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June 2012

Understanding Managed Futures

In a time of historically low bond returns and high realized and potential equity market volatility, two strategies that investors are turning to are commodity trading advisors (CTAs) and global macro hedge funds. In adopting these strategies, it is important for investors to distinguish the similarities and differences between these strategies. CTAs in a hedge fund portfolio can be both a complement to and a substitute for a global macro allocation. Overview of Managed Futures
Managed futures strategies are the general category of investment strategies into which CTAs fall. These managers implement a wide variety of trading strategies, but the common element of each is that they apply these systems primarily to futures contracts, overthe-counter spot and forward contracts (in the case of currencies) and less often, options on futures contracts. Chart 1: Futures Market Volumes by Contract Type (percent)

Evolution of the Futures Markets

The futures markets were originally a way for producers and consumers of commodities to hedge price risk in an economy weighted more heavily toward agriculture than it is today. As the United States and global economies have shifted away from an agricultural focus, so has the composition of the futures markets. Chart 1 illustrates this change. As late as 30 years ago, the futures markets were heavily weighted towards

Metals 16%

Interest Rate 14% Lumber &

Currencies 7.6% Agriculture 8.7%
Energy 12.2% Interest Rate 41.8% Metals 2.9%

Currencies 5%

Energy 1%

Agriculture 64%

Equities 26.8%

A key feature of these contracts is that they are very liquid. The futures contracts are traded on global futures exchanges where large numbers of buyers and sellers transact every day. The liquidity provides easy entry and exit of positions as well as lower transaction costs because of narrower bid-ask spreads. Lower transaction costs can improve the performance of the strategy.

agricultural products. By 1980, trading in financial products besides currencies was limited primarily to US Treasury Bill and Bond futures.1 With the advent of trading Eurodollar futures in 1981 and stock index

Interestingly, the first financial futures contract to trade was one on Government National Mortgage Association (Ginnie Mae) certificatessuggesting the longstanding importance mortgages have had in the US.

Table 1: Examples of Contracts that CTAs trade

Equity Indexes S&P 500 CAC-40 DAX NASDAQ Energy Crude Oil Natural Gas Unleaded- Gasoline Electricity Interest Rates Eurodollar Fed Funds Rate Short Sterling Government Bonds 30-Year US Treasury Bond German Bunds Japanese Government Bonds Grains & Soft Commodities Corn Soybeans Coffee Wheat Sugar Currencies (vs. US Dollar) Canadian Dollar British Pound Euro

Metals Gold Silver Copper Tin Aluminum

Livestock Live Cattle Lean Hogs Pork Bellies Feeder Cattle

futures in 1982, the futures industry took a decided turn toward financial instruments trading. These contracts along with the Treasury Bill and Bond contracts permitted financial market participants to hedge and speculate on a variety of financial risks. The development of these new futures contractscombined with the agricultural and industrial contracts already in existence opened vast new opportunities for traders in these instruments. Government regulation of the futures marketspart of which created the CTA designation for an asset manageralso played a role in the growth of the managed futures industry. Prior to the development of futures markets in extensive and diverse underlying assets, futures traders could still implement trading systems in the markets that did exist. Likewise, global macro managers could implement their views in cash markets for government bonds and equities, but while using already existing futures markets for instruments such as precious metals. The development of the futures markets, however, made taking positions in these markets easier and more capital efficient because margin requirements on the futures exchanges enable managers to gain the desired exposures to the markets with less upfront commitment. The liquidity of the futures markets also permitted manages to put on and take off positions with relative ease.

variety of underlying asset classes with a diverse geographic focus. Although global macro managers may also trade individual equities, as well as ETFs and cash bonds, futures are an important way they express a view in the markets they trade. As Table 1 illustrates, futures contracts can cover the government bond markets as well as the equity markets in a variety of countries. In addition, the physical commoditiessuch as oil, gold or wheatthat managers in both strategies use are traded on global markets. As such, the price movements of these commodities reflect overall global economic strength or weakness, as well as the relative economic conditions of one versus others. In addition to trading similar instruments, the strategies of CTAs and global macro managers can be assigned to similar categories. Both types of managers can take long and short positions in the markets that they trade. Both can trade systematic strategies, discretionary strategies or a combination of the two. Systematic strategies utilize quantitative models to identify trade opportunities and to make decisions about entry and exit points for trades. Discretionary strategies rely on the managers judgment to make trading decisions.2 In order to identify the differences between CTAs and global macro managers, it is necessary to make some generalizations. CTA managers often focus on the price movements and trading volumes that individual commodities display. If they utilize technical analysis as

How CTA and global macro strategies are alike and different
Both CTAs and global macro hedge funds often trade the same instruments, namely futures contracts on a

For a fuller discussion of the strategies and styles that CTAs employ, see the Asset Alliance presentation, The Benefits of Managed Futures, 2012

part of their trading strategy, price and volume data may be the only data they look at. Even if CTAs view commodity prices within a more fundamental, supplydemand framework, it will often be the case that they look at price movements most heavily in the trades that they make. Global macro managers in contrast, will often make trading decisions with the context of an array of macroeconomic data. The will base their view on whether to take long or short positions in government debt or equities in a particular country based on overall changes in such economic data. This is not to say that global macro managers ignore asset prices; clearly they do not. It is simply generally true that they base their trades on more than just prices. Both types of managers can adopt relative value strategies in their trading, meaning that they will take a long position in one instrument or market and a short position in another. In such a case, each strategy will be basing their trade on the expectation that the spread between the instruments will tighten or widen, depending on the type of position they have taken. Even in this case, however, the focus of their analysis will be different. CTAs generally will be focused on historical relationships between the two instruments themselves, while global macro traders will base their judgments on spread widening or tightening on macroeconomic relationships. Despite these differences in approach, however, for both types of managers, the prices that both types of managers observe and at which they trade are influenced by the same set of factors. Some CTAs might not look at macroeconomic data, and some global Chart 2: 1990-1998
20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% 0% HFRI Index S&P 500 TR

macro managers might not look at technical indicatorsbut they both observe and respond to the same set of prices. Those prices in turn are influenced by the factors that the managers are responding to. One implication of the above observation is that CTAs can be considered a subset of a larger trading strategy that includes both CTAs and global macro manager. For this reason, many investors include both CTAs and pure global macro manages in their allocations to a global macro portfolio.

CTA performance in different market environments

We shift our focus now to the performance of CTAs during different market environments. As any financial market observer over the last two decades can attest, the market environment has varied greatly. The environment in each market period has presented different challenges to each asset class and strategy of investing. Although the division of the last twenty years into different sub-periods is somewhat arbitrary, we have chosen to delineate the different environment into periods marked by crises. For that reason we chose the following periods to examine the performance of CTAs: 1990-1998the run-up to the Russian/Asian debt crises 1998-2007the period between the above crisis and the global financial crisis 2007-2012the global financial crisis and its aftermath.

Chart 2 depicts the performance of CTAs with respect to other asset classes and to hedge funds generally in each 2007-2012

20% 18% 16% GSCI 14% HFRI Total Index 12% Return 10% Bond Index 8% Barclay S&P 500 6% TR CTA 4% Index 2% 0% -2% 0% 10% 20% -4% -6% Standard Deviation

14% 12%
10% Bond Index

Compound ROR

Compound ROR

Compound ROR

Bond Index

Barclay CTA Index

8% 6%

GSCI Total Return

Barclay CTA Index S&P 500 TR

2% 0%
-2% 0% -4%

HFRI Index
10% 20%

GSCI Total Return







Standard Deviation


Standard Deviation

of these two periods. In the first two periods, CTAs produced a comparable compound returns to bonds, but with somewhat higher volatility. In all three periods, CTAs produced lower volatility than either equities or commodities. In the third period, CTAs have outperformed equities, commodities and hedge funds overall. It is interesting to note that the risk and return performance of CTAs has been much more stable during these periods than have equities, commodities or overall hedge funds. These charts demonstrate that while it is true that CTAs do not always outperform standard asset classes or hedge funds, the performance of the strategy overall is much more similar to the performance of bonds than are other strategies.

alpha that CTAs producethat is the uncorrelated return relative to the benchmark under comparisonis significant across the board. These data are monthly numbers, so for example, from 2007-2012, CTAs produced a monthly uncorrelated return of 0.4 percent relative to the S&P 500. Table 2: Diversification benefits of CTAs
S&P 500 TR 1990-1998 Correlation Alpha 1998-2007 Correlation Alpha 2007-2012 Correlation Alpha -6.0% 0.4% 0.8% 0.4% 19.3% 0.4% 18.9% 0.4% -22.6% 0.5% 27.9% 0.1% 27.9% 0.4% -3.7% 0.5% -8.9% 0.8% 14.0% 0.4% 13.1% 0.7% -10.8% 0.9% Barclays Aggregate Bond Index GSCI Total Return HFRI Fund Weighted Composite Index

Diversification benefits of CTAs

A number of analyses have focused on the diversification benefits of CTAs in an overall portfolio. We focus here on two indicators of this diversification benefitcorrelation and alpha. Table 2 presents these two statistics for the same three time periods as in the risk-return comparison above. As the table shows, CTAs have exhibited a low or negative correlation to equities in all three periods that we examine. CTAs are also negatively correlated to a broad hedge fund index in two of the three periodsthe aftermath of the global financial crisis being the exception. CTAs also show a low correlation to both bonds and commodities in all three periods. Recent months represent examples of the lack of correlation. In May, when the S&P 500 Index was down 6.1 percent, the Barclay CTA Index rose 2.7%; In contrast, for June the CTA Index fell 1.62% whereas the S&P rose 4.1 percent. As more evidence that CTAs provide diversification, the alpha that they produce relative to other investments is significant in each of the time periods we consider. The

Final thoughts
In this article we have shown how CTAs compare as an investment strategy to global macro hedge fund strategies. In general, CTAs can be considered either a substitute or a complement to global macro strategiesdespite the differences in the approaches because the instruments they trade are responding to the same conditions in the global economy. We have also seen how the performance and diversification characteristics of CTAs can add value in an overall asset allocation. We have also seen that over the period since 1990, the performance of CTAs contrasts with the performance of commodities in having lower volatility. The staff of Hedgeharbor will be glad to discuss further how one or more CTA managers can add benefit an existing portfoliowhether or not it already contains a hedge fund allocation. We look forward to discussing this issue further.