What are the benefits of using a CTA (managed futures) fund in a portfolio? What is a reasonable allocation, and where should that allocation come from?
Commodity trading advisors (CTAs) are an important strategy that should be considered as part of a diversified portfolio.
CTAs can be characterised into three groups based on the length of trends and holding times. Trends and holding times of less than eight to nine days are considered short term, three months to six months as medium term and beyond six months as long-term.
Each group has a different response to market volatility, and sometimes market volatility will not work for CTAs – in particular, when market volatility is high but a trend is not identifiable.
Investors in CTA funds need to understand that not all market conditions are conducive to positive returns and indeed, on a standalone basis, CTAs can disappoint.
However, they typically display positive skew – that is, the upside capture when a CTA programme captures a trend significantly outweighs the small losses while waiting for a trend to follow.
In a portfolio context, this characteristic significantly de-risks traditional assets.
Medium-term CTAs have historically provided an offset at times of acute equity market stress and, in Zenith’s view, have often provided an offset in dislocated equity markets.
But we are hesitant to class CTAs as being un-correlated to equity markets. Rather, on the whole, they are non-correlated to equities.
This is an important observation as it suggests that the returns from CTAs are independent of equity markets but are not an equity market hedge and should not be used for that purpose in a portfolio.
There is a large dispersion of returns between CTA funds, and over time they display significant rotation between top and bottom performers.
A systematic approach to risk management and portfolio construction coupled with ongoing research provides a strong rationale for the fees charged.
Importantly, over a three- to five-year period, good CTAs often display protection from market volatility wrapped up with positive returns, after fees.
CTAs are offered with a variety of targeted or realised risk levels and should be allocated on a risk-adjusted basis. For example, take a fund with a volatility target of 8 per cent and another with a volatility target of 16 per cent.
If looking at investing in just one CTA fund, a capital constrained investor would find that a smaller allocation to the higher volatility CTA, in general, will provide the same outcome to a portfolio as an allocation of twice the size to the lower risk CTA. This frees up scarce capital to be placed in other opportunities.
Zenith believes CTA allocation should be part of the alternative allocation funded by proportionally reducing allocations to fixed income and equities.
CTA strategies, which we interpret as encompassing commodity trading advisers along with managed futures strategies, offer investors low correlation to equity and bond markets over time.
Their absolute return focus means that they can be positively correlated to equities in up markets and negatively correlated in down markets.
This enables lower portfolio volatility over time and may mean a better long-term compound rate of return.
A reasonable allocation depends on the investor’s opportunity set.
CTA strategies should form part of an alternatives allocation which van Eyk suggests should account for 25 per cent to 30 per cent of an overall balanced portfolio. CTA could conceivably account for up to 25 per cent of this alternatives allocation.
In van Eyk’s view, the CSL Active Long Short Commodity program is a high quality CTA fund.
What we particularly like about this strategy is that the manager adjusts for the volatility of the underlying market, as well as the roll cost and roll yield structure, in estimating the risk-adjusted outcome of each position.
Broadly speaking, the manager seeks to earn risk-adjusted yields high enough to offset contango forward structures.
Alternatively, it seeks exposure to moderate volatility, backward-dated forward curves so as to earn a roll yield while holding a position.
The manager trades across multiple timeframes and is broadly balanced across energy, metals and agriculture exposures, which aids diversification.
The manager has a sensible approach to portfolio construction, allocating more capital to markets with a higher risk-adjusted expected return.
The fund can be up to 150 per cent long and up to 75 per cent short, which means that it can outperform in both rising and falling markets.
This fund can achieve significant negative correlation which makes it a good choice for an alternatives allocation. The trade implementation process is run daily, which recalibrates to a balance allocation each day.
Both open positions and stops are recalibrated on a regular basis.
CTAs, also commonly referred to as Managed Futures Strategies, specialise in the commodity and financial futures markets.
Often employing sophisticated computer-driven trading programs, these funds tend to use very precise trading rules to capture price movements and focus on short-term patterns.
It is important to note that CTA strategies are very different to global macro funds. Many people tend to not really understand the fundamental difference between the two.
Macro managers typically employ quantitative strategies that tend to stand aside when market fundamentals don’t make sense to them, when one aspect of the fundamental picture contradicts another.
They would have trouble, for example, taking a long fixed income position while being long commodities and would be likely to sit out this type of market environment since the fundamentals suggest a cautious approach.
But systematic trend followers such as CTAs do not care about contradictory fundamentals.
CTA managers are typically short-term momentum traders therefore they tend to be reactive as opposed to macro funds which are anticipatory quantitative strategies.
Some of the major reasons typically bandied around for investing in CTAs include that they offer improved risk adjusted performance and a low correlation to equities and fixed interest markets.
While this is all true, it is important to note that not all CTAs are the same.
Within the CTA world, there are a range of strategies and timeframes. Some managers blend short, medium and long-term models in a single program, while others run multi-strategy programs.
There are also many degrees of diversification across markets.
It is critically important that investors understand exactly what they are purchasing.
Fund manager selection is important, as it is not just the difference between a good manager and an average one, but also the difference between a highly aggressive, volatile or leveraged strategy and a more conservative, risk controlled strategy.
So what does this really mean?
It means the difference between allocating to a fund as a diversifier to equities and fixed interest, or taking a gamble by investing in a highly volatile fund – in other words, a fund that has the potential to make you a lot of money and just as great a chance to lose a lot of it as well.
Within the constructs of a portfolio, we believe that even those strategies that are more risk controlled should only be used by investors who understand the funds, are willing to have exposure to single-strategy hedge funds and have a high growth risk profile.
Even the more risk controlled funds are not defensive in nature and therefore not appropriate for more conservative investors. There are plenty of other hedge fund strategies that fulfil this criterion.
Lonsec’s Highly Recommended CTAs include Winton Global Alpha Fund and Aspect Diversified Futures Fund.
We suggest that the key to appreciating CTAs lies in seeing how this strategy can enhance the diversification of a portfolio and therefore play an important role in improving the risk/reward characteristics of a portfolio, whether traditional or alternative.
CTAs have exhibited low if not negative correlation to traditional and alternative investments.
In turn, this allows CTAs to provide sound downside protection during periods of severe market dislocations.
Further, through their use of futures, CTAs are also indifferent to economic gyrations over time – in other words, they can be profitable regardless of the direction of markets provided that any trend persists long enough.
As Mercer categorises CTAs as growth strategies due to their ability to long and short securities and their ability to use leverage, our preferred approach to allocation would be to reduce the portfolio’s equities exposure to fund an allocation to CTAs. That allocation will depend on the model portfolio risk profile.
For more moderately conservative portfolios, a reasonable allocation would be 2.5% whereas for higher growth portfolios, a reasonable allocation would be 5 per cent.
However, this would be dependent on the portfolio’s total exposure to alternative investments.
A highly rated CTA manager is Aspect. Amongst momentum managers, we believe that Aspect has the potential to be as good as any.
Trading is well managed and portfolio construction has some innovatory risk procedures.
The continuous execution system controls risk and ensures effective implementation.
There have been improvements in the research area and the risk group.
Performance has been good both in absolute terms and relative to peers and the headcount is increasing with plans to expand further while the business is managed to high levels of professionalism.
Firstly, it’s worth pointing out, as is the case for all alternative investment strategies, that no one strategy is the same.
CTAs, or managed futures strategies, are no different but, for the purposes of this article, we refer to them as diversified, systematic, medium-term trend followers.
The key reason for using such a strategy in a broader portfolio is their historic lack of correlation to traditional asset classes, and associated diversification benefits.
For example, a number of managed futures strategies posted healthy gains in 2008 when stock markets plummeted.
This is because they are able to profit from both rising and falling prices.
They aim to do this by identifying medium-term trends in asset classes ranging from equities to bonds and currencies to commodities.
It is not all good news however, because these types of strategies suffer at major turning points and in periods where markets are choppy or range-bound because at inflection points, they will generally be positioned to take advantage of the prevailing trend and often don’t react quick enough to mitigate losses associated with the turnaround.
Adding an alternatives allocation to a portfolio is not an exact science given the complexities of the underlying strategies, their individual characteristics, and the lack of reliable long-term data.
However, we believe that an alternatives allocation of up to a maximum of 10 per cent could be used to add additional diversification and this should come entirely from the growth component of the portfolio.
Any less and the benefits of diversification may not be sufficient to warrant inclusion.
Any more risks exposing the investor to too much strategy-specific risk.
It’s important to remember that these strategies can be very volatile and can carry significant leverage. As a result we also believe they are only suitable for investors with a Balanced (50/50 growth/income split) risk profile or higher.
As with any investment they should be considered carefully and as a long-term holding.
Good managed futures strategies should be able to demonstrate strong risk management credentials and systems, a diversified and wide opportunity set, experienced and dedicated personnel, a long-term track record, thorough ongoing research, and a strong parent organisation, amongst other things.
Investors looking to jump in should also be wary of the elevated costs and rapid growth in assets that these strategies have experienced over the last few years, both of which could hinder future potential returns.