The growth of investments in CTA (Commodity Trading Advisor)
funds has been explosive. In 2003 alone, CTA investment growth
has been in the magnitude of 30% according to the Barclay
Group. Total CTA assets now exceed $66 billion. What is the
appeal of CTA strategies, and more importantly, what is the
outlook? This article will provide a definition of CTAs, differentiate
among the approaches to trading, and then discuss reasons
for their popularity. The conclusion will attempt to outline
what investors should and should not expect from a CTA investment.
CTAs and managed futures are synonymous. CTAs use a methodology,
either systematic (model driven) or discretionary (decision
driven) to trade a wide range of futures and indices. Core
markets for CTAs include equities, fixed income, currencies,
commodities, and spreads.
The majority of CTAs are trend-following, and references
to CTAs in this article will be to trend-followers. Trend-following
CTAs have time horizons that range from short term (several
hours to several days) to medium term (up to 30 days) to long
term (2-3 months). CTAs make money by identifying trends in
underlying markets and putting on trades that make money as
long as the trend remains in force. CTAs have very disciplined
risk management systems; when they implement a trend that
never materialises or fizzles, strict stop-outs will be initiated.
For this reason, CTAs are said to have a large optionality
component. A position is essentially a call on the continuation
of a trend; a stop-out represents the loss of option premium.
CTAs also lose money when a trend reverses. Because CTAs stay
in trends for periods, sometimes extended periods, after the
reversal of a trend, it is important for an investor to be
familiar with the CTA's approach to conserving profits before
trend reversals cause major profit give-backs, also known
If one thinks about the pattern of returns generated by a
CTA, it is clear that there are patterns of small losses (trends
that do not materialise), periods of large gains (trends captured),
and large drawdowns, as depicted below:
Two observations come to mind with respect to this pattern
of returns. Losses are usually small, virtually eliminating
the ugly "left tail" representing outsized losses.
Second, periods of market dislocations (stock market meltdowns,
capital crises) often result in large gains for CTAs. Incidentally,
these gains usually come when your portfolio needs them most.
If you look at the returns of a trend-following CTA such as
our fund, Quantimix, you will see large returns in May 1997
(Asian crisis), and August 1998 (Russian crisis, Long Term
This latter point highlights the greatest appeal of CTAs:
their non-correlation to other asset classes. The most important
correlation is the negative correlation to equity returns.
Significantly, as equity market downturns accelerate, that
correlation becomes more negative. Below is the correlation
of Quantimix returns to those of the major asset classes.
|Carr Barclay Index
|Lehman Aggregate Bond
|Russell 2000 Index
There are several additional reasons for the infusion of
assets into CTA strategies. There is no evidence that large
position implementations materially affect prices and no evidence
that an increase in position size adversely affects profitability
expectations. Contrast this with a long/short equity hedged
strategy; position implementation will compress spreads, with
larger positions exacerbating the compression and reducing
expected profitability. In addition, CTAs are free of the
interest rate constraints that limit the expected returns
of most relative value hedge fund strategies. Relative value
returns are usually a multiple of the risk-free return rate;
with the risk-free return rate hovering at 1%, the expected
return of most relative value strategies is in the 3%-7% range.
So where is the catch? Why doesn't everyone cash out their
other hedge fund investments and put it all into CTAs? One
reason is that the black box nature of many systematic strategies
is incomprehensible or undesirable to many investors, so they
avoid them. The biggest negative for CTA returns is their
volatility. While expected returns for most trend-following
CTAs are in the mid-teens, drawdowns can be of similar magnitude.
A short-term investment in a CTA can be painful, particularly
if made right before a major drawdown. The net result is that
even though expected CTA returns are robust, their volatility
causes many investors to view them as a tactical allocation
to protect against market dislocations. A kind of flu shot
for your portfolio.
Our firm views CTAs in a very different light. We use a diversified
CTA as a core manager, one with stringent risk management
and drawdown controls. We chose a manager that is diversified
across many markets and who utilises proprietary research
to uncover profitable new markets, instruments, and methodologies.
We further reduce the volatility of our CTA by employing an
overlay strategy whose returns are non-correlated to those
of the core manager. In this way, we hope to be the low volatility
provider of CTA returns, and by producing a steady pattern
of positive returns to become a core portfolio investment.
What of the future? The simple answer is that as long as
there are identifiable, tradable trends, the outlook for continued
positive returns from CTA strategies is good. Furthermore,
many investors are beginning to view CTAs as something akin
to a global macro strategy with a disciplined risk management
system in place. We also live in a more volatile world than
we lived in only a few short years ago. At the very least,
the possibility of market dislocations increases the value
of CTAs as insurance against these events. And finally, the
negative correlation of CTA returns to those from equity markets
confirms the validity of the strategy as a hedge against significant