The corollary of this being that there are also hedge funds absolute return funds in the truest sense that pride themselves on an unexciting ride, low market correlation and slow steady returns. You can see more about the positive effects of managing volatility in our article about variance drain.
Previously, due to high minimum-investment requirements , — 10,, USD the hedge fund investment universe was reserved only for the extremely wealthy but now, due to the prevalence of personal portfolio bonds provided by regulated life insurance companies, small investors are able to benefit from the dynamic returns produced by hedge funds with a much smaller initial investment often from as low as 10, USD. Due to this hedge funds will continue to permeate into the investment portfolios of normal people who seek the diversification and returns offered by alternative investment instruments.
In recent years CTAs have gained notable attention and knowledge of their existence has finally made its way to discretionary investors. Where we encounter confusion is where CTAs are brought into the conversation alongside hedge funds; often being introduced as opposing terms.
CTA , noun. Simply put, 9 times out of 10 a CTA is in fact a hedge fund, i. Trading physical commodities is not only costly business but problems routed in illiquidity and delivery may impede trading strategies on an ongoing basis. Accordingly, Futures contracts are a cost effective way to mitigate these issues whilst participating in commodities markets, via derivatives. S omewhat perversely CTA strategies are not limited to trading Commodities markets and we commonly see funds which also participate in equity, indexes, rates and currencies- all of which provide sufficiently deep liquidity to satisfy the redemption requirements of investors whilst adding an extra layer of diversification and in some cases inadvertently sacrificing low beta correlation for alpha.
Accordingly, the definition of a CTA is perhaps appropriately as amorphous and commonly as unhelpful! During the financial crisis in Q4 , many pension funds learned their portfolios were not as diversified as they previously believed.
This led to a sharp increase in growth in the CTA industry. Correlations between fundamentally based long-only and hedge fund strategies are dynamic. They frequently exhibit a negatively skewed performance distribution with correlations increasing dramatically during market selloffs, just when investors want correlations to be low. Many investment committees were shocked when they received their year end performance report which showed their emerging market equity managers down over 50 per cent, US equity managers down approximately 40 per cent, high yield fixed income mangers down close to 30 per cent, the DJ-UBS Commodity Index down 35 per cent and the average hedge fund manager down in the high teens.
While all these strategies caused carnage across investment portfolios, the Barclays CTA index was up over 13 per cent. We expect the demand for CTAs to increase again based on how well some of them performed during the selloff in the 1st quarter of Unlike most fundamentally based long only and hedge fund strategies, many trend following CTAs have exhibited positively skewed performance distribution.
This dynamic has been driven by their systematic models which are designed to make money based on both bull and bear trends in markets. This means that the diversification benefits of CTAs are not entirely explained by their average correlation over time.
A better statistic to look at is the skewness of their performance distribution and how their correlation changes in both up and down markets. Other attributes investors find attractive about CTAs include: Liquidity : Most CTAs trade only in liquid, price-transparent futures contracts and typically allow their investors monthly and often weekly or daily liquidity.
In addition, gates and suspension of redemptions are highly unusual for those CTAs focusing on liquid markets. In addition, their largest weightings and performance can be understood intuitively That is to say, depending on the CTAs time horizon, after a trend has been established either up or down, one can conclude that a trend following strategy has a significant long or short position in that market.
The largest position weightings are likely to be in markets that have demonstrated the most robust trends. Institutional infrastructure : Many of the leading CTAs are mature and well-developed businesses, which offer an institutional infrastructure with large teams in research, technology, operations, legal, and compliance.
Controlled risk : Most of the leading CTAs have highly sophisticated risk management systems that target a specific volatility of performance by weighting positions based on risk parity. Many are constantly updating their models based on changes in volatility and correlations of the markets in which they invest. In contrast, most fundamental managers will typically allow the volatility of their fund to fluctuate with the volatility of the markets in which they are invested.
What is the underlying philosophical basis of the strategy? This article will provide a definition of CTAs, differentiate among the approaches to trading, and then discuss reasons for their popularity. The conclusion will attempt to outline what investors should and should not expect from a CTA investment. CTAs and managed futures are synonymous.
CTAs use a methodology, either systematic model driven or discretionary decision driven to trade a wide range of futures and indices. Core markets for CTAs include equities, fixed income, currencies, commodities, and spreads. Trend-following CTAs have time horizons that range from short term several hours to several days to medium term up to 30 days to long term months.
CTAs make money by identifying trends in underlying markets and putting on trades that make money as long as the trend remains in force. CTAs have very disciplined risk management systems; when they implement a trend that never materialises or fizzles, strict stop-outs will be initiated. For this reason, CTAs are said to have a large optionality component.
A position is essentially a call on the continuation of a trend; a stop-out represents the loss of option premium. CTAs also lose money when a trend reverses. Because CTAs stay in trends for periods, sometimes extended periods, after the reversal of a trend, it is important for an investor to be familiar with the CTA's approach to conserving profits before trend reversals cause major profit give-backs, also known as drawdowns.
If one thinks about the pattern of returns generated by a CTA, it is clear that there are patterns of small losses trends that do not materialise , periods of large gains trends captured , and large drawdowns, as depicted below:. Two observations come to mind with respect to this pattern of returns. Losses are usually small, virtually eliminating the ugly "left tail" representing outsized losses.
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