Financial Commodity Investments (FCI) Alternative Investments/Managed Futures Blog

TIP SHEET: Looking Not For Value, But Rather The Overvalued

By Tom Sellen

(Dow Jones)–Not that he’s contrarian, but Craig Kendall and his staff have a way of viewing the markets that sets them apart from traditional investors.

“So many people ask where is the next value play,” said Kendall, president of Financial Commodity Investments, Inc., based in Herndon, Va. “Another way of looking at it is to ask what stuff is currently way overvalued.”

Financial Commodity Investments offers two funds, an Option Selling Strategy fund and a Credit Premium Program fund, both of which are designed to make money by collecting premiums off derivative contracts that are sold.

One needs to look no further than the U.S. stock market for an example of Kendall’s philosophy of overvalued trading. The slowing U.S. economy is limiting investment opportunities in equities because they are viewed as expensive in the current weak environment. Those opportunities will increasingly be viewed as “way overpriced” once investors realize they will not make large and quick returns as they had in the past, he said.

Though companies will grow, they will do so at a much slower rate, making it virtually impossible for investors to meet their original growth targets, he said. Investors will continue to exit equities, leading to further losses.

However, “those that invest ‘outside the box’ realize that positive returns can also be achieved even during overvalued conditions,” said Kendall.

He launched the OSS fund in 2004 and the CPP in 2006. The funds trade a diversified group of liquid commodities, evening out and buffeting against potential risk that would likely be amplified if they were trading just one or two markets. The funds’ strategy incorporates both chart-based and fundamental inputs. (While Kendall said he is happy to discuss his trading strategy, he added that there is a risk in trading and stresses past performance is no indication of future results.)

Gaurav Gupta, portfolio manager, says the OSS fund focuses on selling naked options on liquid commodities, including gold, silver, soybeans and livestock. It targets positive returns of 1% to 3% a month.

Fund tracker BarclayHedge ranked the OSS fund a top-20 performer during the five years ended March 2010.

The CPP is also an options selling program, but it sells vertical credit spreads and targets stronger monthly returns of 3% to 7%. Instead of seeking options that are further away from the money, the CPP gets closer to the money and hedges all positions against adverse price movements.

An example of a vertical credit spread: selling August crude $90 calls and simultaneously buying September crude $100 calls, with the premium collected equal to the difference between the premiums on the two options. Like the OSS program, the CPP looks to sell spreads in commodity markets that have above-average volatility.

Extreme volatility, like the kind that wreaked havoc among hedge funds and markets in 2008, also hurt Kendall’s funds. The OSS fund lost 23.02% that year, while the CPP gained just 6.94%.

The funds have since bounced back. The OSS fund has gained 21.57% in 2010 through June, data from Barclay Hedge showed. In 2009, the fund saw returns of 38.9%.

The CPP fund is up 9.37% this year through June, after being up 29.04% in 2009. By comparison, the Barclay CTA Index, an industry benchmark representing the performance of commodity trading advisers, is down 1% through June.

Since the Dow Jones Industrial Average is down 10% from the late-April highs, Gupta said it’s best to avoid equities and invest in cash instead. “The [equity] market could drop another 15% from here,” he said.

Speculation that the U.S. economy could sputter into a double-dip recession and the increased fear of deflation–after a string of weaker-than-expected manufacturing, home sales and jobs reports–mean that commodities will likely suffer due to decreased demand, he said, adding that is another reason to be in cash.

Gold has often been viewed as a safe-haven investment in times of economic strife, and the market did vault to record highs in June, but traders have recently dumped the yellow metal and sought out cash investments instead.

“If you listen to CNBC there’s a lot of people saying to invest in gold, and obviously gold has gone up quite a bit in the last two years,” said Gupta, “but I think a top in gold would be close as well.”