BMFR 3nd Qtr 2001

Understanding the Sources of CTA Performance

By Fernando Diz

Every investor often wonders if there is a way of predicting who the winning CTAs will be next year. The extensive academic research on this subject suggests that investors should not waste their time trying to answer this question. Academics have done it for them and the general verdict is that it is impossible to predict future performance. Ask a CTA the same question and they will probably agree.

So what should investors and consultants do when they need to select different CTAs for their portfolios? The answer is simple: understand the factors that are responsible for CTA performance over time. A recent study by the author tried to answer this question.

The author examined the track records of 974 CTAs from 1974 to February 1998. A summary of some of the attributes examined is presented in Table 1. CTA "style" characteristics such as whether a CTA is diversified or not or whether he is discretionary or systematic were also examined.

Table 1

The two performance variables examined were the annual compounded rate of return and the volatility of returns. A model was constructed to answer the following question: can performance differences among CTAs be explained by some of their characteristics?

Let us interpret the results in Table 2. First, it seems that style variables (whether a CTA is diversified, discretionary, or systematic) does not make a bit of difference explaining why a particular CTA performance is different from another. All style variables are statistically insignificant. This is true for both returns and volatility. According to conventional wisdom one would expect "diversified" CTAs to be less volatile than non diversified ones. This study shows that this is not true in the managed futures world.

Table 2

Differences in performance between CTAs cannot be discriminated by management fees. Better performing CTAs, however, seem to charge larger incentive fees. On average, for every 1% higher incentive fees, CTAs deliver an extra 20 basis points of after fees annual returns. More importantly, CTAs do not seem to incur extra risks to deliver this extra performance as this variable does not have any impact on volatility.

The leverage level used appears to have power discriminating between CTAs with different performance. Programs with higher leverage deliver higher returns with higher volatility. On average, for every 1% increase in the margin to equity ratio CTAs deliver an extra 25 basis points of after fees annual returns with about 24 basis points higher volatility. This finding has important implications for CTA selection. CTAs are often ranked by their Sharpe ratios. The accepted practice in the industry is that a higher Sharpe ratio is better than a lower one. This study's finding is that the increase in returns and volatility of a cross section of CTAs are roughly of the same order of magnitude and proportional to the level of leverage. What does that mean? It means that the practice of ranking CTAs by Sharpe ratios may have the undesirable effect of ranking by leverage levels. CTAs that use higher levels of leverage (risk) may show higher Sharpe ratios.

Another variable that appears to have power telling CTAs apart is the ratio of "up" volatility to "down" volatility. For the average CTA this ratio is about 1.68. The results in Table 2 indicate that the higher the volatility ratio the higher the after fees annual returns. For every unit increase in this ratio, CTAs deliver on average an extra 5. 3% of after fees annual returns with a 5.7% increase in volatility. As the volatility ratio increases, a larger proportion of the increased volatility is "upside" or good volatility. The volatility ratio is very likely to be associated to the trade selection and money management approaches used by the CTA and may be a more important "style" variable than previously thought.

Summary

Understanding the sources of CTA performance can be a very valuable tool when selecting managers. Commonly used "style" variables do not seem to be associated with CTA performance. Variation in management fees does not appear to have any relationship with performance. Incentive fees seem to be associated with performance. Managers charging higher incentive fees appear to deliver higher after fee returns without incurring any extra risks. Leverage appears to be an important variable associated with performance. Both after fee returns and volatility increase with the level of leverage. An important implication of this finding is that rankings of CTAs by Sharpe ratios may translate into leverage rankings. The ratio of "up" to "down" volatility also appears as an important factor explaining the cross section of CTA returns and volatility.

Fernando Diz is an Assistant Professor Of Finance at the Syracuse University School of Management, and has also taught at the Johnson School of Management, Cornell University. His research has appeared in "The Review of Financial Studies", "The Journal of Futures Markets", "Advances in Futures and Options Research", and numerous industry publications.

RISK DISCLOSURE WHEN CONSIDERING ALTERNATIVE INVESTMENTS YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS USE LEVERAGE AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. WITH RESPECT TO ALTERNATIVE INVESTMENTS IN GENERAL, YOU SHOULD BE AWARE THAT: RETURNS FROM SOME ALTERNATIVE INVESTMENTS CAN BE VOLATILE. YOU MAY LOSE ALL OR PORTION OF YOUR INVESTMENT. WITH RESPECT TO SINGLE MANAGER PRODUCTS THE MANAGER HAS TOTAL TRADING AUTHORITY. THE USE OF A SINGLE MANAGER COULD MEAN A LACK OF DIVERSIFICATION AND HIGHER RISK. 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