CTA’s 'positively skewed' performance helps reduce tail risk in a diversified hedge fund portfolio
By Don Steinbrugge, Agecroft Partners – Commodity Trading Advisers (CTAs) are one of only a few hedge fund strategies that performed well throughout the market selloffs of 2000-2002, 2008 and 1st Q of 2020. Yet, investor’s perception of the strategy is more divergent than any other major hedge fund strategy.
Many investors view the strategy as “smoke and mirrors” using black box models that they cannot understand or properly evaluate. Other investors view CTAs as one of the purest hedge fund strategies that has very low correlation to long only equity, fixed income and other hedge fund strategies, thus providing valuable diversification benefits. Advocates of CTAs have helped propel the strategy to approximately 10 per cent market share of the hedge fund industry with USD318 billion in assets as of 1/1/2020 report by BarclayHedge. The strategy also boasts many of the largest hedge funds in the world. This brings us to the following questions:
What is a CTA?
The term CTA or commodity trading advisor broadly refers to quantitative investment strategies that buy or sell futures contracts across four primary markets: commodities (metals, energy, agriculturals), currencies (dollar, yen, euro, pound), equities (S&P 500, Nikkei, DAX, FTSE) and interests rates or sovereign bonds (10-year US treasuries, JGB’s, Bunds, Gilts). Some CTAs are very specialised and only trade in a few sub-markets while others are highly diversified allocating across over 140 different sub-markets. The CTA marketplace is highly competitive with approximately 1000 offerings. The strategies used by these firms vary widely between those using fundamentally based models to those that are purely quantitatively driven. There are also two major categories in investment time horizons within the industry broadly divided between: short-term, turning the portfolio over weekly, daily or intra-day and medium/long-term oriented, where the average holding period is a couple of months.
Why have investors allocated such a large percentage of industry assets to the strategy?
During the financial crisis in Q4 2008, many pension funds learned their portfolios were not as diversified as they previously believed. This led to a sharp increase in growth in the CTA industry. Correlations between fundamentally based long-only and hedge fund strategies are dynamic. They frequently exhibit a negatively skewed performance distribution with correlations increasing dramatically during market selloffs, just when investors want correlations to be low. Many investment committees were shocked when they received their 2008 year end performance report which showed their emerging market equity managers down over 50 per cent, US equity managers down approximately 40 per cent, high yield fixed income mangers down close to 30 per cent, the DJ-UBS Commodity Index down 35 per cent and the average hedge fund manager down in the high teens. While all these strategies caused carnage across investment portfolios, the Barclays CTA index was up over 13 per cent. We expect the demand for CTAs to increase again based on how well some of them performed during the selloff in the 1st quarter of 2020.
Unlike most fundamentally based long only and hedge fund strategies, many trend following CTAs have exhibited positively skewed performance distribution. This is due to their dynamic correlation to the equity markets which has been positively correlated in up markets and negative in down markets (the Newedge CTA index was positive in four of the last five calendar years in which the S&P posted negative returns: 2000, 2001, 2002, and 2008, but not 2018). This dynamic has been driven by their systematic models which are designed to make money based on both bull and bear trends in markets. This means that the diversification benefits of CTAs are not entirely explained by their average correlation over time. A better statistic to look at is the skewness of their performance distribution and how their correlation changes in both up and down markets.
Other attributes investors find attractive about CTAs include:
Liquidity: Most CTAs trade only in liquid, price-transparent futures contracts and typically allow their investors monthly and often weekly or daily liquidity. In addition, gates and suspension of redemptions are highly unusual for those CTAs focusing on liquid markets.
Transparency: Many CTAs provide complete transparency of underlying positions and typically welcome separately managed accounts (SMA’s). In addition, their largest weightings and performance can be understood intuitively That is to say, depending on the CTAs time horizon, after a trend has been established either up or down, one can conclude that a trend following strategy has a significant long or short position in that market. The largest position weightings are likely to be in markets that have demonstrated the most robust trends.
Institutional infrastructure: Many of the leading CTAs are mature and well-developed businesses, which offer an institutional infrastructure with large teams in research, technology, operations, legal, and compliance.
Controlled risk: Most of the leading CTAs have highly sophisticated risk management systems that target a specific volatility of performance by weighting positions based on risk parity. Many are constantly updating their models based on changes in volatility and correlations of the markets in which they invest. In contrast, most fundamental managers will typically allow the volatility of their fund to fluctuate with the volatility of the markets in which they are invested.
What is the underlying philosophical basis of the strategy?
The CTA industry is highly diverse, but most of the assets have flowed to managers that use market trend following models. The basic philosophical belief behind these strategies is that markets trend in the same direction over short and medium time periods and by identifying these trends early, investors can make money regardless of market direction. Pure trend following CTAs believe that markets begin to move before the drivers are reflected in the fundamental economic signals and that by the time all the fundamental data is available the markets have already moved. They also believe that trends are enhanced by human emotion, which causes markets to rise above intrinsic value when investors are confident in the market. Conversely, investors’ disproportionate aversion to losing money drives markets far lower than intrinsic value during market sell-offs. The bottom line is that trend following CTAs’ performances is not driven by fundamentals, but by how strong trends are in the futures markets either up or down. They also can do poorly in non-trending, choppy markets when fundamental strategies may do well as we saw for long stretches of time over the past decade.
What are some of the things to consider when selecting a CTA?
There is a large dispersion in performance across CTA managers. As is broadly the case with all hedge fund or mutual fund strategies, a vast majority of CTAs do not justify the fees they charge. It is very important to identify managers of the highest quality among the approximately one thousand CTAs in the market place. Investors should consider using multiple evaluation factors to select the appropriate CTA managers which include:
Firm assets under management - Investors might want to consider investing in managers within the mid-sized asset range of USD500 million to USD10 billion. This asset size is big enough to support the substantive expense of the research team and analytics, but not too large that alpha might be diluted over a growing asset base.
Size and quality of investment team - One of the keys to running a successful CTA is to constantly enhance proprietary models. If left static, the models’ effectiveness erodes, causing a decline in performance. As a result, it is important to hire a CTA with a well-developed research team.
Research process - Another important issue is how much transparency into the process fund managers provide to investors. Can they clearly articulate the inefficiency in the market place they are targeting and what their differential advantage is in capturing that inefficiency?
Skew adjusted returns - Most investors tend to adjust returns by volatility. However, this does not tell the full picture as volatility can be highly unstable, especially during crisis periods. A more appropriate way to look at CTAs is to analyse the skewness in performance distribution and correlation in down markets, since diversification is one of the main reasons investors allocate to CTAs. Because CTA models (and organisations) tend to evolve over time, it is important to put greater emphasis on more recent short and medium term performance when examining a firm’s historical track record.
Finally, for investors that invest in CTAs, there are significant diversification benefits to investing in both a long and short term CTA. These benefits include capturing uncorrelated returns, diversifying the systematic portion of a portfolio, and reducing the potential drawdowns in performance.
In summary, CTAs had growing success over the past decade in gaining credibility with institutional investors. These investors have been drawn to their uncorrelated return stream. In addition, for some CTAs, their performance has historically experienced good dynamics by increasing in correlation during up markets, and becoming negatively correlated in protracted down markets. If an investor decides to invest in CTAs, it can be advantageous to view the strategy as a long-term portfolio diversifier, rather than trying to market time when they think CTAs will be in or out of favour. Employing multiple evaluation factors when selecting mangers and considering diversifying across multiple managers may lead to optimal results.