Introduction to CTAs and their Role in Portfolio Allocations

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 as drawdowns.

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 Capital Management).

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.

Correlation Analysis

  Quantimix Carr Barclay Lehman Aggregate Russell 2000 S&P 500
Quantimix 1.00        
Carr Barclay Index 0.78 1.00      
Lehman Aggregate Bond 0.42 0.42 1.00    
Russell 2000 Index -0.40 -0.23 -0.21 1.00  
S&P 500 -0.53 -0.39 -0.27 0.67 1.00

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 equity exposure.