For some advisors, the stock market's two-year winning streak has revived confidence in equities. But any such complacency may be misplaced, and while bonds have held up remarkably in the face of rising interest rates, inflation has begun to return. That is something that never bodes well for fixed income. So what, then, to do?
Managers who have ventured into the world of alternative investments have found that commodity trading advisors (CTAs) have developed an effective means to diversify beyond traditional securities and to profit whether the broad market is up or down. Indeed, there has been an explosion in assets flowing into CTAs, according to the industry-tracking firm Barclay Trading Group. Total global assets in CTAs were $51 billion as of the end of 2002. By the end of 2004, that had climbed to $131.9 billion. The flows have been driven by formidable movement in commodity prices and increasing awareness by institutions and retail investors that managed futures--the strategy CTAs follow--can be effective. Among the largest pure players among the more than 400 CTAs (see table, page 86) are Campbell & Company ($9.4 billion under management), Graham Capital Management ($5.8 billion), FX Concepts ($4.7 billion), John W. Henry ($3.6 billion), and Sunrise Capital Partners ($2.6 billion). However, most CTAs are mom-and-pop firms that manage as little as several million dollars. Most CTAs' performance is regularly reported to industry groups such as International Traders Research and Barclay Trading Group, which provide in-depth performance analysis. "Most money managers don't realize that commodity trading advisors offer an effective means to diversify a portfolio with virtually no correlation to stocks and bonds while sustaining a proven record of long-term profitability," notes Richard Pfister, vice president of institutional research at Altegris Investments in La Jolla, California.
By their very nature, managed futures excel during bouts of uncertainty that challenge traditional investments. Using futures contracts to make leveraged bets on the global economy--currencies, energy, bonds and interest rates, stock indexes, and agricultural and consumer goods--CTAs attempt to profit from price swings no matter in which direction they are heading.
If this sounds like hedge fund strategies, you're right. CTA managers can invest in a great variety of financial instruments and are able to go short as well as long everything from corn to Mexican pesos. Like many hedge funds, CTA management costs typically average 2% plus incentive fees of around 20%, paid when a fund's price exceeds its previous high. Some top hedge funds, such as those of Paul Tudor Jones and Renaissance Technologies, started as commodity trading advisors.
CTAs, however, differ from hedge funds in two basic ways. They are more transparent than hedge funds as positions and performance are reported regularly. This lets advisors discern strategy, exposure, and liability, as well as profitability. Many also offer significantly lower minimum investments, making them available to a far greater number of investors.
To Brian Kline, an Indiana-based CPA and financial advisor, commodity funds are an effective way of enhancing portfolio returns. "But," he notes, "the potential for greater performance often comes with greater risk, and investors must not only be able to tolerate this, they also must do their homework in selecting and maintaining a position in a fund." Some programs, Kline has observed, have falsely claimed to have earned high returns. Kline recommends advisors contact two oversight agencies, the Commodity Futures Trading Commission (cftc.gov) and the National Futures Association (nfa.futures.org), to vet the integrity of individual programs and learn the ins and outs of managed futures.
Risk and Return
While the average CTA program underperformed stocks last year, it has significantly outperformed major U.S. market indexes over the longer term. Through the end of 2004, three-year annualized price returns of the S&P 500, the Dow, and Nasdaq were 1.82%, 2.50%, and 3.71%, respectively. By contrast, the average annualized return of Altegris' benchmark ITR Premier 40 CTA index was 11.08%. This dollar-weighted index tracks the 40 largest CTAs, representing approximately half the managed futures industry's assets. The gap for five-year annualized returns since the beginning of 2000 is even greater. The S&P 500, Dow, and Nasdaq indexes were off 3.71%, 1.30%, and 11.77%, respectively, while the ITR 40 was up an annualized rate of 9.83%. Moreover, CTAs have been able to consistently outperform the market with less risk. The historical standard deviation of the ITR 40 is lower than that of the stock indexes: 12.87 versus 14.81 for the S&P 500; 18.78 for the Dow; and 22.29 for the Nasdaq.
An additional measurement of risk is known as the maximum drawdown--the largest price descent from a peak to the bottom of a trough. Since 1990, when the ITR 40 index was created, its worst drawdown was 15% during an eight-month period, bottoming in April 1992. While varying in duration, all three equity indexes experienced their worst drawdown, excluding the Great Depression, during the last bear market. All bottomed in September 2002: The S&P fell 46.28% over a 35-month period, the Dow lost 33.97% over 33 months, and the Nasdaq collapsed by 75.04% over 31 months. "Over the long term," says Perry Jonkheer, president of Institutional Advisory Services Group, a CTA industry clearinghouse and brokerage based in Glen Ellyn, Illinois, "managed futures can enhance portfolio returns while decreasing risk."
A portfolio composed of 70% S&P 500 and 30% Lehman Brothers Aggregate Bond Index generated annualized returns of 4.8% with an average standard deviation of 11.47% between August 1997 and January 2005. But Jonkheer maintains that replacing 10% of both stock and bond exposure with 20% managed futures reduces the standard deviation to 9% while pumping up potential returns to 5.38%. "Even a 10% exposure to managed futures decreases risk by more than a full percentage point while boosting returns by 29 basis points," he says.
While the efficient frontier theory on which these findings were based carries weight in portfolio management, advisors must be mindful that actual performance will likely vary significantly depending on the investments made. This point emphasizes the need for continuous due diligence to prevent significant underperformance.
Where many of the largest CTAs, including most making up the ITR Premier 40 index, are diversified programs, a significant number focus on specific sectors. These programs are especially useful to ensure diversity. Putting money in several diversified programs may actually be redundant, where allocating assets into specific sectors ensures weighted exposure to distinct markets. That is why Carmel Capital, a California-based private investment company with a third of its $9 million in assets in managed futures, thinks investors should be exposed to three to five different CTAs, combining diversified with specific sector programs. Concurring, Jonkheer says, "overlaying programs that have little to no correlation with one another is among the simplest ways to reduce volatility and create a consistent rate of return."
Since 1987, Barclay Trading Group has extensively tracked performance of managed futures' three largest sectors: financials and metals, currencies, and agriculture. Its findings help advisors discern average performance and risk by sector, revealing virtually no correlation with U.S. stocks and bonds.
Financials and metals CTAs have been among the best performing specialized sectors. Barclay found that while the 77 programs reporting suffered an average loss of 0.14% in 2004, they realized annualized returns of 7.20% over the last three years and 6.41% over the last five (the returns are not asset-weighted). Since Barclay started tracking financial and metals traders in 1987, they have had two down years in addition to 2004, off 4.70% in 1994 and 4.52% in 1999. Their worst drawdown: 11.14%.
CTAs investing exclusively in the foreign exchange market had only modest gains in 2004 despite the dollar's volatility. Barclay found that the 72 programs reporting were up 1.44%. However, annualized returns averaged 6.20% over the past three years and 5.14% over the last five, outpacing the broad market. Barclay's currency index registered only two down years since its inception, off 3.33% in 1993 and 5.96% in 1994. Its worst drawdown was 15.26%.
Agricultural traders, meanwhile, had a very good 2004, with 17 programs averaging gains over 15%. Longer term, Barclay found the sector to be among the weakest performers due to generally weak and trendless crop prices. Between 2002 and 2004, the sector's annualized return was only 2.06%. Historically, this sector appears to be the riskiest, having experienced four down years in the late 1990s and early 2000s, the worst occurring in 2001 when the index was off 11.75%. The index's worst drawdown reached close to 20%.
In contrast, Barclay's survey of 217 diversified programs reveals that a multisector approach, on average, has generated superior returns since 2000. They turned in only modest gains in 2004 (1.21%), but diversified programs had respective three- and five-year annualized returns of 8.79% and 7.88%. Since 1987, only the financial and metals sector has outperformed the diversified group on an annualized basis: 13.40% versus 11.97%.
While Barclay's averages suggest that CTAs in general are not the high-stakes plays many outsiders perceive them to be, advisors looking for more oomph can certainly find plenty of programs with higher risk/reward characteristics. One small but rapidly expanding sector is option writing. "Advisors," says Barclay's CEO Sol Waksman, "write short-term contracts sufficiently out-of-the money so that they don't expect them be exercised, thereby profiting from a continuous premium flow." Most options programs focus on stock indexes, such as the S&P 500, but they may also get into currencies, interest rates, and commodities. Key variables are spreads between current and strike prices as well as implied volatility and the length of contracts. This category is especially noteworthy because of the performance of the Zenith Resources "Index Options" Program, based in Godley, Texas. Since commencing in December 1999 the program has achieved an annualized rate of return of 30.76% with an annual standard deviation of just 8.01. Its worst drawdown was a mere 3.12%.
The program, with a minimum investment of $50,000, has somehow managed to stay off most managers' radar screens. Its assets are a modest $18.25 million and staying small may be part of the program's success, reflected in the fact that it is now closed to new investors. The firm's president, Ed Padon, says his "focus is on risk, not premiums. We make sure that we sell S&P 500 contracts at least 100 points out of the money. This reduces the premium we can collect but helps ensure we are more often than not on the right side of the bet."
While writing primarily naked put option contracts, Padon wants to see adequate market liquidity to enable him to buy put options below the strike price he previously sold. Buying these puts hedges his premium and margin risks. He closed his program because he currently feels there isn't adequate liquidity to establish additional defensive positions at specific strike prices.
The Way They Work
Because futures are leveraged plays, an advisor need be right only once out of every two to three bets to make money. The down side is managed through two basic techniques: systematic trading programs to automatically limit losses, and maintenance of approximately two thirds of assets in Treasury bills as margin protection on futures positions.
Systematic trading is based on a wide series of metrics including price movements and trading volumes to trigger non-discretionary decision-making. "This approach removes the emotional factor from trading," explains Jeremy O'Friel, principal of Dublin-based Appleton Capital Management. Its use of systematic trading allows its programs "to quickly cut losses while permitting profitable positions to run."
Mark Rzepczynski, president and chief investment office at John W. Henry & Company in Boca Raton, Florida, also relies extensively on systematic trading to sidestep many of the problems that occur when markets disconnect from underlying fundamentals. "We've achieved more consistent and less volatile results," Rzepczynski says, "by developing programs based on trading patterns generated by how the market responds to various stimuli."
With momentum shifts triggering investment decisions, CTAs are largely known as trend followers. They don't care which way the price of a currency or a commodity is heading as long as it keeps moving in a particular direction. It is no surprise, then, that the least profitable times for CTAs are when price movements are trendless.
This is precisely why currency traders did not fare well in 2004. "The strong late-year rally against the dollar is what saved many currency funds," says Michael Clarke, principal of Clarke Capital Management in Hinsdale, Illinois, whose new FX Fund soared by more than 25% in November to end the year up 4.75%. But Clarke's Millennium Program, with $200 million in assets and among the best-performing programs around, reveals the many advantages of diversified systematic trading. Between 1999 and the end of 2004, it achieved annualized returns of 25% while the S&P 500 lost 2.3% a year. Program trades have recently enabled Clarke to profit from long positions in oil, currency, and metal contracts. However, since January his programs have pared back investments as trends have broken down. Only 10% of his assets are currently invested, across various positions.
With short-term rates expected to continue to rise and long-term rates to fall, Millennium is short two-year U.S. Treasuries and long both 10-year euro and U.K. bonds and 30-year Treasuries. Its agriculture bets are mixed, betting on cotton and sugar prices to rally and soybeans and wheat to falter. Clarke's consistent performance does come with substantial risk: ITR calculates that the program's annualized standard deviation is 27.67, nearly twice that of the S&P's. But such volatility in the context of strong gains can be understood by looking at the rolling 12-month performance. It has been nearly consistently positive, generating profitability that has swung frequently between average and extraordinary.
Integrating a systematic approach with some discretionary authority may seem like the way to optimize results, but Vienna-based Quadriga Fund Management found that not to be the case. When the CTA started its diversified AG Fund in March 1996, it lost 10.3% for the year. "We had a program trading system in place, but with the ability to override the computer when our gut told us so," says CEO Christian Baha, who notes that the fund is not available to U.S. investors. "We learned that was a mistake." Since 1997, the fund has always been profitable, enjoying annualized returns of 27.3%. Like Clarke's Millennium Program, such profits come with substantial volatility. The annual standard deviation averaged 24.17.
Do not dismiss outright the merits of discretionary trading. Nearly a third of CTAs still rely on this. Several of the largest CTAs run successful discretionary programs with more than $1 billion in assets. Beach Capital Management has had five-year annualized returns in excess of 15% with standard deviation under 15%, while Connecticut-based Graham Capital Management generated annualized growth of more than 10% with a standard deviation of 4.24%.
Carmel Capital believes that CTA exposure should be split between systematic and specialized discretionary programs. Last year's performance validated that strategy. According to Barclay, 85 programs that rely on at least 65% discretionary judgment significantly outperformed 333 systematic programs, 8.70% versus 0.51%.
Altegris' Pfister believes that discretionary traders can excel during specific market conditions in which they have expertise. However, they are vulnerable to underperformance when things change. This might explain why over four of the last five years, when markets have seen substantial volatility, systematic programs have outpaced discretionary traders by an annualized rate of 144 basis points, 6.75% versus 5.31%.
The Small Print
CTA programs tend to close more frequently than mutual funds, most likely between the third and fifth year of a program's life. Pfister says at this point "a CTA has likely proven the ability to invest effectively but is now confronted with the tricky chore of balancing asset expansion with increasing operational costs." A drawdown will not likely hurt the assets of a large established firm, but it could send new investors fleeing a younger trader, threatening investments and leaving it with excessive costs, miles away from its high-water mark.
Helping to identify CTAs prone to failure, Greg Gregoriou, associate professor of finance at the State University of New York College at Plattsburgh and an editor of Commodity Trading Advisors: Risk, Performance Analysis, and Selection (John Wiley & Sons, 2004), has identified key traits of the most sustainable programs. Tracking performance between 1990 and 2003, Gregoriou found that half of all CTAs do not last beyond 4.4 years. The main reasons: too few assets, excessive volatility, and management fees either too high to compete or too low to sustain operations. The group identified four factors essential for selecting CTAs: assets of at least $2.9 million; mean monthly average returns above 0.98%; minimum investments of at least $250,000; and annual management fees no greater than 2%. (Commodity Trading Advisors is available from the IA Bookstore at www.invest-store.com/investmentadvisor/.)
As with stocks, the market is starting to offer indexes as a means of mitigating risk and achieving balanced returns. New York-based PlusFunds Group offers access to the S&P Managed Futures Index, which provides an accurate cross-section of the CTA world by tracking 14 diversified programs with at least a three-year track record and $100 million minimum under management. On the smaller end of the scale, Chicago-based RSI/Access Asset Management has created an emerging CTA Index fund that invests in 40 to 60 programs, each with less than $20 million under management. Most CTAs are removed when AUM exceed $50 million. Barclay, along with Asset Alliance, meanwhile, is seeking approval to market the Barclay BTOP 50 index that represents 50% of CTA assets. Barclay has maintained this index since 1987 and has never had a loss during a full calendar year.
While many CTAs' long-term performance numbers may suggest that this asset class is a sensible alternative to traditional investments, Clarke warns both money managers and investors that they should not be deluded into establishing heavy positions. "All markets can be mercurial," he says, "and short-term volatility is inherent when investing in futures contracts." Advisors and investors must realize this in advance. Otherwise, they could suffer unaffordable losses or they may panic and sell out at the worst possible time. Accordingly, Clarke recommends that the decision to invest in CTAs should be predicated on a long-term investment horizon and significant risk tolerance, with allocation best limited to 5% to 10% of an investor's portfolio.
New York-based financial writer Eric Uhlfelder can be reached at firstname.lastname@example.org.