures. Elementally, AIMFV provides exposure to managed futures sectors. This exposure is complemented with innovative overlays that account for multi-factor seasonality, and a focus on efficient access to directional movements inherent in the underlying components of futures contracts. Index Features: The liquid components are methodologically formed into representative sectors and are further optimized for contract roll and risk controls based on dynamic systematic factors. Each sector will then have directional long, short, or flat/neutral positions based on the underlying component futures based on a rules-based quantitative approach. The index measures the extent (and duration), i.e., the extended volatility, of the trends of these sectors in aggregate. Futures derive their returns differently from other financial assets. Unlike declining equities, where usually only short-sellers benefit, declining futures prices have as much benefit as rising futures prices: rising prices benefit producers; declining prices benefit consumers. As such, within the futures markets both buying and selling play an equally important economic role. Futures prices primarily reflect the equilibrium price where those who are commercially and naturally long or short a commodity agree upon an immediate price for trade. Futures prices do not reflect forward looking economics. Unlike stocks and bonds their values are not based upon the discounting of a futures stream of earnings or interest income. The Arrow Insights Managed Futures Volatility Index methodology is investable, intending to reflect and capture the profit potential in price trends, and flat/neutral when such trends are not significant based on a multi-factor model. Speculators play an important role in the economics of futures markets. They provide liquidity and accept the risk of price fluctuations in return for a premium from hedgers (those who are inherently long or short the commodity) who are unwilling to bear that risk. This methodology considers the index s internal diversification and how the long exposure tends to capture inflation over long periods. The overall process tends to mitigate and even profit from commodity and financial price cyclicality. Finally, there is a discussion of long/short/flat measures compared to long-only commodity indexes and why the index tends to be profitable in a variety of market conditions. 3

4 Introduction The A.I. Managed Futures Volatility Index (AIMFV) is an evolution to traditional systematic managed futures strategies. It is the intellectual property of Arrow Insights, and is constructed, calculated, and maintained by Arrow Insights with participation with Arrow Investment Advisors, LLC. The index follows a quantitative methodology to track prices of a diversified portfolio of 24 individual commodity, financial and volatility futures contracts. The individual contracts (also called components) are grouped into inherent sectors and each sector is represented on either a long, short or flat/neutral basis. The initial directional position or neutral position is based on recent price trends of that sector and then on second level of multi-factors of seasonality and trader sentiment. The implementation of long/short positions serves as an overlay (circuit breaker) to the dominant price trend indication of the underlying futures contract. With the ability to go long, short, or flat/neutral, the A.I. Managed Futures Volatility Index is designed to capture the economic benefit derived from both rising and declining trends within a cross-section of sectors within the futures markets. A non-directional position is taken when the index goes flat/neutral a constituent futures contract. The objective of the index is to measure directional price movement, sentiment and price dispersion and premium expansion of certain highly liquid futures and to serve as an investment tool. Limiting the volatility of the index was a guide in the determination of the methodology. The methodology is implemented in a rules-based, systematic manner. The index is not intended to be representative of or serve as a benchmark for a particular futures market or group of markets. 4

5 Description of the AIMFV Index The key characteristics of the A.I. Managed Futures Volatility Index include: 24 components (futures contracts), divided by optimized weights, and grouped into 10 sectors Three financial (bonds, currencies and Six commodity sectors (energy, industrial metals, precious metals, meats, grains, softs ) and the infrastructure sector Diversified by optimized sector/component weights divided between commodities and financials Long, short, flat/neutral positions are determined by price trends & multi-factor position overrides Sectors and Components are also rebalanced monthly Performance has a positive correlation to the index s standard deviation (i.e., performance tends to increase or decrease with increased/decreased volatility) Index exposures can potentially mitigate the negative effects of commodity and financial price cyclicality 5

6 Sector and Component Weights Vary BASE Category WEIGHT Commodities 70% 2015 sector weights are fixed for 12-months SECTOR WEIGHT Energy (Crude Oil (Light), Heating Oil, RBOB Unleaded Gas, Natural Gas) 35% Industrial Metals (High Grade Copper ) 2.55% Precious Metals (Gold, Platinum and Silver) 9.45% Livestock (Live Cattle) 2% Grains (Corn, Soybeans, Wheat) 7% Soft (Cocoa, Coffee, Cotton and Sugar) 10% Lumber 4% Financials 20% Australian Dollar (component) 2.22% Canadian Dollar (component) 1.73% Euro (component) 6.88% Japanese Yen (component) 4.17% U.S. Treasury Notes (2 & 10 T-note components) 5% Volatility 10% VIX Futures 10% 100% 100% 6

7 Selection Criteria Of the factors considered in determining the A.I. Managed Futures Volatility Index components and weights, liquidity the volume and notional size of futures contracts traded is one of the most important. Liquidity is an indication both of the significance of a particular market and the ability to trade with minimal market impact. All the components of the index are consistently in the lists of top contracts traded in the U.S. Investability is another important t consideration. Other liquid id contracts t may exist, but exceptionally large contract values (i.e., $1,000,000 per contract for Eurodollar futures) would make the cost to replicate the index very inefficient. Contracts are limited to those traded on U.S. exchanges to minimize any impact from major differences in trading hours, avoid currency exchange calculations, and allow for similar closing times and holiday schedules. 7

8 Initial Weightings For commodities, commercial production is an indication of the significance of a given component to the world economy and of such component s significance within the futures markets. The index goes beyond these factors to determine initial weightings. Contracts in the currencies, bonds, and energy, grains, metals, and softs sectors are weighted within their respective sector based upon the ratio of each contract s fundamental and market aspects. As an example, contracts such as gold are relatively weighted based upon these factors as opposed to live cattle, lumber and equity volatility which are fixed due to economic and risk/reward factors. For commodities, the index takes into consideration the historical significance of individual components and the intercorrelations to create a distinct line up of components. Due to a lack of standard source for a commodity s commercial productions, various optimizations can be used in selecting and making sector allocations. Markets are divided between tangible commodities, financials and volatility in order to increase the internal non-correlation among the components. This is not done to reflect their relative notional values outstanding, but rather to produce a smoother, less volatile return. Base weightings within the currency, bond, energy, grains, metals, and softs sectors are based on and are directly proportional to contract volume and contract open interest of the sum of each contract s volume and open interest. For example, contracts in these sectors are weighted within their respective sector based upon the ratio of each contract s volume plus the number of contracts held as open interest of all index constituents at the end of the year. Base weightings are held for 12-months and then recast at the end of each year. The currencies of the countries within the financial sector are balanced between nations with commodity-based and financial sector based economies. Financially based currencies have a higher weight relative to commodity based currencies because financially based economies are larger than commodity based economies. Thus, the financially based euro and yen have a higher importance in global monetary exchange than the Australian and Canadian currencies, which are dominant commodity based economies. Consequently, volume and open interest of currencies from financially based economies tend to be much higher than the volume and open interest of commodity currencies markets and are weighted less than financial currencies. All constituents t are subject to some adjustment t to their portfolio weightings based upon each contract s t liquidity, idit trading significance, and potential correlation to other sectors within the index. These considerations are monitored by the Index Committee. 8

9 Rebalancing Sectors are rebalanced monthly to their fixed base weights. The rebalance date is the last business day of the month. Rebalancing monthly helps to keep volatility low since otherwise an extended move in one group or sector would overweight the A.I. Managed Futures Volatility Index and potentially lead to higher volatility overall. In addition, implementation to commercial seasonal contracts has been added as a refinement of the contract roll process. Sectors and components are rebalanced every month within the index to their annually determined base weights. 9

10 Position Determination The rule for the directional or neutral positioning regarding long, short, or flat/neutral positions can be summarized as follows: The index employs a multi-iterative methodology to determine positions. The initial determination for long positions occurs when a component's current price input is equal to or greater than its specified moving average. This is inter-related to past market and price inputs; conversely, short positions are determined by moving average and a long term moving average of the past price inputs. A flat/neutral position determination is indicated when both the proprietary short term and long term provide a conflicting signal. For commodities and currencies, the initial result is weighed against a multi-factor model to further quantify the position based on the prevailing market inputs. The remaining financials and volatility exposures do not employ a multi-factor comparison, and are therefore purely price driven. The trade activity date is when the contracts are executed, which is the last business day of each month If the market for a position closes at limit (up or down), the trade will be executed at the opening of the first day that it opens for trading. 10

11 Contract Maintenance The A.I. Managed Futures Volatility Index is a tracking index of futures contract price trends, and futures contracts have limited durations. Consequently, in order for the index to be calculated an ongoing basis, it must change (or roll) from tracking contracts that are approaching expiration to tracking new contracts. Currently, each contract has two to four roll periods each year and its own "roll pattern" based on historical liquidity. The following rules are observed in rolling from an expiring contract to the next contract: The non-currency component contracts are rolled over from the current contract to the next contract beginning with the activity date for the month that is two months before the current contract matures. The currency contracts are rolled over from the current contract to the next maturing futures contract four times per year as of the activity date for the month prior to the contract's final maturity month. 11

12 Index Committee In order to provide for the smooth functioning of the A.I. Managed Futures Volatility Index, the Index Committee will make any decisions that cannot be systematized either semi- annually (June and December) or on an as needed basis. The Index Committee will implement the established methodology or determine a new policy if market conditions warrant change. For example, it is unclear how long the U.S. Treasury 10 year Note contract will remain viable if the U.S. government were to announce that it will no longer issue 10-year notes. Alternatively, an exchange might substantially change the contract terms or even discontinue trading a component contract. In each case, the Index Committee would determine any component or weighting changes. The Index Committee does not, however, use discretion to affect performance. Ultimately, the goal is to maintain liquidity and low volatility in the index.. 12