Swedroe: Trend Following & Managed Futures

October 17, 2018

A commodity trading advisor (CTA), also known as a managed futures fund, is a hedge fund that uses commodity futures contracts. They use a variety of trading strategies, including systematic trading and trend following—the vast majority of CTAs use strategies based on trends (time-series momentum)—which take long positions on securities that are trending upward and/or short positions on securities that are trending downward. CTAs tout the benefits of diversification and the generation of alpha. Assets under management in this strategy have risen to more than $340 billion.

The intuition behind the existence of price trends is behavioral biases exhibited by investors, such as anchoring and herding, the disposition effect and confirmation bias, as well as the trading activity of nonprofit-seeking participants, such as central banks and corporate hedging programs. For instance, when central banks intervene to reduce currency and interest-rate volatility, they slow down the rate at which information is incorporated into prices, creating trends.

CTA Performance Research

Martin Florea, Stefan Florea, Iliya Kutsarov, Thomas Maier and Marcus Storr contribute to the literature on the performance of CTAs with their study “CTAs: Superior Performance or Diversification Only?”, which was published in the Spring 2018 issue of the Journal of Wealth Management. Their data set, which is free of the survivorship bias that plagues many studies, covered 1,558 CTAs and the period 1971 through 2016. The authors examined two issues related to the performance of CTAs:

1) Does allocation to CTAs improve risk-adjusted returns of traditional portfolios (stocks, bonds and commodities)?

2) Do they deliver above-average risk-adjusted returns on a stand-alone basis?

If the study were a boxing match, the outcome would be a split decision.

On the first question, the authors found that, while on a stand-alone basis, the risk-adjusted returns delivered by CTAs have been lower than those of traditional asset classes, the addition of CTAs improves a portfolio’s overall Sharpe ratio due to their diversification benefits—CTAs have exhibited virtually no average correlation with traditional asset classes. The diversification benefit allowed them to conclude that traditional portfolios would benefit from a significant (up to 20%) allocation to managed futures.

They also found that CTAs performed better during both extremely good and extremely bad periods in equity, bond and commodity markets—their strong performance during extremely bad periods provides a hedging benefit for traditional portfolios.

Another finding of interest was that CTAs do not exhibit fewer drawdowns compared with traditional asset classes. However, they typically have shorter drawdown periods, and ultimately manage to reduce average drawdown depth and maximum drawdown compared with equities and commodities.

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