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How CTA strategies work: a guide to managed futures

How CTA strategies work: a guide to managed futures

Managed futures or Commodity Trading Advisors (CTAs) are back in fashion as some of the most famous names in the space become available in the Ucits III format.

Despite their reputation, these strategies are not as mysterious as some people think.

The secret behind them is simply momentum indicators, such as price moving average or price channel breakout models. The vast majority of CTAs are trend followers, which means that when a market shows a clear uptrend, there is a strong chance that CTAs are long this market.

It is exactly the same when a market goes down and CTAs can make money on the downside, by being short. This major feature makes them interesting in terms of portfolio diversification. For example, the Barclay CTA Index was up +14.09% in 2008 when the S&P500 was down -38.49%.

The models which generate the buy or sell signals are usually no more complicated than prices crossing moving averages or exiting a channel. However, these models sometimes cover more than 100 markets over different time frames – from seconds to months.

Once a strategy has been statistically proved profitable, if is coded into the global quantitative system. This kind of system takes the emotion out of investing and places the trades on its own. There is usually no human intervention between the trade signal generation and the orders placed on the market.

But this does not mean human beings are absent from the quantitative trading process. Managers come up with ideas, test strategies and decide which ones to use, which kinds of instruments to trade, at what speed, and so on. Some managers have an emergency button which allows them to reduce risk if they think markets are behaving outside the scope of their models’ capabilities.

Quantitative strategies are often ignored by long only investors as being opaque and incomprehensible. Even specialists who focus on this niche tend to spend most of their time understanding the core of the strategy.

However, I think there are many other parts of the quantitative trading process that should be understood and evaluated. It pays to look at transaction cost models, for example, which helps determine the correct turnover rate for a strategy.

Risk models are another factor and helps keep the strategy from betting on the wrong exposures.

Finally, portfolio construction models are also key as they balance the conflicting process of generating returns, minimising transaction costs, and managing risk.

It is also worth noting that CTAs – often called managed futures funds – only trade futures contracts traded on exchanges. They do not imply any counterparty risk and are the most liquid traded instruments in the financial markets. The counterparty is the clearing house of the exchange. What makes the strategy also very compelling is the fact that losses are realised through the mechanism of margin calls.

Recently some investment banks structured Ucits III funds with daily or weekly liquidity based on managed accounts of CTAs. These Ucits III funds are not very different from the original funds, except that they have to comply with the investment restrictions imposed by the Ucits III framework.

One example is the rule of a 35% limit per silo (or market). But this will be rare with CTAs as embedded risk management models would rarely let the exposure of a given market be more than 35% of the fund.

The cash management of Ucits III funds might also differ from what exists at the offshore fund level, while fees may also be higher as the investment bank structuring the fund will take its cut.

In terms of diversification, since 1990 the correlation of the Barclay CTA Index with the S&P500 was -0.12 and with the Barclays aggregate Bond index it was +0.17.

But overall CTAs in a Ucits III format offer an interesting opportunity for long only investors, as true diversifiers which you can rely on when markets go south are hard to find. 

Olivier Baumgartner-Bezelgues, CAIA, CIIA, is an independent hedge fund consultant. His email address is olivier.baumgartner@sunrise.ch

This article originally appeared in the September issue of Citywire Global.

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