An Honest Update On The CTA Trend Following Landscape by Red Rock Capital
Background
Trend following is the most prevalent strategy utilized throughout the managed futures industry. Over 22 months ago, during the toughest recession our industry has ever experienced, we published the original version of this paper to offer a transparent and intellectually honest update on the track records of many of the most well-known trend followers. At that time, all twenty managers included in our analysis, including our Systematic Global Macro (systematic trend following) program and all of the major CTA indexes, were in a drawdown off their all-time high water marks.
As Central Bank policies began to diverge, beneficial volatility (i.e. directional and sustained) began to manifest itself in many of the futures markets that are the core of most trend following CTAs’ portfolios. Most trend followers were able to capitalize on these favorable market conditions, with the best-performing managers producing all-time net-new equity highs, and in many cases, and then some.
As of the end of May 2015, the approximately $74 billion of manager assets under management that constitute the Newedge Trend Index was up 2.49% year to date and 4.77% into drawdown off its most recent high water mark.
The question remains the same as we posed in the original version of our paper: what is the best way to objectively analyze, measure, and compare the performance of a group of trend following CTAs?
To help answer this question we developed our own metric that measures and compares the “goodness” of similar managers’ returns. This paper updates our original work (and subsequent versions that were published in September 2014 and May 2015) and the measurements and ranking methodology that we initially introduced remain the same.
Who was analyzed?
This updated version of our paper includes analysis on 19 of the 20 trend following managers that we initially studied (one closed down), plus we include the Newedge CTA Index, the Newedge Trend CTA Index, the Newedge Trend Indicator, and an additional 4 managers. It is important to note that the Newedge CTA Index represents the equal-weighted performance of the top 20 largest diversified CTAs open for investment, the Newedge Trend CTA Index represents the equal-weighted performance of the top 10 largest trend following CTA open for investment, and the Newedge Trend Indicator is a fully-disclosed, rule-based trend following strategy that offers an interesting and transparent look into the daily performance and positions of a professionally developed, albeit basic, trend model.
Common Misunderstandings
Two of the managers we include in our analysis, one that we specifically added to help make an important point, received accolades for their impressive, outsized performance during 2014: Mulvaney Capital Management made +67.38% and ISAM produced +61.95%. However, the problem is (and this is a fact, not just our opinion), reporting only these types of “return” numbers tells only half of the story. When you hear a manager’s performance being quoted, the first question someone should ask is, “At what level of risk / margin-to-equity / volatility?” A Commodity Trading Advisor makes a subjective choice as to what level margin-to-equity to operate his or her program – but the level chosen is not, in and of itself, a source of “goodness.” Furthermore, an investor who opens a managed account with a CTA, through the use of notional funding, can modify the manager’s regular program volatility to suit their own appetite for risk. Therefore, due to the inherent leverage (i.e. free; no cost to lever up – unlike stocks) found in the futures markets, risk-adjusted returns (not absolute returns) are the only accurate and proper way to compare similar managers’ returns.
This point is repeatedly misunderstood by many in the managed futures industry. A program run with a higher margin to-equity ratio will produce a higher compound rate of growth at the price of higher drawdowns (periods of loss). For example, assume one manager produces a +60% net return over 12 months and another manager only produces a +20% net return. If the second manager used only 1/3 as much margin-to-equity, and produced only 1/3 as much volatility in his returns, then the two managers’ performance were essentially equal on a risk-adjusted basis. However, the first manager will often win awards and be touted for having “better” performance – which demonstrates a lack of understanding of, or at least a lack of concern for, a crucial aspect about managed futures and how to correctly measure performance.
To bring this point full-circle, while Mulvaney’s +67.38% and ISAM’s +61.95% performance in 2014 indeed sound impressive on the surface, a study of their track records shows that the former lost over 35% in one recent calendar year (and lists a 45.04% maximum historical drawdown) and the latter lost money in three consecutive recent calendar years and lists a 34.79% maximum drawdown. Both managers recently made all-time net-new equity highs, for which they should be commended, however, in order to get an intellectually honest and accurate reading of their true performance, one must include data on both returns and risk in one’s analysis.
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