CTA Cocktail - part one. 

FXVol Alternatives Research  Notes

"...Nor has the bad news been confined to equities. This year the value of all manner of risky investments, from corporate bonds to commodities to hedge funds, has been clobbered. The belief that diversification into "alternative assets" could prevent investors loosing money in bear markets has been proven false. And of course housing..."

from The Economist 12 Dec 2008.  

The Economists' sweeping indictment of the alternative investment industry while in broad measure true, nevertheless  fails to mention that some alternative strategies did live up to the promise of providing un-correlated, absolute returns to traditional investments in 2008. Most notable as a group, and perhaps the least well-understood  was the general out-performance of CTA's or Commodity Trading Advisors. 

Commodity trading advisors are licensed  investment managers that trade primarily on the worlds futures exchanges, in  Chicago, Sydney, Tokyo, Singapore, London and elsewhere.  They are often misconstrued as being purely commodity-based,  however this is no longer the case  as over time,  the worlds futures exchanges have substantially expanded their product mix.  In addition to trading both soft and hard commodities CTA's can now take short and long term trading positions  in bonds, precious metals, foreign exchange, energy, and stock index futures and options. Most of them are looking to capture long term price trends that can last anywhere from a few weeks to several months, however a smaller group are trying to exploit counter-trend price action or short term market anomalies that may only last a few hours or at most a few days. The market environment in which CTA's do well, and often the systematic investment styles they follow are not easily understood to the general public. Despite their significant diversification away from commodity markets, CTA's type investments are often viewed as speculative, risky, and volatile. CTA's are generally perceived as traders rather than as investors. However, this distinction is important, because it is the trading vs. investing investment philosophy  that is the real source of their ability to add value to a dedicated long-only portfolio. CTA's are not biased to being long or short any particular market or asset class. They have the ability to go long or short as their systematic models dictate. For example, many systematic CTA's remained generally long commodities up to the middle of 2008 as the multi-year commodity bull market remained in full swing. However most of these CTAs  posted sharp losses in July and August as commodity peaked and then suffered a sharp pull-back. And, given the magnitude of the price decline many CTAs commodity positions went from long, to flat to increasing short as the slide continued. By the later part of the autumn as the commodity prices continue to slide most CTA's had recouped their summer losses and went on to finish the year with historic gains. In contrast, many endowments and pension funds investors who were passively long commodities suffered sharp losses  having bought into the idea that we were in a multi-decade bull market.  In effect, the outsized returns provided by CTA's and managed futures in 2008 were obtained because these managers followed a trading rather than investing methodology. 

As a consequence the stigma that is often  attached to CTAs and managed futures traders many now finally be lifting  given the flat performance of equities over the past ten years and the substantial underperformance of long-short equity hedge funds in '08 relative to the managed futures.    

As an  example, an investment of $1,000 dollars in the S&P 500  index in January 1998 had by November 2008 appreciated to slightly less than $1,050 -- an average annual return of less than 0.50%.  An identical investment in the Barclays Hedge Fund Index would have appreciated to approximately $2,464 over the same period or generated an average annual return of roughly 9.4%. While hedge fund managers have, as a group, outperformed a strategy of  passively holding the index,  these statistics don't reveal is that hedge fund returns have become increasingly positively correlated with the index as a whole. From 1998 to 2008 the correlation of the S&P 500 with the Barclay HFI has been +.75 -- thus undermining (to some degree) the  argument that they are in the business of providing uncorrelated, absolute return strategies. And in a  market like 2008 of enormous equity  market stress the correlation has risen still further. Year-to-date the S&P 500 is down roughly 39%, while  the Barclays HFI has declined by approximately  22%. (see chart below)

2008 will likely be a break-out year for the managed futures & CTA industry not only because they were able to generate significant returns, but because the industry did so at a time when traditional long-only as well as  long-short hedge fund returns were sharply negative. What is more, according to a recent Credit-Suisse report, CTA's were only one of  two performing sectors within the Credit Suisse Hedge Fund Index in 2008 (the other being dedicated equity short sellers). Year-to-date the Barclays CTA index has gained approximately +12.49%, the BT50 index is up +12% and the IPR40 (an index of larger CTA's) has returned +12.42%. 

The second chart below is the same as the one above except here we've added-in the returns from the index of larger CTA's or the IPR40 Index. 

The correlation of the IPR40 with the S&P 500 over the ten year period  was -0.27, and the correlation of the IPR40 with the Barclays Hedge Fund Index was -0.07. From 1998 through to 2000 equity and hedge fund returns outperformed CTA or managed futures, while from 2007 to the end of 2008  managed futures have significantly outperformed stocks. While hedge fund returns have become increasingly positively correlated to the S&P500, managed future and CTA returns have been moving in the opposite direction.  It has become increasingly clear that managed futures are a better stand alone diversifier for a long-only portfolio than hedge funds -- and, over all time frames.  This year,  during a period of extreme market stress and volatility, managed futures and other systematic CTA type strategies were able to provide protection for equity market portfolios at a time when hedge funds as a group failed to do so.  

The key to achieving consistent returns in the managed futures space and tempering volatility is through portfolio construction. The right  mix of uncorrelated  CTA type strategies can mitigate volatility,  reduce draw downs, and generate significant long run growth of capital. But, choosing the right combination is important because not all CTAs are implementing similar or even correlated investment styles.  Surprisingly, in 2008,  there we actually a few trend followers that posted negative returns. At the same time despite enormous volatility and huge trends,  there were some short term counter-trend strategies that did well. Less surprising was the underperformance of  volatility or option-based short sellers. Option based short sellers were essentially betting on range-trading markets or consolidating price action (when, for example a stock stays within in a high/low range) and by implication lower volatility. The  extreme volatility witness across all asset classes in 2008 (stocks, bonds, currencies, and commodities)  severely undermined option short-sellers in 2008 and many of them have or will close down. 

In the second part of this report will demonstrate how such a portfolio can be constructed. It would be made up of a mixture of three highly systematic & diversified  CTA investment styles:

1)  a highly diversified long-term trend following system with a holding time that can last months and in a few cases exceed one year.

2) a short term single stock index counter-trend program with a holding time that averages no more than a week, and 

3) a  highly diversified, limited-loss FX volatility mean reversion program with an  average holding time of a few months. 

Of course, the downside of diversification is that you will be giving back some of the outside gains that each individual strategy may deliver if all the stars on in alignment for that particular strategy, be in trend following, counter trend or volatility arbitrage. But the upside is the potential of owning a portfolio that consistently delivers superior returns to equities without the kind of volatility that is usually associated with the CTA or managed futures space. 

If you would like to see this research please send me an email at my address below : 

James Rider    Email : jr@fxvolresearch.com

For Further Reading: Finding Stable, Predictable Returns in Times of Extreme Market Stress (R. Austrup Integrated Managed Futures)