Commodity Trading Advisors are better used as portfolio diversifiers than employed as a mechanism to produce strong returns. David Smythe explains.
Hedge funds that trade in derivative instruments – whether they are futures, forwards or options – are known as Commodity Trading Advisors (CTAs). Within the alternative investment industry they are also known as Managed Futures. CTAs manage clients’ assets by employing a proprietary trading system.
There is a variety of different trading styles amongst CTAs, but broadly speaking they can be classified as either systematic or discretionary.
Systematic models tend to use a quantitative approach – mostly automated – and use technical analysis to evaluate momentum. They can use a spectrum of timeframes (long and short) and can use moving averages, break-outs of price ranges, or other technical rules to generate buy and sell signals. Position sizes are generally small (0.5 per cent to 1.5 per cent), protective stops are generally used, and most portfolios are typically globally diverse across multiple markets (generally up to 50).
Discretionary models tend to use a qualitative approach, use fundamental data and rely on personal experience/judgement for the basis of their trading decisions. Rarely are two discretionary models alike, with specialisation common (that is, a focus on commodities, currency et cetera).
CTAs tend to take long and short positions in futures contracts, offered worldwide, such as equity indexes (S&P futures, FTSE futures et cetera), soft commodities (cotton, cocoa, coffee et cetera), metals (gold, silver), grains (corn, wheat et cetera), foreign currency and government bond futures.
CTAs trade in highly liquid, regulated, exchange-traded instruments, which allow the portfolio to be “marked-to-market” daily.
Due to the fact that CTAs mostly use complex quantitative strategies and are reluctant to describe their systems in detail, some investors hesitate to invest in the sector. In reality Zenith has found that CTAs, at least conceptually, are not complex, and in their simplest form use price trend models. Some investors have labelled CTAs “black boxes”, but in a post-GFC environment where transparency is paramount, most CTAs are now available in an individual managed account where positions are disclosed on a daily basis.
The charts above illustrate the current market share of the CTAs/Managed Futures and Macro sectors and their movements over the past three years. The sector has grown 50 per cent over this period, from 8 per cent to 12 per cent of the alternative investment market, much of which is likely to be due to a stellar 2008 calendar year, which saw it top the sector performance league tables as the best-performing strategy with a 10.98 per cent return.
It was one of only two hedge fund sectors to produce a positive return result in a year in which global stockmarket dislocation occurred in the aftermath of the GFC – the other was Convertible Arbitrage. Mainstream growth-oriented benchmarks were generally all negative and included the following returns: -53.99 per cent for the S&P/ASX 200 Property Accumulation Index; -38.93 for the S&P/ASX 300 Accumulation Index; and -24.92 per cent for the MSCI World ex Aust $A Index.
The following analysis will conclude that a diversified investment portfolio which incorporates an allocation to Managed Futures has historically offered a superior distribution of returns when compared with a portfolio which comprises traditional asset classes only.
Comparing the distribution of returns of Managed Futures with the returns of a balanced model portfolio comprising 30 per cent Australian equity, 20 per cent global equity, 10 per cent property, 35 per cent fixed interest and 5 per cent cash shows that both are positively skewed relative to a normal distribution.
But CTAs/Managed Futures exhibit “fatter tails” – that is, a larger-than-expected number of extreme returns – and the extreme returns are more likely to be positive than negative. This acts like a long call option where the downside risk is limited and there is optional potential upside. This can be attributed to the fact that approximately 70 per cent of CTAs have a trend-based approach, which delivers strong returns when markets are trending and attempts to limit losses during sideways markets.
A common measure of the health of volatility is the “tail ratio” – the sum of all +4.0 per cent or greater returns divided by the sum of all -4.0 per cent or worse returns.
The tail ratio for CTA/Managed Futures was 6.33; the equivalent for the balanced model portfolio is only 0.87. This highlights the “good” volatility in Managed Futures. A simple volatility measure, like standard deviation, overstates the risk of loss. By comparison the standard deviation figures for CTAs/Managed Futures and the model portfolio are 11.28 per cent and 6.84 per cent respectively.
Examining the correlation of CTA/Managed Futures with mainstream asset classes over a 20-year period indicates that historically, CTA/Managed Futures have presented a zero to negative correlation with equity markets and a low correlation with property/fixed interest markets. CTAs have historically had a low to negative correlation with stock and bond markets. This can be attributed to the fact that economic and political uncertainty can have a negative impact on markets but a positive influence on the prices of currencies and commodities – a potential profit opportunity for CTAs.
The table above drills further into the correlation data and examines the 10 worst quarters for the S&P/ASX 300 Accumulation Index over a 20-year period and compares this to how the HFN CTA/Managed Futures Index has performed in the corresponding period.
