We have another “buy the drawdown” signal for all you managed futures investors out there who love getting involved in a managed futures program at a discount. This time around, the popular Dominion Sapphire short term multi-market program is experiencing some tough times, and much like those newscasters who make a career out of reporting from hurricanes while the public is running the other way, we see the storm of a drawdown as a great opportunity to add value to your managed futures portfolio.

Here is the skinny on the Dominion drawdown:

As you can see above, after bouncing up nearly 6% from their Max DD of -13% in January of 2011; Dominion has struggled in the volatility of the past two weeks to lose that gain and return right back down to that -13% Max DD number.  And while others may be sounding the alarm bells, we’re saying now is the time to get in or if already in, increase your allocation. [Disclaimer: Past performance is not necessarily indicative of future results.]

Besides our general belief in investing in good programs in Drawdown (see here), we like this drawdown in particular because of how Dominion trades and their pedigree.  Being a short-term trader who risks small amounts on each trade, this drawdown isn’t from a single trade gone bad or bet against volatility or the like, but the result of being wrong more often than right over a higher than average time span.

What we like about that scenario is that all that is required to pull the program out of drawdown is a reversion to the mean in their winning percentage.  They don’t need volatility to shrink, trends to emerge, the Greeks to get bailed out,  or a large bet to go their way  – they just need a few more winners.  It is like a baseball player in a hitting slump – where each strikeout seems like they will never get another hit, but a few hits brings them right back to their long term average.

So, what is going on here? Why is a program that is regarded by many in the industry as a short-term trading benchmark (the program is included in the Newedge AlternativeEdge Short-Term Traders Index) performing so poorly? In our conversations with Dominion, they believe a volatility mismatch is to blame for the poor performance.

…. during the past 2 weeks, erratic volatility has ruled the markets and created a difficult trading environment for our models. The pattern is one where the intraday price swings are unusually large compared to longer term average daily ranges. We’ve seen an unusual amount of markets make new highs during a morning session and then proceed to reverse and test new lows prior to the close. The momentum we look for in a short term trade has been lacking follow through and conviction.

Although we are unsure of the exact cause of this type of market action, we do have our suspicions. Political influence in the market place, government and central bank participation, high speed algo trading, instability of global capital markets, are all possible candidates for being the underlying momentum killers that are causing a difficult time for our strategy.

We have several remedies for this difficult environment. [One]  As a key part of our risk management process, we dynamically reduce exposure/leverage to markets that are losing. If a bad environment persists in any given market or model, the risk we allow per trade will begin to decrease. [Two] Our research is leading us to employ more models that can trade through the intra day noise. By extending our horizon and adding models with varying time frames (all still considered short term momentum models) we think we may be able to avoid the chop and noise that has been causing us problems.

We have seen a similar lack of “follow-through” in the markets affect other short term programs and intraday trading systems over the past few weeks, and can see exactly what Dominion is talking about. Much like a golf swing or tennis serve that requires a complete rotation from start to finish for a successful shot, short-term traders require that the market momentum that initiated the trade continue through the end of the trading day / opportunity window to have success.

If the market is rarely closing near the highs (if long) or lows (if short), that means there are lots of intraday reversals (imagine Dow up 200, then down 50, then closing up 75 for the day to picture what intraday reversals look like). That sort of back and forth creates havoc for systematic programs designed to identify short term breakouts (say when the Dow is up 100) and risk a small amount on the trade (say risking back to Dow up 25). The high level of intraday volatility creates many false short term breakouts which see the models get in and shortly after get stopped out.

So, where does intraday volatility go from here? That is the question which will determine how long it takes for Dominion to snap back from this drawdown. There is no guarantee that the conditions plaguing diversified short-term traders will disappear any time soon, and if it is a result of High Frequency Trading it could be here to stay.

But to us, the better bet is following the logic that nothing stays the same for very long when it comes to financial markets. Part of being a successful investor in our opinion is identifying opportunities as they arise, and lowering risk where possible.  In this case,  we don’t see the drawdown for Dominion going much past -20% because to do so would mean an outlier continuation of an already outlier losing streak. That means an investor with the gumption could buy into this drawdown, risk down to -20% (another 7% of drawdown or $70,000); and target a return of 13% ($130,000) should the program regain new equity highs, and $100,000 to $125,000 per year after that should Dominion return to their winning ways.

To us, that is as good of a risk/reward scenario as you are likely to find, and all with a world class operation. Barry Ritholtz talks about valuing process over short term results, and this is a clear case (to us) of investing in a manager with poor short term results despite a good process.