Time for investors to increase CTA exposure
CTAs are well suited to the current economic environment and when selecting these funds investors should pay close attention to past performance
CTA (commodity trading adviser)/managed futures funds make up the second largest hedge fund sector in the world with $320bn (Ä247bn) in managed assets acccording to BarclayHedge.com, having grown by an incredible 18 per cent per annum since 2001.
Sovereign wealth funds, pension funds and other institutional investors invest in CTAs because they can:
• boost risk-adjusted return of the client
portfolio
• reduce drawdowns
• apply rigorous risk management
• act scientifically and systematically in their investment approach
• display impressive liquidity
Besides the strategic reasons to invest in CTAs, there are currently also tactical reasons to increase exposure to CTA funds: markets have started to trend again – the risk on/risk off behaviour of the ‘new normal’ is gone; the valuation of equities, credits and government bonds has become quite stretched; the ratio between Barclay Trader Systematic (a CTA-index) and the MSCI World Total Gross Return in dollars is very near the all-time-low level again – this happened at the peak of the market in 2003 and 2007; the Federal Reserve’s quantitative easing is coming to an end; the financial market seems to underestimate the geopolitical risks; and CTAs do well when the volatility of the equity market increases. In other words, there are plenty of reasons to buy CTAs at this point in time.
Picking the winners
However, which CTAs should you pick? Generally speaking, there are two different approaches here: follow the herd or go through the pain of doing your own research like professional investors do.
The problem with the latter is that the selection of CTA/managed futures is not as easy as it may seem at first glance. In our white paper 10 Fallacies to Avoid when Selecting CTAs, we identified potential fallacies that investors may want to avoid in their fund selection process.
One of the more interesting results of our study was the discovery of the Big Team Fallacy (see chart). For our sample of 23 of the largest CTAs in the world we plotted the size of the research teams against the average risk adjusted returns (measured as the Sharpe ratio) between October 2006 and August 2013.
Most people take it for granted that larger research teams will do better than smaller research teams. However, that view is based on a theoretical ceteris paribus argument and the assumption that all other things are equal is very seldom fulfilled in reality.
For the complete sample, the correlation between the number of researchers and the Sharpe ratio amounted to a mere 0.09, i.e. no correlation. If you were to exclude the two CTA funds with the highest and the lowest Sharpe ratios, you even got a negative correlation of -0.31, i.e. the more researchers a CTA manager has, the lower the Sharpe ratio.
A corresponding analysis was completed for the experience factor, where longer experience is assumed to lead to better performance. We plotted the age of the CTA funds against the Sharpe ratios. Again, the results were fascinating. Whether you include all observations or exclude the two observations with the highest and lowest Sharpe ratios, in both cases you got a correlation of about -0.30. In other words, the longer the fund had existed, the lower its risk adjusted return (on average).
After detailed reasoning we were also able to draw the conclusion that none of the other soft factors are likely to contain any predictive power either: pitch books, communication skills of presenters, the number of people with PhD titles, the manager’s brand, the technological appearance, the trading setup or the degree of transparency provided.
When it comes to performance figures, investors need to watch out for at least seven different pitfalls when managers present their performance data.
To conclude, an objective like-for-like analysis of past performance may be the only remaining factor that potentially possesses some power to predict future performance of CTAs. Investors may therefore want to spend more time analysing, understanding and adjusting track records and running client portfolio simulations to find out which CTAs generate the largest improvement in the risk-adjusted returns for the client.
Hans-Olov Bornemann, head of SEB’s global quant team and portfolio manager of the SEB Asset Selection Fund
