If that’s the case, Standard and Poor’s might have achieved the “marketing coup” of the year/decade/century (time will tell) with their downgrade of US credit rating last Friday (possibly thanks to a $2 Trillion Mistake).

SGMI: a new Trend Following Index

But this is not the piece of news that caught my attention today.
Standard and Poor’s announced the creation of the S&P Systematic Global Macro Index (SGMI).

With this index, S&P basically intends to track – or rather replicate – the performance from the Managed Futures / CTA space:

London, August 9, 2011 – S&P Indices has launched the S&P Systematic Global Macro Index (SGMI), which aims to reflect price trends of highly liquid global futures, representing the general level of volatility taken by managers in the global macro and managed futures/Commodity Trading Advisor (CTA) space.

This is a rules-based index, which will implement a trend following system to trade a (semi-diversified) portfolio of liquid futures markets, with a fairly standard risk-adjusted equal allocation per sector and per instrument:

The Index is diversified globally across 37 constituents, falling into the six most widely traded sectors– Commodities, Energy, Fixed Income, Foreign Exchange, Short Term Interest Rates and Equity Indices.

The weighting scheme applies an even risk capital allocation across the index by sector and again to each constituent within each sector so that no single sector or constituent drives the volatility of the index.

Other Trend Following Indices

Of course, this is not a new concept. There are several companies tracking the performance of Managed Futures (Newedge, BarclayHedge) with their respective indices – or even “closer to home” the Trend Following Wizards report on this blog.

Even the concept of using a rules-based systematic trend following approach has been implemented before. Apart from the State of Trend Following monthly report, also on this blog, long-time readers will recall this Beta of Managed Futures paper by Conquest Capital Group, which developed a mechanical trend following benchmark aimed at replicating CTAs performance. I discussed the paper more than a year ago in this “Betafication of Alpha: towards a Commoditization of Trend Following?” post, and was asking then “when the launch of a Trend Following ETF?“.

The end game of Conquest is of course to market their fund implementing this benchmark and it is pretty certain that the end game with this S&P index is similar. One can only speculate (again) as to how long it will take to see a SGMI Trend Following ETF.

The underlying strategy in this new S&P index seems to contain an adaptive timeframe logic (whereas the Conquest Capital Group benchmark uses a combination of several fixed timeframes to capture trends at different levels):

Uniquely, the trend-following model used [by the SGMI] to determine the position of each constituent is flexible enough to allow a customized time-period for each constituent on a monthly basis, unlike models which are based on fixed time-periods. This means that if a longer term trend is driving the market, the Index reflects that, but if a shorter-term trend becomes significant the Index picks that up, using an iterative process to test the stability of each trend.

Trend Following ETFs: a Viable Possibility?

Of course, despite the potential appeal of strong replication and much lower fees for a “speculative” SGMI ETF, this is not necessarily a winning proposition for the investor. The debate resides in whether CTA managers can justify their fees.

Using a Geometric Information Ratio calculation based on the Conquest benchmark, I showed previously that CTAs still produce alpha over the benchmark on a net-of-fees basis – most likely thanks to their research in other areas such as enhanced rolling methodology, execution efficiency, extra diversification (100+ markets instead of 37), etc.
Note that this calculation was not free of survivorship bias though.

This could be one of the reasons why the Conquest fund has not taken off in any substantial manner (less than $200M in AUM after 7 years trading).

Another similar Trend Following fund is the Cambria Global Tactical ETF (GTAA), run by Mebane Faber. Unlike CTAs it does not trade futures (it is an actively managed “ETF of ETFs”), however its core strategy uses long-term trend following principles to allocate funds between 50 to 100 underlying ETFs representing different global asset classes.

It only launched late last year and is already at the same levels of AUM as the Conquest fund, showing that there is an appetite for this type of product in an accessible format (i.e. no high minimum account size).

A fact also highlighted in the S&P press release:

“Issues like high minimums and high fees have made it difficult for many investors to gain access to global macro and managed futures strategies. We envisage that new products based on this index will give investors the ability to invest in a long/short, comprehensive set of the main futures contracts.”

“Gimmicky” Index and ETF?

Josh Brown and Abnormal Returns argue that, in a case of the tail wagging the dog giving birth to puppies, there is a plethora of index creation, in the sole aim to support “niche and gimmicky ETFs” – quickly turning into “zombie ETFs” destined to populate the ETF Deathwatch list.

It will be interesting to see if the “SGMI ETF” is one these “puppies” or whether it can create a substantial impact in the Managed Futures and Trend Following industry – as its great-grandfather the SPY did within the wider investment industry (trading volume: $80B yesterday).

What To Think of it?

It obviously depends on the actual performance of this index and its derived products, so only time will tell.

CTAs: Do you see this development as a threat to your business, or as a way to bring more awareness to the sector? Are you feeling confident about the added value that you can provide to fend-off this potential new competition?

Investors: Are you excited at the prospects of being able to invest in managed Trend Following without the big “minimum account size” hurdle? Are you skeptical of the capacity of the index to replicate the performance of Trend Followers?

Independent system developers: Does this reinforce your belief into building your own system? Would you reconsider building a system if you could invest in an ETF-like Trend Following product?

I’m keen to hear your opinions… Feel free to contribute to the discussion in the comments section below.
 
 
UPDATE: Tim Pickering from Auspice Capital has commented below but also expressed his (interesting) point of view from a CTA perspective on their blog. In essence they do not feel threatened as they “believe in the separation of the alpha and index methods” (read the post here to see why). He also pointed out that:

S&P is surely not the first to do this. In fact, their previous effort has been widely regarded as unsuccessful from a performance standpoint. The S&P DTI (and related) indices have been around for some time now.

 
 
UPDATE 2: Several Trend Following investment products (ETF, ETN, etc.) already exist actually.

Prompted by reader Pumpernickel’s comment (below), I decided to research more about the DTI index that was mentioned by Tim Pickering in his blog post. I was under the impression that a trend following ETF was a really new concept, but it appears that some products very similar already exist. Below is a summary from this “google” research:

The “Diversified Trends Indicator” (DTI) has been created by Victor Sperandeo, with a few investment products having been launched based on this index (or one of its sub-indices: the “Commodity Trends Indicator” [CTI] and the “Financial Trends Indicators” [FTI]). The DTI is a based on a single mechanical trend following/momentum strategy applied to a portfolio of 24 US futures.

From Alpha Financial Technologies (Victor Sperandeo’s firm) website:

In 2002, AFT granted Standard & Poor’s the exclusive right to sublicense the indexes to third parties, known as the S&P Diversified Trends Indicator, S&P Commodity Trends Indicator, and S&P Financial Trends Indicator. S&P launched the S&P Diversified Trends Indicator in January of 2004. Over the next two years several offshore products linked to the S&P DTI were launched, including a UCITS III Fund by Nomura International PLC. In 2007, Rydex launched the first long/short managed futures mutual fund, which tracks the S&P DTI. Direxion funds launched a mutual fund that tracks the CTI® and a mutual fund that tracks the FTI™ in 2008 and 2009, respectively. In July of 2008, Merrill Lynch structured an exchange-traded note that tracks the S&P CTI.

In November 2009, AFT commenced licensing its indexes directly to third parties, although existing S&P licenses remain in effect. On August 1, 2010 AFT launched the FX Trends Index™ (FXTI®). In January 2011, Wisdom Tree launched an exchange traded fund (ETF) which tracks the DTI®.

Investment banks and financial institutions in over 15 countries worldwide have licensed AFT’s indexes. As of April 2011, there are over $3 billion invested globally in products utilizing AFT’s indexes.

Tickers for the indices and some of their investable products:

Bloomberg Index Tickers:

• AFT Indices: DTI® TR: DTITR , CTI® TR CTITR , FTI™ TR FTITR .
• S&P Diversified Trends Indicator: Price Return: SPDTP, Total Return” SPDTT.

Investable Products:

• Rydex SGI Managed Futures: RYMFX (mutual fund based on S&P DTI and trading since 2007)
• ELEMENTS S&P CTI: LSC (ETN based on the S&P CTI and trading since 2009)
• Direxion Commodity Trends: DXCTX (mutual fund based on the AFT CTI and trading since 209)
• Direxion Financial Trends: DXFTX (mutual fund based on the AFT FTI and trading since 209)
• WisdomTree Managed Futures: WDTI (ETF based on the AFT DTI and trading since 2011)

The methodology used to calculate the index is made public by AFT – it can be found here as a pdf document.
A document for the S&P DTI can be found there as a pdf document.

I have also found this “interesting discussion” between Attain Capital and Victor Sperandeo on whether DTI-based products really can deliver Managed Futures performance.

In the first “missive” (in this article), Attain Capital argue that the DTI-based products are wrongly labeled as “Managed Futures” as they offer no exposure to the sector directly. They go on to show that the DTI index has seriously under-performed the Newedge CTA Index (and that in turn the Rydex mutual fund slightly underperformed its DTI benchmark due to expenses) since 2007 (total return of 28.85% for the Newedege index vs. 3.36% for the Rydex fund). They also chart the 12-month rolling correlation between the DTI and various CTA indexes. The figure oscillates around 0.3 and 0.9 for an average of 0.6 between 2000 and 2007.

Victor Sperandeo responds that he “developed the Diversified Trends Indicator™ as a way for investors to access the “core” returns embedded within trend-following in the futures markets” and that the DTI does indeed implement a (single) Managed Futures strategy by the way of a mechanical trend following system on a diversified portfolio of futures. He further highlights that the DTI actually out-performed the Newedge CTA Index since 2004 while providing a more practical way of investing in Managed Futures, compared to the un-investable CTA index from Newedge.

In a further reply, Attain Capital highlights that comparison between DTI and Newedge CTA Index should be done on a realistic basis (DTI Total return minus an annual 2% fee with the Newedge index already being net of fees), in which case the DTI slightly under-performs the Newedge CTA index, concluding:

  We don’t believe they will see long term success beating the managed futures indices (or if they are even trying to beat those benchmarks) because they track only a single strategy.

It seems that both have a point – and certainly a different viewpoint (and interests). It actually ties back to the alpha vs. replicated beta “debate” and what place the mechanical and investable index-based products take in the managed futures space.

As Tim Pickering was saying “I believe in the separation of the alpha and index methods. We feel it will bring awareness to CTA and offer product to investors that do not know about/understand or have access to “Accredited or QEP” products. For CTAs that generate Alpha at reasonable price, this exposure can only help you.”

It will be interesting to see – but hard to measure – whether a Starbuck effect additionally develops from these products to boost sales from classic CTAs.

These indices and products are something I had completely missed, so thanks again to the readers who offered pointers to more info.
 
 
UPDATE 3: Trader Vic Index (TVI):

Thanks to reader RB, who pointed out the Arrow Managed Futures Trend Fund, which tracks another similar index created by Victor Sperandeo: the Trader Vic Index (TVI).

The index was developed as a partnership between RBS and Enhanced Alpha Management, L.P. (EAM, LP) – Sperandeo’s CTA firm – and launched in 2009. The Arrow Funds mutual fund offering based on that index started trading in 2010, and has around $100M in AUM.

Tickers: TVICTR:IND (Bloomberg index ticker) and MFTFX (Arrow mutual fund on google finance).

The recent turmoils developing in the markets will give us interesting times to monitor how the Trend Following Wizard performances fare. If 2008 is any indication, and if we return to large moves to the downside, some good times might be coming (although some early May figures appeared to be quite strong on the negative side – mostly because of reversal of trends).

For now, the average Wizards return for April is +1.82%.

Full results for April 2010 below:

Notes
<sup>* YTD: Year-To-Date performance.
** AUM: Assets Under Management.
1. Abraham Trading was founded by Salem Abraham, after he was introduced to Managed Futures and Trend Following by Jerry Parker. He is considered as a “second-generation” Turtle.
2. The four founders of Aspect (Eugene Lambert, Anthony Todd, Michael Adam and Martin Lueck) were significant members of one of the most succesful funds in managed futures – AHL (Adam, Harding and Lueck)
3. Chesapeake Capital was founded by Jerry Parker, a former Turtle.
4. Clarke Capital was founded by Michael Clarke in 1993.
5. Drury Capital, Inc., was founded in Illinois in 1992 by Mr. Bernard Drury.
6. Dunn Capital was founded by Bill Dunn.
7. Eckhardt Trading is the firm managed by William Eckhardt, who co-led the Turtle experiment with Richard Dennis
8. EMC Capital was founded by Liz Cheval, a former Turtle.
9. Hawksbill Capital was founded by Tom Shanks, a former Turtle.
10. Hyman Beck & Co. main principals are Alexander Hyman and Carl Beck.
11. JWH & Co. was founded by John W. Henry, Owner of the Boston Red Sox.
12. Originally ED & F Man. Became a succesful CTA under Larry Hite and went on to form part of The Man Group plc, which subsequently bought AHL to form the Man AHL: the systematic trading division of the Man group.
13. Millburn Ridgefield have been trading Trend Following models since the early 1970′s. As they report performance figures one month later, last month performance is not reported in this report and their YTD, AUM stats are from the month before.
14. Rabar Market Research is the company of Paul Rabar, a former Turtle.
15. Saxon Investment was founded by Howard Seidler, a former Turtle.
16. Superfund founder and CEO: Christian Baha.
17. Transtrend is a Trend follower CTA based in Netherlands
18. Winton Capital is a London-based CTA founded by Dave Harding (also co-founder of AHL).</sup>

These are top of the range CTAs/Managed Futures funds in the Trend Following space.
Most of the traders behind these funds have been involved in the Turtle Trading experiment (2 excellent books on this topic: Complete Turtle Trader – featuring the actual turtle rules and The Way of the Turtle), featured in the legendary books by Jack Schwager: Market Wizards and New Market Wizards, or in Michael Covel’s dedicated Trend Following book.
 
 
 
 

This post contains a spreadsheet used to calculate the Geometric Information Ratio, and expanded information on how the classic Information Ratio fails to accurately do its job. We’ll also reiterate the rationale behind the new Geometric Information Ratio and the formula used to derive it.

Where the Information Ratio fails

The main issue with the classic calculation of the Information Ratio is its use of arithmetic returns and lack of leverage adjustment. This is best illustrated with a simplified example:

Consider 3 hypothetical managers:

• Steady Sam: very reliable, she produces 0.3% month after month.
• Volatile Viv, she aims for big moves, which she gets regularly in both directions by alternating 30% up months with 25% down months
• Cautious Carla, Viv’s twin sister, uses the same strategy as her sister but knows she should play it safer with much less leverage: 6% up months followed by 5% down months

Meanwhile, the benchmark regularly alternates 0.5% and -0.3% months.

The formula for the Information Ratio being:

We can calculate the average excess return (alpha) for each manager: Sam gets tw months of 0.3% return while the benchmark returns 0.5% and -0.3% giving excess returns of -0.2% followed by +0.6%, foran average of 0.2%. With the same calculation, Viv scores 2.4% per month with Carla scoring 0.4%. The standard deviation figures for the excess returns are respectively 0.4%, 27.1% and 5.1%, which gives information ratios of:

• Steady Sam IR = 0.5
• Volatile Viv IR = 0.09
• Cautious Carla = 0.08

Carla seems to underperform her twin sister, whereas Sam clearly outscores her 2 colleagues. However, looking at a compounded equity curve from the 3 managers give a different picture with Viv’s volatility pushing her into negative territory.

The Information Ratio calculation penalizes Carla for her lack of leverage, while falsely indicating that Viv produces excess return to the benchmark.
Applying the right amount of leverage to a strategy is part of the manager’s skill and should be part of the Information Ratio calculation.

The Geometric Information Ratio Rationale

The main departure from the classic Information Ratio calculation is the use of a measure of return which takes leverage into account. The geometric average return is such measure: excess leverage applied to a positive strategy will result in a negative geometric average return (unlike the arithmetic return).

We can imagine a strategy where the investor desires exposure to the manager’s alpha with no beta risk. To implement such strategy, the investor would take a hedged position in the manager’s fund. The hedge would consist of a short position in the benchmark, adjusted for the beta coefficient between the manager and the benchmark (if the fund has a beta of 0.5, the short position in the benchmark would be half the size of the long position in the fund).

After one period of such hedged position, the investor would collect both alpha and beta returns from the manager minus the return from the benchmark. Because of the beta adjustment, the beta return and benchmark return would cancel each other out. Rebalancing the positions to repeat the operation for each period would allow to gradually harvest and compound the manager’s alpha only.

The performance of such strategy is a good measure of the manager’s skill and the calculation of the Geometric Information Ratio will follow the same logic.

The Geometric Information Ratio Formula

1. Calculate the manager’s beta to the benchmark:
   
2. Normalise both sets of monthly returns using beta as a multiplier
3. Calculate monthly alphas as the difference between normalised returns:
   
4. Compound alpha and calculate its geometric mean (i.e. compounded growth rate):
   
5. Calculate the geometric standard deviation of the monthly alpha (variability of alpha, i.e. omega):
   
6. Divide alpha by omega to obtain the Geometric Information Ratio

Showing my geeky deviance, I enjoyed playing with phpMathPublisher, an online formula tool to express the full formula in simplified form – Rm and Rb being the respective manager and benchmark returns over n periods:

and in fully expanded form (also on the phpMathPublisher tool):

More useful to you is probably this spreadsheet which implements the calculation for an arbitrary CTA (TransTrend) and a benchmark (Conquest Capital Group MFS fund).

More Performance Metrics and CTA Ranking Information

The Geometric Information Ratio is one way to look at the value added by a manager, improving the concept of the classic Information Ratio. There are, of course, other ways to evaluate a manager or investment’s performance.

A large amount of litterature has actually been written on performance measurement and how best to evaluate and rank managers. For those readers wanting to investigate this topic more in depth, here is what I could find on my bookshelf, related to this topic:

Managed Futures by Jack Schwager
Commodity Trading Advisors: Risk, Performance Analysis, and Selection
Evaluating Hedge Fund and CTA Performance: Data Envelopment Analysis Approach

I read half of Schwager’s book, which is an interesting discussion on various performance ratios, but have not done more than leafing through the 2 other ones (more maths-oriented) yet.

Also these 2 papers discussing the more ubiquitous Sharpe ratio are an interesting read:

How to game your Sharpe Ratio
Sharpening Sharpe Ratios

Alpha by Leo Reynolds

The idea of having a true benchmark for Trend Following (a.k.a. Managed Futures/CTAs), independent from the performance of the existing funds, could shake up the industry and have serious implications (increased competition and fees reduction resulting from commoditization of Trend Following).

The Beta of Managed Futures paper (PDF) by Conquest Group and their claim to an independent, mechanical Trend Following benchmark got me going. I decided to use it as a benchmark for the Trend Following Wizards we track here every month. The comparison calculations (using innovative metrics) can be found at the end of this article.

If CTAs mostly produce beta and a bit of alpha, they should really charge their fees accordingly, i.e. a flat management fee for the beta and a performance fee based on the alpha they produce – instead of a performance fee on the overall performance of the fund. But how do you calculate alpha?

Information Ratio: mis-information?

There are several ways to measure alpa and the Information ratio is a popular one. The concept behind the Information Ratio (IR) is interesting as it aims to measure the alpha (excess return) provided by the fund compared to the benchmark. It also takes into account the tracking error of the fund (volatility of the excess return).

As such the IR can be expressed as follows:

However, there is a (common to many CAPM models/tools) flaw in this ratio calculation: it uses the arithmetic mean return rather than the geometric one. This difference could give a positive IR to a fund producing negative alpha and vice-versa. To convince yourself, consider a hypothetic manager producing +15% alpha followed by -14% alpha at regular intervals. Calculate both average returns: the arithmetic one, +0.5% and the geometric one, -1.1%. How is this for painting a different alpha picture!

Another way to calculate Alpha

Alpha is the true value added by a manager, regardless of the underlying market/benchmark.

If investors simply want to get exposure to the alpha from a specific manager, they could simply “buy the manager” and short the benchmark (with constant rebalancing). Once taking into account the manager’s beta to the benchmark (to derive respective long and short positions), all that is left to the investor is the alpha produced by the manager (with zero market/beta risk).

Taking this logic into account, below is an alternative way of calculating a (modified) Information Ratio to give a more accurate picture of the true alpha as per the logic mentioned just above:

1. Calculate the manager’s beta to the benchmark:
   
2. Normalise both sets of monthly returns using beta as a multiplier
3. Calculate monthly alphas as the difference between normalised returns:
   
4. Compound alpha and calculate its geometric mean (i.e. compounded growth rate):
   
5. Calculate the geometric standard deviation of the monthly alpha (variability of alpha, i.e. omega):
   
6. Divide alpha by omega to obtain this new Information Ratio (let’s call it Geometric IR)

Trend Following Wizards ranking

Below is the calculation of the standard and modified/geometric Information Ratios for the Trend Following Wizards, for which we could find historical performance – as well as other information such as alpha, beta and correlation (using Pearson product-moment coefficient) to the benchmark. To give some background, total performance and standard deviation of returns over the full period have been added as well.

For this exercise, the Conquest Group Managed Futures Select fund was used as a Trend Following benchmark (as this is what it aims to produce), with the period covered being Jun-04 to Mar-10 (full history of the benchmark). All fund performances below are considered net of fees.

 
Notes:
<sup>a. Total Compounded Return since 2004
b. Standard Deviation of monthly returns since 2004
c. Classic Information Ratio
d. Beta of the manager to the benchmark
e. Correlation (Pearson)
f. Annualized Alpha
g. Modified/Geometric Information Ratio
 
1. Abraham Trading was founded by Salem Abraham, after he was introduced to Managed Futures and Trend Following by Jerry Parker. He is considered as a “second-generation” Turtle.
2. Chesapeake Capital was founded by Jerry Parker, a former Turtle.
3. Clarke Capital was founded by Michael Clarke in 1993.
4. Dunn Capital was founded by Bill Dunn.
5. Eckhardt Trading is the firm managed by William Eckhardt, who co-led the Turtle experiment with Richard Dennis
6. EMC Capital was founded by Liz Cheval, a former Turtle.
7. Hawksbill Capital was founded by Tom Shanks, a former Turtle.
8. Hyman Beck & Co. main principals are Alexander Hyman and Carl Beck.
9. JWH & Co. was founded by John W. Henry, Owner of the Boston Red Sox.
10. Originally ED & F Man. Became a succesful CTA under Larry Hite and went on to form part of The Man Group plc, which subsequently bought AHL to form the Man AHL: the systematic trading division of the Man group.
11. Millburn Ridgefield have been trading Trend Following models since the early 1970′s. As they report performance figures one month later, last month performance is not reported in this report and their YTD, AUM stats are from the month before.
12. Rabar Market Research is the company of Paul Rabar, a former Turtle.
13. Saxon Investment was founded by Howard Seidler, a former Turtle.
14. Superfund founder and CEO: Christian Baha.
15. Transtrend is a Trend follower CTA based in Netherlands
16. Winton Capital is a London-based CTA founded by Dave Harding (also co-founder of AHL).</sup>

Note that the negative values of Information Ratio are usually not really relevant.

The Pearson coefficient measures gravitate around 0.60, which shows some degree of correlation to the benchmark – maybe not as strong as initially hinted by the Conquest paper. Obviously, the higher the correlation numbers, the more support for the thesis of a possible Trend Following benchmark.

Interestingly, the two versions of the Information Ratio show some discrepancies (expected as per earlier explanations) with a few funds switching from negative IR to positive geometric IR (and vice-versa). Most notable is the case of Transtrend, which goes from negative IR (-0.02) to the second-best geometric IR (0.24). Comparing all individual results, it seems that the geometric Information Ratio is a much better measure of alpha.

It can appear strange that some funds underperforming the benchmark still appear to produce alpha (example of Chesapeake Capital: return of 44.60% vs 56.95% for the benchmark). This is due to the methodology of the calculation, which assumes constant rebalancing between the benchmark and the fund to capture and compound each period’s alpha.

Finally, it is worth noting that despite (much) higher fees for the Trend Following Wizards (compared to Conquest Group MFS fund acting as the benchmark), most of them still exhibit alpha/excess return.

Below are the numbers for the benchmark and its corresponding leveraged version (3x) from Conquest:

 
Some of these numbers are self-evident (ie correlation, beta of the benchmark to itself); but of interest is the fact that the 3x option produces negative alpha at the rate of over 7% per year while keeping a very strong correlation to the standard fund/benchmark (not so surprising given the previous discussion on leverage). Meanwhile, the classic IR still indicates positive alpha…

^* Note another aberration from the classic IR calculation. It is theoritically not possible to calculate the IR of a benchmark with itself (results in a 0 into 0 division). However, the IR of ALL straight beta multiplications of the benchmark (with correlation = 1) are identical (just a by-product of the linearity of mean and standard deviation). Constructing a virtual benchmark with a beta very close to 1 (ie 1.00001) and a correlation of 1 to the real benchmark allows for calculating both IR (standard and geometric), while, for all intents and purposes, the virtual benchmark can be considered equal to the real benchmark. It would result, from the classic IR calculation, that the benchmark actually produces alpha to itself (IR>0)! The geometric IR correctly computes to 0.

Another Tool in the Box

We can see that the Trend Following Wizards ranking using the Geometric Information Ratio gives a different insight to their raw performance numbers.

Hopefully, you find this Geometric Information Ratio useful to compare several funds, instruments or even your own strategies relative to a common benchmark. In any case, it is worth noting the importance of understanding how any performance metrics work. Following blindly the results from the classic Information Ratio might result in incorrect conclusions.

A bit of a happier month for Trend Followers with an average gain of 3.7% and even a double-digit return for Superfund (enhanced return/leveraged fund). Once again, the results are in line with the findings of our Trend Following benchmark (which had an average gain of 2.2% for March).

The YTD results are right on the 0% mark.

Full results for March 2010 below:

Notes
<sup>* YTD: Year-To-Date performance.
** AUM: Assets Under Management.
1. Abraham Trading was founded by Salem Abraham, after he was introduced to Managed Futures and Trend Following by Jerry Parker. He is considered as a “second-generation” Turtle.
2. The four founders of Aspect (Eugene Lambert, Anthony Todd, Michael Adam and Martin Lueck) were significant members of one of the most succesful funds in managed futures – AHL (Adam, Harding and Lueck)
3. Chesapeake Capital was founded by Jerry Parker, a former Turtle.
4. Clarke Capital was founded by Michael Clarke in 1993.
5. Drury Capital, Inc., was founded in Illinois in 1992 by Mr. Bernard Drury.
6. Dunn Capital was founded by Bill Dunn.
7. Eckhardt Trading is the firm managed by William Eckhardt, who co-led the Turtle experiment with Richard Dennis
8. EMC Capital was founded by Liz Cheval, a former Turtle.
9. Hawksbill Capital was founded by Tom Shanks, a former Turtle.
10. Hyman Beck & Co. main principals are Alexander Hyman and Carl Beck.
11. JWH & Co. was founded by John W. Henry, Owner of the Boston Red Sox.
12. Originally ED & F Man. Became a succesful CTA under Larry Hite and went on to form part of The Man Group plc, which subsequently bought AHL to form the Man AHL: the systematic trading division of the Man group.
13. Millburn Ridgefield have been trading Trend Following models since the early 1970′s. As they report performance figures one month later, last month performance is not reported in this report and their YTD, AUM stats are from the month before.
14. Rabar Market Research is the company of Paul Rabar, a former Turtle.
15. Saxon Investment was founded by Howard Seidler, a former Turtle.
16. Superfund founder and CEO: Christian Baha.
17. Transtrend is a Trend follower CTA based in Netherlands
18. Winton Capital is a London-based CTA founded by Dave Harding (also co-founder of AHL).</sup>

These are top of the range CTAs/Managed Futures funds in the Trend Following space.
Most of the traders behind these funds have been involved in the Turtle Trading experiment (2 excellent books on this topic: Complete Turtle Trader – featuring the actual turtle rules and The Way of the Turtle), featured in the legendary books by Jack Schwager: Market Wizards and New Market Wizards, or in Michael Covel’s dedicated Trend Following book.
 
 
 
 

Above is a diagram by Andy Lo, illustrating how alpha morphs into beta over time, as the initial strategy becomes more common/popular. Could the phenomenon affect Trend Following? And could the 2/20 fee structure charged by CTAs now be inappropriate?

This Beta of Managed Futures paper (PDF) from the Conquest Group hints that Yes, the original alpha provided by Trend Followers has taken the path down the beta-fication route.
Further along these lines the paper claims that Trend Following Managers sell Beta disguised in Alpha clothes:

CTAs: Alpha or Expensive Beta?

Returns can be broken down into alpha (excess returns due to skill), beta and the risk free rate.
Beta is ubiquitous and easily replicable and therefore cheap, while alpha is rare, hard to replicate and therefore expensive. It makes sense to pay a premium for alpha, but there is no need to do so to access beta, as it is available from multiple, competing sources. CTAs purport to provide alpha and justify their fees on that basis. It is clear, however, that there is a good deal of beta in the returns of many alternative investments, which raises the possibility that alternative investments are providing beta but charging alpha prices for it.

The Benchmark

In order to measure the baseline for Trend Following (and derive each CTA’s beta to it), the first step is to establish the benchmark and measure its performance.

Instead of taking an index of Trend Following CTAs, the authors build an index representing investing like a CTA. They do this by implementing a simple mechanical Trend Following system (Donchian reversal system) that covers multiple timeframes (20: from 5-day to 200-day) and a wide range of diversified markets (55 markets with exposure to all asset classes and geographical locations). The system also implements volatility-based position sizing and sector allocations (reflecting average allocation from a sample group of long-term Trend Following managers – possibly a flaw in the benchmark construction as it does not make it completely independent from the CTAs).

Correlating the benchmark to CTA indices

After applying fees, slippage and interest, the returns of the benchmark were compared to the returns of well-known CTA indices (S&P Managed Future Index, CSFB Tremont Managed Futures Index, etc.). The correlation between the benchmarks and these indices range from 0.75 to 0.9 indicating that the benchmark seems to do its job of… well, providing a benchmark for Trend Following.

Measuring CTA alpha

The next step is to calculate each CTA’s beta and alpha to the benchmark. The correlations are still fairly high (between 60% and 90%) and most CTA exhibit negative alpha over the testing period. For example, Rabar and Millburn’s calculated alpha since 1990 is around -2,000%.

Fourteen of the twenty largest CTAs failed to demonstrate alpha to the Conquest Managed Futures Beta benchmark from their inception until December 31, 2004. Six of these CTAs did demonstrate alpha over this period. Alpha, of course, [...] represents merely unexplained variation which can represent either skill, random fluctuation or some combination of the two.

CTAs: Trend Following Wizards or Not?

It is not explicitly stated from the paper but it is safe to assume that the results from CTAs are net of fees. It is arguable which performance to use for comparison (before-fees or net-of-fees). It would be interesting to see a comparison of CTA returns with the benchmark on a before-fees basis.

Since most CTAs charge (much) more than a 1% fee, a before-fees performance comparison should prove more to their advantage. One could speculate that most would actually display some alpha to this benchmark.

2/20 Fee Structure obsolete for CTAs?

If CTAs can display before-fees over-performance to the benchmark despite their net-of-fees under-performance, it simply points to CTAs over-charging for their fund management services and that they must evolve to adapt to the new market environment. In order to become more competitive (from a pricing point of view) and stay attractive to investors, CTAs must keep producing net-of-fees alpha to the benchmark. This can either be done by:

1. lowering fees
2. improve their returns

Option 1 is surely the easier way, but understandably less desirable for CTAs – nobody said free competition was good for everybody (that’s probably why we have all the current interventionism and protectionism in global markets!). But as more competition arises, they will have to – in a Darwinian fashion- adapt to this betafication of alpha or die out.

A probably fair approach would be to differentiate the beta performance from the alpha performance of the fund and charge fees accordingly. Possibly a combination of a flat fee to cover costs of the beta-tracking strategy (similar to a passive management fund) and a variable fee to charge the true “value-add” from the fund (i.e. alpha). The latter fee could be based on the Information Ratio using the Trend Following benchmark.

Obviously, this is based on the assumption that there can be a widely-accepted and valid benchmark for Trend Following (including variables such as slippage, roll yield, asset selection and allocation, etc.); or each fund could possibly designate their own benchmark for this calculation – to be agreed with investors.

Other Implications

There are a few good points to take away, as an investor:

First, it shows that Trend Following Wizards‘ returns are reproducible with simple strategies. As discussed earlier, saving fees for yourself can give you a big headstart.

Second, for those not inclined to build their own system, there should be more products and funds available charging a much more competitive fee – when the launch of a Trend Following ETF?

However, this could also be bad news for Trend Following in general: if there is only a finite amount of alpha/profit available in the markets for Trend Following, and if the Trend Following space becomes more crowded there will be less opportunities for each player.

This is also in line with another Darwinian market theory, from Andy Lo: the Adaptive Market Theory (AMH), whose papers are an interesting read. The AMH theory tries to reconcile the Efficient Market Hypothesis (EMH) with its numerous flaws, as described by behavioral investing theory. The main premise of the AMH theory is that markets’ target and ideal model is the EMH model. However inefficiences (profit opportunities) arise from behavioral biases and as a result markets oscillate towards/away from the EMH model. The level of inefficiency in a market is related to that market’s “ecology” – with more competition bringing on more efficiency.
Could too much Trend Following kill Trend Following?…

He now manages $183M in his WMA program – from his website:

DUNN’s WMA is a 100% systematic long-term trend-following program which began trading
in November 1984. WMA utilizes DUNN’s original trend following algorithm developed in
1974, encompassing a portfolio of financial, energy, metal and agricultural futures markets.

Dunn WMA program performance since inception

In his “other life” Dunn is chairman of the Reason foundation, a non-profit think tank who also publishes Reason magazine: Free Minds and Free Markets. Their ideas are mostly libertarian – which seems to be a common theme among some Trend Followers: maybe a case of talking their books (or is it the other way around)?

Below are 2 videos of a Dunn interview by Michael Martin from the MartinKronikle.

The first video starts with a discussion of the Reason foundation and Dunn’s political views of the markets and regulation. At around 7:00 he starts discussing how he started the fund and how they changed the composition of the portfolio for fear of liquidity issues.
Check that eyebrow action on the intro:

Dunn also discusses the difficulties of dealing with emotions while following the system.

The second video is a continuation of the interview where Dunn provides his advice on somebody wanting to get into Trend Following (starting at around 7:00)

Quite a diversified set of results this month for the wizards with a median and average return around +0.5%. YTD performance still in the red at an a median/average around -3%. This is in line with the results from the State of Trend Following current benchmark.

Full results for February 2010 below:

Notes
<sup>* YTD: Year-To-Date performance.
** AUM: Assets Under Management.
1. Abraham Trading was founded by Salem Abraham, after he was introduced to Managed Futures and Trend Following by Jerry Parker. He is considered as a “second-generation” Turtle.
2. The four founders of Aspect (Eugene Lambert, Anthony Todd, Michael Adam and Martin Lueck) were significant members of one of the most succesful funds in managed futures – AHL (Adam, Harding and Lueck)
3. Chesapeake Capital was founded by Jerry Parker, a former Turtle.
4. Clarke Capital was founded by Michael Clarke in 1993.
5. Drury Capital, Inc., was founded in Illinois in 1992 by Mr. Bernard Drury.
6. Dunn Capital was founded by Bill Dunn.
7. Eckhardt Trading is the firm managed by William Eckhardt, who co-led the Turtle experiment with Richard Dennis
8. EMC Capital was founded by Liz Cheval, a former Turtle.
9. Hawksbill Capital was founded by Tom Shanks, a former Turtle.
10. Hyman Beck & Co. main principals are Alexander Hyman and Carl Beck.
11. JWH & Co. was founded by John W. Henry, Owner of the Boston Red Sox.
12. Originally ED & F Man. Became a succesful CTA under Larry Hite and went on to form part of The Man Group plc, which subsequently bought AHL to form the Man AHL: the systematic trading division of the Man group.
13. Millburn Ridgefield have been trading Trend Following models since the early 1970′s. As they report performance figures one month later, last month performance is not reported in this report and their YTD, AUM stats are from the month before.
14. Rabar Market Research is the company of Paul Rabar, a former Turtle.
15. Saxon Investment was founded by Howard Seidler, a former Turtle.
16. Superfund founder and CEO: Christian Baha.
17. Transtrend is a Trend follower CTA based in Netherlands
18. Winton Capital is a London-based CTA founded by Dave Harding (also co-founder of AHL).</sup>

These are top of the range CTAs/Managed Futures funds in the Trend Following space.
Most of the traders behind these funds have been involved in the Turtle Trading experiment (2 excellent books on this topic: Complete Turtle Trader – featuring the actual turtle rules and The Way of the Turtle), featured in the legendary books by Jack Schwager: Market Wizards and New Market Wizards, or in Michael Covel’s dedicated Trend Following book.
 
 
 
 

Not a good start of the year for Trend Followers – starting 2010 in the same way as 2009 closed: by very negative performances.

Well, Trend Following is not about winning every month. I guess if we experience some “shaky” markets in a remake of 2008 (which seem to start materialising – think about Greece, the Equities markets crumpling again), we might see most of these funds rise and shine. Time to get working on this Trend Following strategy!

Notes
<sup>* YTD: Year-To-Date performance.
** AUM: Assets Under Management.
1. Abraham Trading was founded by Salem Abraham, after he was introduced to Managed Futures and Trend Following by Jerry Parker. He is considered as a “second-generation” Turtle.
2. The four founders of Aspect (Eugene Lambert, Anthony Todd, Michael Adam and Martin Lueck) were significant members of one of the most succesful funds in managed futures – AHL (Adam, Harding and Lueck)
3. Chesapeake Capital was founded by Jerry Parker, a former Turtle.
4. Clarke Capital was founded by Michael Clarke in 1993.
5. Drury Capital, Inc., was founded in Illinois in 1992 by Mr. Bernard Drury.
6. Dunn Capital was founded by Bill Dunn.
7. Eckhardt Trading is the firm managed by William Eckhardt, who co-led the Turtle experiment with Richard Dennis
8. EMC Capital was founded by Liz Cheval, a former Turtle.
9. Hawksbill Capital was founded by Tom Shanks, a former Turtle.
10. Hyman Beck & Co. main principals are Alexander Hyman and Carl Beck.
11. JWH & Co. was founded by John W. Henry, Owner of the Boston Red Sox.
12. Originally ED & F Man. Became a succesful CTA under Larry Hite and went on to form part of The Man Group plc, which subsequently bought AHL to form the Man AHL: the systematic trading division of the Man group.
13. Millburn Ridgefield have been trading Trend Following models since the early 1970′s. As they report performance figures one month later, last month performance is not reported in this report and their YTD, AUM stats are from the month before.
14. Rabar Market Research is the company of Paul Rabar, a former Turtle.
15. Saxon Investment was founded by Howard Seidler, a former Turtle.
16. Superfund founder and CEO: Christian Baha.
17. Transtrend is a Trend follower CTA based in Netherlands
18. Winton Capital is a London-based CTA founded by Dave Harding (also co-founder of AHL).</sup>

These are top of the range CTAs/Managed Futures funds in the Trend Following space.
Most of the traders behind these funds have been involved in the Turtle Trading experiment (2 excellent books on this topic: Complete Turtle Trader – featuring the actual turtle rules and The Way of the Turtle), featured in the legendary books by Jack Schwager: Market Wizards and New Market Wizards, or in Michael Covel’s dedicated Trend Following book.
 
 
 
 

With no further ado, here is the last Trend Following Wizards update for 2009:

Notes
<sup>* YTD: Year-To-Date performance.
** AUM: Assets Under Management.
1. Abraham Trading was founded by Salem Abraham, a former Turtle.
2. The four founders of Aspect (Eugene Lambert, Anthony Todd, Michael Adam and Martin Lueck) were significant members of one of the most succesful funds in managed futures – AHL (Adam, Harding and Lueck)
3. Chesapeake Capital was founded by Jerry Parker, a former Turtle.
4. Clarke Capital was founded by Michael Clarke in 1993.
5. Drury Capital, Inc., was founded in Illinois in 1992 by Mr. Bernard Drury.
6. Dunn Capital was founded by Bill Dunn.
7. Eckhardt Trading is the firm managed by William Eckhardt, who co-led the Turtle experiment with Richard Dennis
8. EMC Capital was founded by Liz Cheval, a former Turtle.
9. Hawksbill Capital was founded by Tom Shanks, a former Turtle.
10. Hyman Beck & Co. main principals are Alexander Hyman and Carl Beck.
11. JWH & Co. was founded by John W. Henry, Owner of the Boston Red Sox.
12. Originally ED & F Man. Became a succesful CTA under Larry Hite and went on to form part of The Man Group plc, which subsequently bought AHL to form the Man AHL: the systematic trading division of the Man group.
13. Millburn Ridgefield have been trading Trend Following models since the early 1970′s. Millburn Ridgefield Principals: Harvey Beker, George E. Crapple, Mark Fitzsimmons, Barry Alan Goodman, Kenneth P. Pearlman and Grant Norman Smith.
14. Rabar Market Research is the company of Paul Rabar, a former Turtle.
15. Saxon Investment was founded by Howard Seidler, a former Turtle.
16. Superfund founder and CEO: Christian Baha.
17. Transtrend is a Trend follower CTA based in Netherlands
18. Winton Capital is a London-based CTA founded by Dave Harding (also co-founder of AHL).</sup>

These are top of the range CTAs/Managed Futures funds in the Trend Following space.
Most of the traders behind these funds have been involved in the Turtle Trading experiment (2 excellent books on this topic: Complete Turtle Trader – featuring the actual turtle rules and The Way of the Turtle), featured in the legendary books by Jack Schwager: Market Wizards and New Market Wizards, or in Michael Covel’s dedicated Trend Following book.