I mentioned, in a recent post, a paper by Newedge presenting a Trend Follower CTA sub-Index as well as a mechanical Trend Following benchmark (Newedge Trend Indicator).
I recently found another paper taking the concept further: Fooling some of the People all of the time: The inefficient Performance and Persistence of CTAs.
Investors face significant barriers in evaluating the performance of hedge funds and commodity trading advisors (CTAs). The only available performance data comes from voluntary reporting to private companies. Funds have incentives to strategically report to these companies, causing these data sets to be severely biased. And, because hedge funds use nonlinear, state-dependent, leveraged strategies, it has proven difficult to determine whether they add value relative to benchmarks. We focus on commodity trading advisors, a subset of hedge funds, and show that during the period 1994-2007 CTA excess returns to investors (i.e., net of fees) averaged 85 basis points per annum over US T-bills, which is insignificantly different from zero. We estimate that CTAs on average earned gross excess returns (i.e., before fees) of 5.4%, which implies that funds captured most of their performance through charging fees. Yet, even before fees we find that CTAs display no alpha relative to simple futures strategies that are in the public domain. We argue that CTAs appear to persist as an asset class despite their poor performance, because they face no market discipline based on credible information. Our evidence suggests that investors’ experience of poor performance is not common knowledge.
The irony is in the timing of the report: it was published in Autumn 2008 – with one of its main authors from AIG Financial Products!
The paper is quite academic, but simple empirical evidence from 2008 showed that:
- It might be wise to apply a healthy does of skepticism with regards to AIG financial engineering.
- CTAs are able to produce extraordinary (and uncorrelated) returns.
In its first part, the paper builds a “bias-free” index of CTAs to establish their collective risk and return performance – and “establishes” that CTAs do produce alpha (statistically significant above-T-bill returns) but capture most of it in their fees, making the net (of fees) returns insignificantly positive, relative to T-bills
The performance numbers used in the paper are all derived from the Lipper-TASS hedge fund database and the index building methodology considers the following biases, while not being able to correct all of them:
- Survivorship: all CTAs that have “died” are included in the index
- Backfill: “non-live”, historical reporting is not included in the index. CTAs can include past data when they start reporting to the database. These performance numbers are not included in the index.
- Selection: since CTA reporting is voluntary, some funds are not included in the database. These are likely to be bad-performing ones. Nearly impossible to correct for this bias.
- Look-back: some funds can request to have their track record history completely removed from the database
In the second part, the paper presents some benchmarks developed using systematic trading strategies in equities, currencies and commodities (strangely, the trading model aims to reproduce a trend following strategy by considering the fundamental price-to-book ration for equities for instance…).
Comparing the CTA index performance to these models, the paper concludes that CTA performance is poor. However it does seem that the models built by the authors fail to represent CTA and trend following very well. In their own words:
The finding […] already suggests that CTAs follow strategies that are different from those embedded in the benchmarks.
The predominant style has been one of trend-following, most pronounced in currencies, but the combined factors have a maximum explanatory power of 33% (over the period 2001-2007).
In the last parts, the paper attempts to explain the persistence of CTAs, in the face of these “poor performances”.
Positive returns coupled with low to negative correlations to other asset classes (to improve portfolio performance as per Liz Cheval’s presentation for example) would be on top of my list, but the paper only quickly “glosses over” the subject without giving it further investigation:
What is less clear is whether this tail behavior (negative correlations) is sufficient to justify an investment in CTAs despite the poor performance. This would not seem to be justification since this type of diversification can be achieved at much lower cost using passive indices of commodity futures; see Gorton and Rouwenhorst (2006). The correlations of CTA returns with traditional asset classes in the tails seem unlikely to justify investors allocating $200 billion to an asset class that offers T-bill returns with a standard deviation that is comparable to equities.
We conclude that there is no compelling evidence to justify investing in CTAS in a portfolio context.
Other areas covered are returns skewness and information asymmetry between investors and funds.
Is the CTA Index Realistic?
Given the low barrier to entry and high attrition rates highlighted by the report, I believe it would make sense to adjust for these factors – as would real-life investors/allocators, who are fully aware of these issues (this is probably the primary reason why it is very hard to sell a CTA to investors without a track record of any decent length).
In order to “flush out” all the “bad CTAs” that fail after their first few years, the paper could mimic natural investor behaviour, and only include CTA track records after a minimum live reporting period. This would have been an interesting addition and represented more realistic investor’s expectations.
Moreover, the association “CTA = Trend Followers” established by the paper might be true for CTAs in activity, but who knows what percentage of failed CTAs actually used Trend Following as their main strategy. Maybe the database graveyard is littered with mean-reverters or other CTAs.
Commoditization of Trend Following
Nevertheless, the paper goes in the same direction as a few others, hinting at a possible “commoditization of Trend Following” (discussed last year in this post on the blog). I actually thought that the Beta of Managed Futures from the Conquest Group provided a better illustration of the concept.
This is also a concept I have been able to verify on the blog by running the State of Trend Following report every month and by comparing its results to those of the Trend Following Wizards. I have not run any correlation calculations (note to self: add this on the to-do list) but the results of the report have usually been a good empirical predictor of the wizards monthly performance.
Since I wrote that “trend following commoditization” post, a new actively managed ETF based on Trend Following/Tactical Asset Allocation principles (GTAA) was launched by the guys at Cambria (i.e. Mebane Faber from World Beta blog).
It is not directly comparable to a futures trend follower CTA as it only deals with ETFs, but its rapid success since launch (it raised over $150M since launch about 6 months ago) shows that there is a space for low expense/fee mechanical funds in the Trend Following area.
Whether these types of funds manage to perform on-par with (or outperform) CTAs on a net-of-fees basis will be interesting to follow. Another such fund, The Managed Futures Select (systematic CTA replication strategy, with low fees) from the Conquest Group claims to outperform CTAs. However, it depend which group of CTAs one looks at for comparison. On this other post from last year, using a modified version of the Information Ratio to compare the respective performances of the Trend Following Wizards and the Conquest MFS fund, those CTAs still appeared to produce alpha over the “Index fund” (with the disclaimer that the Wizards group might include some selection/survivorship bias).
I concluded last year’s post with :
When the launch of a Trend Following ETF?
Now that this has happened, what is the next step in the commoditization of Trend Following?