A Needle in a Haystack: How to Select the Best CTAs
contributed by Capital Trading Group
A Needle in a Haystack
Once an investor makes the decision to break free from stale asset allocation models and takes the plunge into alternative investments, the real work begins. Managed Futures as an asset class have become very fragmented over the years, as more strategies have been developed and improved technology and reduced costs have made existing trading models viable for additional classes of investors.
The increasing variety of programs is a positive to investors who can really target different nuances in their portfolios but it comes with a price: much deeper analysis is required. As explained in previous articles, most studies on portfolio construction and asset allocation conclude that adding Managed Futures to a traditional portfolio reduces the volatility and improves the returns of the entire allocation. However, most studies are built on calculations that use non investable alternative indexes; the trick is translating theory into practice and as Yogi Berra used to say: “In theory there is no difference between theory and practice, in practice there is.”
There are probably over 1000 registered CTAs and a few additional exempted outfits, so to the inexpert it may feel a little like looking for a needle in a haystack; still it is a much smaller haystack than looking for a mutual fund or hedge fund manager, two investment vehicles which list thousands and thousands of choices.
Looking for the right CTA is a complex process but once a framework is developed, the procedure becomes efficient and results will follow. A right approach consists of three major areas of analysis: qualitative, quantitative and operational.
It’s All about Quality
Often a screening process is built strictly on a quantitative approach in an attempt to achieve analysis efficiency and economies of scale; however, a true edge is discovered when a detailed qualitative analysis is accompanied to the process of number crunching. The first step required relates to what general strategy – or mix of strategies – an investor should investigate. Sub-categories in Managed Futures are moved by different dynamics and risk profiles can be vastly diverse. Trend-following, one of the predominant strategies, has essentially a long volatility profile and tends to do well at times of extreme market conviction and during significant dislocations. On the other hand, mean reversion, or a contrarian approach, should work better during times of uncertain direction and tends to have shorter time frames.
Another popular strategy consists in option writing or volatility selling. This approach can be very successful but it has a diametrically opposed risk profile than trend following. Ultimately, the key is to truly understand the characteristics of the strategy chosen and the inherent advantage of the specific program. An investor should always ask herself/himself why this strategy worked in the past and why it should continue to work, what are the drivers of price formation and whether this edge can be arbitraged away.
Another qualitative element that should be taken into consideration is whether the money manager is emerging or established. There are many different definitions of Emerging Manager but usually they refer to a program with less than 3 years of track record and usually less than $10 million AUM. Emerging Managers usually produce higher rates of return due to a greater level of “hunger” and more flexibility due to their smaller positions. However, they also carry a superior risk level because of their unproven ability to escalate their business operations and potential inability to continue to produce higher returns as the assets under management significantly grow.
Established managers will probably produce, on average, lower annualized returns but they will have a much reduced operational risk and a much less potential for unexpected “blow-ups.” Their much longer track record will also allow for different “scenario dependent” analyses or the ability to see how a program performed under different macro-economic contingencies.
The qualitative variables discussed earlier should help the investor create a short list of interesting CTAs which will then be analyzed via different quant formulas. The first and most immediate risk check should be the Margin/Equity ratio. This number indicates how much minimum collateral is required for trading this specific program. This level is an immediate spot check on the leverage of the manager and a good indication of its risk level. For instance, if manager A returns 20% with an M/E of 50%, he will actually be inferior to manager B who returns 10% with an M/E of 20%. On a risk adjusted basis, manager B produces more return for dollar risked. Margin to Equity ratio is a good, quick spot check but it is limited in its analysis and it can vary widely during different market conditions. A good idea is to ask for a long term chart of M/E compared to the benchmark.
As the analysis gets deeper, one should look at the following three risk formulas: Sharpe ratio, Sortino ratio and Omega ratio.
The Sharpe ratio was developed by Nobel Prize Bill Sharpe in an attempt to adjust returns for systematic and unsystematic risk. The ratio subtracts the risk free rate (usually the 10 year US Treasury) from the program return and divides it by the standard deviation of the program’s returns. This is a relative ratio and allows an investor to compare and rank different programs; the higher the ratio the better.
This ratio, over the years, has become the “uber alles” of all risk ratios but it does have a flaw since it may penalize for good and bad volatility. In other words, as an investor, you may be upset if losses end up being higher than expected but you may be rather happy if the gains are higher than expected. The Sharpe ratio would penalize for both deviations.
In order to mitigate this issue, a new ratio was developed: Sortino ratio. In this case, one subtracts a minimum acceptable return from the program return and divides it by downside volatility (or the downside deviation of actual returns falling below the minimum target). This formula also allows investors to set different minimum acceptable targets; for example, an investor could run the ratio with a target of 10%, 5% and 0 and see the strength of the program under different scenarios. The Sortino ratio is also a ranking ratio and not an absolute number and usually one would look for a Sortino ratio higher than the Sharpe.
A supplementary look at risk adjusted returns is accomplished by running the Omega ratio. This formula provides one additional layer of analysis to the Sharpe and Sortino ratios; the Omega ratio is the weighted gain/loss ratio relative to any given targeted return level. Value at Risk and Rank correlation analysis can also be beneficial within the context of a quantitative framework.
A serious investor should also study monthly returns to get a better sense of the volatility of the program and check performance against specific market moves. During this analysis, one should check the maximum drawdown or the loss in the program from the peak to the next trough and how quickly such decline was recovered. When analyzing returns, one should also remember that arithmetic averages will most likely overstate performance while a geometric calculation will be closer to reality. To this point, an investor should look at the Value Added Monthly Index (VAMI) or the equity curve, a representation of compounded returns.
One important element to consider when analyzing returns is to avoid so called “performance chasing.” A classic tendency is to be drawn to the hottest and most recent returns and practically act on momentum. Many studies have shown that serial correlation in CTA returns is quite random; in simpler words, past performance is not necessarily an indication of future results. This factor highlights once more the need to analyze performance quantitatively and qualitatively.
The Operational Edge
Analysis of the operational backbone of a CTA is another often overlooked element, yet it can be extremely beneficial in avoiding unnecessary problems. Some of the factors that require an investor’s attention include the experience of key people and their role within the outfit. Special attention should be given to a CTA’s succession and replacement plan. In other words, one should make sure that the success of a strategy is not dependent exclusively on one individual with no real back up plan should something unexpected occur.
Investors should review a CTA operational structure also within the context of future growth of the program; for instance, does the CTA have a plan in place to allow for significant increases in AUM and the following increase in back-office work?
The ability of a CTA to plan for growth is not only restricted to its capacity to handle paperwork but it is also important from a trading perspective. Many strategies have a capacity limitation, or that level of AUM beyond which a manager finds it increasingly difficult to arbitrage market anomalies due to liquidity issues or execution complexity.
While investigating a CTA’s operational organization is fundamental in each case, it is especially important when analyzing Emerging Managers.
We are on the same boat
One last consideration relates to the alignment of incentives. The best way to insure that manager and client are aligned is to invest with a CTA who has also invested a significant portion of his/her assets in the strategy.
In conclusion, to be successful in choosing the right CTA, one really needs to apply serious analytical work and qualitative evaluation. It is advisable to be pro-active and schedule a personal meeting or at least a conference call with the managers to gain that intangible insight unavailable through mere number crunching.
The following are some sample questions one should consider asking:
1. What percentage of the portfolio is traded systematically and/or discretionary?
2. Do you utilize fundamental or technical analysis?
3. What is the time horizon of the average trade?
4. What is your expected intra-month drawdown?
5. What is the program annual return objective?
6. What is your risk management process?
7. What is the maximum capacity of your program?
8. How quickly do you align new accounts or new funds?
9. How many people are involved in operations and how many are in-house versus outsourced?
10. What percentage of time is the principal trader involved in administration and marketing?
About the writers:
Nell Marie Sloane
Nell Sloane is a principal of Capital Trading Group LP (CTG). Nell began her career at the Chicago Futures Exchanges more than 25 years ago, working for a grain trader at the Chicago Board of Trade. She became a featured contributor to many financial publications and eventually launched her own commodity newsletter called The Opening Belle. She has been a featured speaker at numerous financial seminars and radio shows, and was recognized by financial publications such as Hume Super Investors Files, Opportunities in Options by David Caplan, McMaster OnLine by R.E. McMaster, and The Art of the Trade published by McGraw Hill.
Nell formed CTG with Patrick Lafferty. CTG has clearing relationships with ABN AMRO, FCStone, Cunningham Clearing, RJOBrien, RCG, and OEC. In addition to being principal and an associated person of CTG, Nell holds her securities registration and matches high net worth clients with institutional traders who fit their criteria. CTG is an investment firm specializing in trade execution, account management for CTAs and matching investors with the appropriate managed futures products to provide a more diversified portfolio that the traditional stocks and bonds have to offer. In addition, Nell is the managing member of a multi-advisory commodity fund.
If you have any questions about this article, please feel free to call Nell Sloane at 800.238.2610 or email her at NSloane@CTGtrading.com