By Don Steinbrugge
Commodity trading advisors’ (CTAs) perception among investors is more divergent than any other major hedge fund strategy. A large percentage of 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 is uncorrelated to long only equity and fixed income indices, as well as other hedge fund strategies; thus providing valuable diversification benefits. Advocates of CTAs have helped propel the strategy to a 12% market share of the hedge fund industry at approximately a quarter trillion dollars in assets. The strategy also boasts many of the largest hedge funds in the world. This brings us to the following questions:
- What is a CTA?
- Why do many investors think trend following CTAs are a bunch of Mumbo Jumbo?
- What is the underlying philosophical base of the strategy?
- Why have investors invested such a large percentage of industry assets to the strategy?
- What are some of the things to consider when selecting a CTA?
What is a CTA? The term CTA or commodity trading advisor refers primarily 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 specialized and only trade in a few markets while others are highly diversified allocating across over 140 different markets. The CTA marketplace is highly competitive with approximately 1000 offerings for investors to choose from. The strategies used by these firms vary widely between those using fundamentally based models to those that are purely quantitatively driven focusing on market trends. There are also major differences in investment time horizons with some firms being very short term orientated, turning the portfolio over a few times a week or even intra-day to others that are long-term oriented. Despite this broad range of alternatives among CTA strategies, most of the assets are concentrated in a few firms that focus the majority of their strategy on identifying medium-term market trends.
Why do many investors think trend following CTAs are a bunch of mumbo jumbo? The primary reason is that most investors do not understand why they work or are not confident they will continue to work in the future. CTA investment strategies are very different and sometimes counter to what most investors are used to evaluating. Most investors allocate all of their assets to either discretionary fundamentally based investment managers whose strategies focus on adding value through bottom up security selection or index funds. Pure trend following CTAs believe that the markets are efficiently priced and that fundamental information of markets or individual securities is irrelevant.
Many investors also find it difficult to evaluate and differentiate between the broad array of CTA firms and strategies in the market place which causes them to put off making a decision to invest indefinitely. Other investors have seen that CTAs historically have had periods where they outperform the market and other times underperform. As a result, they hold off on allocating until they are able to properly time when the strategy will outperform. Since this is potentially impossible to do, these investors also put off making a decision to invest indefinitely.
The bottom line is that if an investor does not understand how a strategy works they are very unlikely to invest.
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 by participating in these trends. The CTA industry has done significant research to show that markets have trended over time. These trends are created based on a number of factors including human emotion. For example, increased confidence in markets that are rising may cause markets to rise, at times, well above their intrinsic value. On the other hand, investors’ disproportionate aversion to losing money may drive markets significantly lower than intrinsic value due to increased selling. Other theories point to the fact that markets begin to move before it is reflected in the fundamental economic signals and by the time all the fundamental factors are available the markets have already moved.
Unlike most hedge fund strategies, trend following strategies have very low correlation to the capital markets. Some CTAs also have exhibited a historical dynamic correlation to the equity markets where they have been positively correlated in up equity markets and negatively correlated in down markets (the Newedge CTA index was positive in 2000, 2001, 2002, and 2008 which were the last four years the S&P posted negative returns). 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 correlation levels at a particular point in time. A better statistic to look at is their correlation in down markets minus their correlation in up markets.
CTAs tend to do well when strong trends are present in the futures markets either up or down and poorly in non-trending markets and during periods of sharp reversals.
Why have investors invested such a large percentage of industry assets in the strategy?
The discovery among many pension funds, during the 4th quarter of 2008, that their portfolios were not as diversified as they previously believed led to a sharp increase in growth in the CTA industry. Correlations between fundamentally based long-only and hedge fund strategies are dynamic and can dramatically increase during market selloffs, which is exactly when an investor wants 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%, their US equity managers down approximately 40%, high yield fixed income mangers down close to 30%, the DJ-UBS Commodity Index down 35% and the average hedge fund manager down in the high teens. While all this carnage was going on in their portfolios, the Barclays CTA index was up over 13%.
Other attributes investors find attractive about CTAs include:
- Liquidity: Most CTAs in general trade only in liquid, price-transparent futures contracts and typically allow their investors monthly liquidity. Some CTAs have even begun to offer weekly or daily liquidity. In addition, gates and suspension of redemptions are highly unusual for those CTAs focusing on the liquid markets.
- Transparency: Many CTAs provide complete transparency of underlying securities and typically welcome separate accounts. In addition, their largest weightings and performance can be understood intuitively That is to say, after a trend has established itself either up or down, after approximately one or two months, one can conclude that a trend following strategy has a long or short position in that market of significant size. 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, that are able to offer an institutional infrastructure with large teams in research, technology, operations, legal, and compliance.
- Controlled risk: Many of the leading CTAs have highly sophisticated risk management systems that target a specific volatility of performance. Their models are constantly being updated based on changes in volatility and correlations of the markets where they invest. Most fundamental managers will let the volatility of their fund fluctuate with the volatility of the markets where they are invested.
What are some of the things to consider when selecting a CTA? The big question left with institutional investors is how to differentiate among more than a thousand CTAs in the market place. Over the past five years, a majority of institutional investors have chosen to make their initial CTA investment in a small number of the largest fund managers in the industry, which has caused these CTA firms’ assets to swell significantly. The major problem with hiring mangers that have experienced such rapid growth is that you cannot participate in the historical performance that occurred before you invested in the fund. Although many of these managers state they continue to trade across a large number of markets, the fact is that the least liquid, but more diversifying markets may represent a smaller and smaller percent of their portfolio as they grow. Some may even alter their investment process or reduce the level of targeted volatility and returns in order to expand capacity.
Institutional investors should consider using multiple evaluation factors to select the appropriate CTA manager which include assets under management, size of research team, organizational infrastructure, research process, historical performance and risk controls. Instead of investing in the largest managers, investors might want to consider investing in managers within the mid-sized asset range of $1 billon to $10 billion. This asset size is big enough to support a substantive research team, but not too large that alpha may be diluted over a growing asset base.
One of the keys to running a successful CTA over time is to constantly enhance proprietary models. If left static, eventually 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. In evaluating their research process, one of the key factors to focus on is how much transparency into the process they provide to investors. Since CTA models and organizations 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. Another strategy gaining popularity among institutional investors is hiring a small basket of CTAs since individual CTAs can be volatile and among which differentiation can be challenging. Many investors prefer to spread their CTA allocation over smaller investments with two or three managers. The benefits include capturing the uncorrelated returns, while reducing the potential drawdowns in performance.
In summary, CTAs have come a long way over the past 5 years in gaining credibility with institutional investors. These investors have been drawn to their uncorrelated historical return stream compared with long only benchmarks as well as other hedge fund strategies. In addition, for some CTAs, their correlations have historically experienced good dynamics by increasing in correlation during up markets, and becoming negatively correlated in protracted down markets. By contrast, fundamentally based strategies’ correlations have experienced bad dynamics of increasing during market sell offs. If an investor decides to invest in CTAs, it can be advantageous to view the strategy as a long-term holding, rather than trying to market time when they think CTAs will be in or out of favor. Employing multiple evaluation factors when selecting mangers and considering diversifying across multiple managers may lead to optimal results.
Donald A. Steinbrugge, CFA, is the Founder and Managing Partner of Agecroft Partners, a global hedge fund consulting and marketing firm. Agecroft Partners has won 23 industry awards as the Hedge Fund Marketing Firm of the Year. Agecroft is in contact with over a thousand hedge fund investors on a monthly basis and devotes a significant amount of time performing due diligence on hedge fund managers. Don frequently writes white papers on trends he sees in the hedge fund industry, has spoken at over 80 hedge fund conferences, has been quoted in hundreds of articles relative to the hedge fund industry and is a regular guest on business television.