Managed futures (CTAs) are non-correlated to equities and tend to be negatively correlated in times of volatility making them an important part of any portfolio, writes Don Steinbrugge.
Managed futures are one of only a very few hedge fund strategies that performed well throughout the market selloffs of 2000-2002, 2008 and the first quarter of 2020. Yet, investor’s perception of trend following, the most widely represented strategy within the managed futures space as accessed through Commodity Trading Advisors (CTAs), is more divergent than any other major hedge fund strategy.
Many investors view the strategy as simply black box models that they cannot understand or properly evaluate. Other investors view CTAs as one of the purest hedge fund strategies that has very low correlation to long only equity, fixed income and other hedge fund strategies, thus providing valuable diversification benefits. Advocates of managed futures have helped propel the strategy to approximately 10% market share of the hedge fund industry with $318 billion in assets as of Jan. 1, 2020 according to database BarclayHedge. 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 have investors allocated such a large percentage of industry assets to the strategy?
- What is the underlying philosophical basis of the strategy?
- What are some of the things to consider when selecting a CTA?
Will try and knock this off one by one.
What is a CTA? CTA stands for commodity trading advisor, a regulatory designation from the Commodity Futures Trading Commission for futures brokers managing money trading futures. While CTAs can utilize any of a dozen strategies and focus on financial or physical commodity futures contracts, a significant portion of CTAs are systematic diversified trend followers, which can be defined as quantitative investment strategies that buy or sell futures contracts across four primary markets: commodities (metals, energy, grains, meats & softs), currencies, equities and interests rates. Some CTAs are very specialized and only trade in a few sub-markets while others are highly diversified allocating across over 140 different markets. The CTA marketplace is highly competitive with thousands of offerings. The strategies used by these firms vary widely between those using fundamentally based models to those that are purely quantitatively driven. Strategies are applied across various timeframes.
Why have investors allocated such a large percentage of industry assets to the strategy? Perhaps a better question is why it is not more. During the financial crisis of 2008, managed futures was basically the only asset class that performed well. Obviously, traditional investments tied to the broad market tanked but many equities based alternatives that claimed to be non-correlated performed poorly as well. Pension funds learned that their portfolios were not as diversified as they had believed. This led to growth in the CTA industry. Correlations between fundamentally based long-only and hedge fund strategies are dynamic. They frequently exhibit a negatively skewed performance distribution with correlations increasing dramatically during market selloffs, just when investors want 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%, U.S. 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 these strategies caused carnage across investment portfolios, the Barclays CTA index was up over 14%. We expect the demand for CTAs to increase again based on how well some of them performed during the selloff in the first quarter of 2020.
Unlike most fundamentally based long only and hedge fund strategies, many trend following CTAs have exhibited positively skewed performance distribution. This is due to their dynamic correlation to the equity markets which has been positively correlated in up markets and negative in down markets (the Newedge CTA index was positive in four of the last five calendar years in which the S&P 500 posted negative returns: 2000, 2001, 2002, and 2008, but not 2018). This dynamic has been driven by their systematic models which are designed to make money based on trends in markets and their ability short markets as easily as going long. This means that the diversification benefits of CTAs are not entirely explained by their average correlation over time. A better statistic to look at is the skewness of their performance distribution and how their correlation changes in both up and down markets.
Other attributes investors find attractive about CTAs include:
Liquidity: Most CTAs trade only in liquid, transparent futures contracts and typically allow their investors monthly and often weekly or daily liquidity. In addition, gates and suspension of redemptions are highly unusual for those CTAs focusing on liquid markets.
Transparency: Many CTAs provide complete transparency of underlying positions and typically welcome separately managed accounts. In addition, their largest weightings and performance can be understood intuitively. That is to say, depending on the CTAs time horizon, after a trend has been established either up or down, one can conclude that a trend following strategy has a significant long or short position in that market. 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, which offer an institutional infrastructure with large teams in research, technology, operations, legal, and compliance.
Controlled risk: Most of the leading CTAs have highly sophisticated risk management systems that target a specific volatility of performance by weighting positions based on risk parity. Many are constantly updating their models based on changes in volatility and correlations of the markets in which they invest. Also, investors can often choose a weighting that fits their risk profile; meaning you can ramp up or down your exposure. In contrast, most fundamental managers will typically allow the volatility of their fund to fluctuate with the volatility of the markets in which they are invested.
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 (though this is changing and trend following itself has much more diversification that correlation models would indicate). The basic philosophical belief behind these strategies is that markets trend over short and medium time periods and by identifying these trends early, investors can make money regardless of market direction. Pure trend following CTAs believe that markets begin to move before the drivers are reflected in the fundamental economic signals and that by the time all the fundamental data is available the markets have already moved. They also believe that trends are enhanced by human emotion, which causes markets to rise above intrinsic value when investors are confident in the market. Conversely, investors’ disproportionate aversion to losing money drives markets far lower than intrinsic value during market sell-offs. The bottom line is that trend following CTAs’ performances is not driven by fundamentals, but by how strong trends are in the futures markets either up or down, and often human emotion causes these trends to go further than the fundamentals would indicate, which is beneficial to these models. CTAs tend to do poorly in non-trending, choppy markets when fundamental strategies may do well as we saw for long stretches of time over the past decade.
What are some of the things to consider when selecting a CTA? There is a large dispersion in performance across CTA managers. As is broadly the case with all hedge fund or mutual fund strategies, a vast majority of CTAs do not justify the fees they charge. It is very important to identify managers of the highest quality among the thousands of CTAs in the marketplace. Investors should consider using multiple evaluation factors to select the appropriate CTA managers which include:
Size and quality of investment team: While many successful CTAs are run by a small team, it is important that they have the bandwidth to update their models and have the ability to conduct proper due diligence. However, a red flag for managers is still drift so large shifts in models is not a good sign.
Research process: Another important issue is how much transparency into the process fund managers provide to investors. Can they clearly articulate the inefficiency in the market they are targeting and what their differential advantage is in capturing that inefficiency?
Any CTA you consider should be registered with the National Futures Exchange (NFA). Before investing in any CTA go to NFA Basic portal to research the CTA. Any regulatory issue or charge against that CTA will be there.
Donald A. Steinbrugge, CFA, is Founder and CEO Agecroft Partners, LLC.
donsteinbrugge@agecroftpartners.com; www.agecroftpartners.com
