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Comeback of the Machines?

Wednesday, July 29, 2015

Dr Sushil Wadhwani, founder and CEO of Wadhwani Asset Management and former member of the Bank of England’s Monetary Policy Committee, explains why he expects managed futures strategies to perform well over the coming years. Together with his team, he manages a CTA strategy for GAM.

Commodity Trading Advisors (CTAs) have come a long way since the 1850s, when futures contracts for agricultural commodities first began to be traded. They have now expanded to cover all of the main asset classes – ie commodities, fixed income, equities and foreign exchange (FX), and are one of the main alternative investment strategies within the hedge fund universe. Essentially, CTAs are asset managers that specialise in using futures contracts and/or options on futures. Hence they are sometimes known as ‘managed futures’ accounts/funds.

Typically, CTAs use technical analysis to help devise their trading strategies – looking for evidence that the prices of assets exhibit trends, or ‘momentum’. Some CTAs, however, also take into account economic fundamentals and use indicators other than just asset prices to help devise their trading strategies.

Unlike traditional long-only investors, CTAs do not require asset prices to rise in order for them to be rewarding: a CTA is just as likely to be able to exploit a down-trend in prices as an up-trend. Consequently, they may offer traditional, long-only investors a potential benefit from diversification.

The importance of CTAs to a traditional investor

Managed futures had a tough run from around 2009 to 2013, but their historic and long-term merits should not be dismissed on the basis of just a few years of weak performance. Let’s look at some facts: Some evidence of the usefulness of CTAs in helping to improve investment performance for a traditional long-only investor is their strong track-record during episodes in which equity markets have performed poorly. Over the last four decades, for example, there have been 27 episodes when equities lost 7% or more (in non-overlapping periods of 1 to 4 months in duration). During these 27 episodes, CTAs were profitable on 25 occasions.1

Likewise, during the 26 periods over the past 40 years when bonds performed poorly – with the Barclays Treasury Bond Index falling by 2% or more over a 1- to 4-month long period – CTAs managed to deliver returns of 2.4% per episode, on average.

Taking a typical traditional long-only (60% equities / 40% bonds) portfolio, and again looking back at investment performance over the last 40 years or so, CTAs have been good diversifiers for traditional long-only investors. For they generated positive performance in nine out of the ten 12-month-long periods when a traditional portfolio performed worst, and detracted from performance (just 0.5%) only once. During these ten episodes, a traditional portfolio lost nearly 10% per annum on average, whereas CTAs delivered positive returns of more than 20% per annum – as detailed in table 1.


Table 1: The performance of CTAs during periods when a traditional portfolio performed poorly2

Periods of biggest 1-year losses in 60/40 portfolio, ending 

1-year returns (%)

Portfolio with 60% in US equities and 40% in US Treasury bonds

Managed futures

 Sep-74  -24.7 40.0 
 Feb-78 -3.9  32.1 
 Mar-82 -3.2  27.3 
 Jun-84 -2.1  -0.5 
 Aug-88 -8.0  32.8 
 Sep-90 -2.5  27.1 
 Jan-95 -0.4  11.6 
 Sep-01 -12.5  22.3 
 Mar-03 -10.8  31.4
 Feb-09 -26.2  5.8

Source: Wadhwani Asset Management LLP. Table covering periods of biggest one-year losses between January 1974 and June 2015.


CTA performance relative to that of a traditional bond / equity portfolio

Over the long run, CTAs have performed well. Since 1973, for example, an index of CTA returns (see Chart 1 above) has risen at an average annual rate of just over 10%, which compares with one of just under 10% per annum for a traditional bond / equity portfolio (comprising 60% equities and 40% bonds). More importantly for a long-only investor, the correlation between the monthly returns of CTAs versus a traditional bond / equity portfolio has been very low – at 0.01.

CTAs typically experience quite long periods during which they tend to under- or outperform traditional bond / equity portfolios, as shown in chart 1. Since 1973, for example, there have been three ‘long’ periods during which CTAs outperformed a traditional portfolio – each of duration of at least eight years. There have also been three periods when CTAs have underperformed (shown in the grey shaded bars in the chart) – each of which was of a somewhat shorter duration (of 4 to 6 years). Perhaps too last year witnessed the beginning of a fourth period of CTA outperformance – with quite a marked move up in their relative performance having occurred over the past 12 months or so.

In each period of underperformance, CTAs typically underperform by around 50%. In each period of outperformance, they typically produce about double the return of a traditional portfolio.

Chart 1: The performance of CTAs relative to those of a traditional (60% equities / 40% bonds) portfolio

Cta 02

Source: Wadhwani Asset Management. As of June 2015. In order to measure CTA (managed futures) returns, we spliced together the DJ CS Managed Futures Index, the CISDM CTA Asset Weighted Index and the Campbell and Company Composite Index – using the first of these to measure returns after 1993, the CISDM index to measure returns from end-1979 to end-1993, and the Campbell and Co. index to measure returns before 1980. For equities, we used the MSCI Total Return Index for the US. For bonds, we used the Barclays Treasury Bond Index. Past performance is not necessarily indicative of future performance. 


Are CTAs due a prolonged period of outperformance?

Looking ahead, traditional investors need to ask themselves if it is reasonable or not to expect the combination of strong equity performance and moderate bond performance of the recovery years to continue. If not – say, because bond yields rise along with official rates over the next few years or because stock markets react poorly to Fed monetary policy tightening – then the past year’s marked outperformance of CTAs may well be something that may persist. If this is the case, then we believe that traditional investors might do well to consider allocating more of their portfolios to this type of investment.

There are a number of reasons why CTAs struggled to perform as well as a traditional portfolio during the early stages of the recovery following the financial crisis of 2008 and may now be entering an environment that is more conducive to their outperforming again. This includes:

  • Correlations across asset classes were very high post crisis, but have now dropped back. The correlation of returns across the main asset classes rose sharply in 2008 and continued ratcheting higher during the early years of the recovery – reaching a peak of close to two-thirds in late 2011 (Chart 2). Over the past three years or so, however, correlations have started falling back again, and are now close to where they were pre-crisis – ie back to the sort of levels that were witnessed in the last period when CTAs outperformed traditional long-only portfolios.

  • Interest rates are rising again. When interest rates are near, or at, the zero lower bound (ZLB) for any length of time, it is very difficult for trends to emerge in short-term interest rate futures. Consequently, it is very difficult for CTAs to generate performance on short-term interest rate futures in this situation. (Indeed, our research found that most simple momentum-based strategies that worked well when interest rates were well above the ZLB actually performed poorly once the major central banks cut rates to close to zero.) As rates begin to normalise, however, we believe trend-following should start to perform well again. Indeed, after the first hike, it is normal for central banks to spend several years gradually raising interest rates: an ideal situation for momentum to develop in fixed income markets. Carry strategies will also become more attractive strategies to employ in FX markets if rates normalise in some countries – as one side effect of the ZLB has been a lowering (by about one half) of the average absolute interest rate differential between countries with ‘high’ rates and countries with ‘low’ ones across the G10. Finally, a higher short-term interest rate should benefit CTAs directly, as they tend to have high cash holdings.

  • Greater divergences should help throw up new opportunities. The Reserve Bank of Australia governor, Glenn Stevens, rightly pointed out, about a year ago, that “normalisation” of rates may have been the big monetary policy story in the US for the past year or so (and will remain so for a while yet), but that policy easing is the big one for Europe and Japan (and China too). What that means is that, as he put it, “the monetary trajectories of the major currency areas could diverge, and increasingly so, over the next couple of years”. Such an environment typically provides attractive opportunities for CTAs – partly, again, for those employing carry trades (as we believe it should raise the returns on offer when these strategies are successful), but also because the greater diversity should help those CTAs that take into account more information than just price trends. For example, business cycle divergence will likely increase hand in hand with interest rate divergence, implying that those who take into account macroeconomic lead indicators may be able to boost their risk-adjusted returns. This is especially true for the minority of CTAs who, like ourselves, trade relative value – where divergence is the essence of the strategy.

Chart 2: Average absolute correlation across the major asset classes3

Cta 03

Source: Wadhwani Asset Management. As of June 2015.

Are all CTAs alike?

As was mentioned earlier, not all CTAs simply wait for trends to become apparent in the prices of assets and then follow them. Rather, some look to take advantage of non-price information. This might take the form of market positioning indicators (eg information based on surveys of market participants); of valuation models; or the use of macroeconomic indicators and models (such as lead indicators of the business cycle).

We have employed this sort of tool over the past decade in our own portfolios. We believe that investors should not treat all CTAs as being alike. Rather, they should look to invest in CTAs that are doing more than merely trend-following.

This is likely to be especially important in periods when – as today – policymakers are likely to be a major driving force behind markets, and when there is growing diversity among policymakers regarding their policy actions. To take just one example that is apposite today: contrast the ECB, which has recently started a bond-buying programme that will likely expand its balance sheet by some 10% of euro-area GDP, with the Fed, which may soon not only decide on a first rate hike in nearly a decade, but also thereby signal that it will soon start reducing its balance sheet again. These divergent policy shifts were one of the important drivers of the euro-dollar exchange rate last year, of European stock markets, and of European bond yields (both in the periphery and the core) – all of which helped CTAs do well, and perhaps start the next period of CTA outperformance.


CTAs have a long history – illustrating that momentum is a useful investment strategy, delivering much the same sort of return as traditional long-only portfolios. CTAs are especially good diversifiers – generally performing well when traditional long-only portfolios perform poorly. Those who judge that fixed income markets are now due a perhaps quite long period of poor performance and/or that equities are unlikely to reproduce the sorts of returns they have during the recovery from the Great Financial Crisis might do well to consider investing in CTAs, especially those that do more than just examine price-based trading.

 A couple of recent studies that have examined the usefulness of investing in CTAs when equities performed poorly are “Diversification? What Diversification?”, Ineichen Research and Management Research Report, June 2012 and “The Bond ‘Bubble’, Hedge Funds and Portfolio Allocation”, by Wadhwani, S., and Dicks, M., Economic Outlook, Wadhwani Asset Management, November 2012.

2 In order to measure CTA (managed futures) returns, we spliced together the DJ CS Managed Futures Index, the CISDM CTA Asset Weighted Index and the Campbell and Company Composite Index – using the first of these to measure returns after 1993, the CISDM index to measure returns from end-1979 to end-1993, and the Campbell and Co. index to measure returns before 1980. For equities, we used the MSCI Total Return Index for the US. For bonds, we used the Barclays Treasury Bond Index. Past performance is not necessarily indicative of future performance.

3 Chart shows correlation between 5-day returns of equities, bonds, commodities and FX, each measured using a 120-day moving average (indices used are the MSCI World Equity index, the Citi World Bond index, the GSCI Commodity index and the USD DXY index).

Source: GAM unless otherwise stated. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be solely relied on in making an investment or other decision. It is not an invitation to invest in GAM products and is by way of information only. The views expressed herein are those of the Manager at the time and are subject to change. Opinions, estimates and other information in this document may be changed or withdrawn without notice. GAM is not under any obligation to update or keep current this information. To the maximum extent permitted by law, GAM makes no representation whatsoever as to the truth, accuracy, completeness, adequacy or reasonableness of any of this information, nor do any of them accept any liability whatsoever for any loss or damage of any kind arising out of the use of all or part of the information. Certain laws and regulations impose liabilities which cannot be disclaimed. This disclaimer shall in no way constitute a waiver or limitation of any rights a person may have under such laws and/or regulations. This document is not available for distribution in any jurisdiction where such distribution would be prohibited. Past performance is not indicative of future returns. References to any security or company are not a recommendation to buy or sell any security and are for information purposes only. In the United Kingdom, this material has been issued and approved by GAM London Ltd, 20 King Street, London, SW1Y 6QY, authorised and regulated by the Financial Conduct Authority.
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