HALF DONE 7.2 / 26 - Investing in CTAs Flashcards
LO 26.1: Demonstrate knowledge of the historical performance of commodity trading advisors (CTAs).
- Identify factors that contribute to the operational and informational efficiency of futures markets.
- Analyze the statistical properties of CTA returns, and compare and contrast these properties with those of returns with other asset classes.
- Discuss the effects of trend-following strategies on the skewness of a portfolio’s return profile.
- Discuss the risk factors to which CTAs are exposed.
- Discuss theory and evidence regarding the relationship between market divergence and the performance of CTAs.
- Discuss the exposure of CTAs to market volatility.
- Describe the effects of gamma exposure on CTAs.
winning ratio of trades (CTAs)
The winning ratio of trades, which is equal to the ratio of the number of profitable trades to the total number of trades, is usually below 50% in practice. In the best-case scenario, a manager is able to discern a price trend that gives rise to frequent and significant gains. In one example of a 22-day period in a typical trend-following strategy2, there is a combination of many small losses causing drawdowns, but they are more than offset by gains that are fewer in number but larger in size.
This is positive skew
convex payout profile (CTAs)
many small losses that are contained and more than offset by a few large gains
What are two common CTA indexes?
Barclay Trader Index Discretionary (lower deviations, lower exposure to equities, commodities etc.0
Barclay Trader Index Systematic
CTAs and MDI (market divergence index)
In one example that compared the MDI with rolling 100-day returns of a typical trend-following strategy between 2001 and 2013, the correlation was strong at 0.74. Based on the example, CTA performance and the MDI were usually stronger during periods of market stress. MARKET STRESS can be defined as a period during which there are larger structural shifts in the financial system, balance in supply and demand, valuation, and aggregate risk appetite.
CTAs can benefit during scenarios of drop in equity prices if they hold any of the following positions;
(1) short equity indices, (2) long short-term Treasuries, (3) long strong currencies, or (4) long volatility derivatives.
During periods of market stress, trend-following strategies require early exit in the cases of losses, but allow gain opportunities to be pursued in an attempt to offset the losses and still earn profits
Are CTAs long volatility?
Overall, is not clear that CTAs are long volatility. The term volatility exposure is vague and is dependent on the type of trading strategy being used. Furthermore, it is not clear whether it means that CTAs earning higher returns did so because of high volatility levels or because of increasing volatility levels. Finally, it is not clear whether expected or unexpected volatility changes are taken into account.
Gamma Exposure (options) and CTAs
Gamma measures the rate of change in an option’s delta with respect to price changes in the option’s underlying asset. (Delta is the sensitivity to change in underlying).
trend-following CTA strategies are characterized as being long gamma because they increase their positions when markets are rising. When a market starts to move upward, trend-following CTAs add to their positions as the delta becomes positive and increases. When a market starts to move downward, trend-following CTAs take larger short positions as the delta becomes negative and decreases.
the active trading of CTAs creates return profiles that appears to be close to a long straddle position (Long Put and Call options on same asset). However, the CTAs are not long volatility in the same sense as a long straddle position. Instead, CTAs achieve their return profiles by engaging in dynamic trading
dynamic-trading-based long gamma strategy (CTA trend strategy)
defined as a portfolio management method that alters portfolio weights over time so as to have a high probability of small losses and a low probability of large gains that would result in the convex payout profile discussed earlier.
LO 26.2: Demonstrate knowledge of the diversification benefits provided by CTAs.
- Describe the relationship between crisis alpha and CTA performance.
- Recognize the portfolio diversification benefits of CTA investment for a 60/40 investor.
- Recognize the portfolio diversification benefits of CTA investment for a fund of hedge funds investor.
Crisis Alpha defition
a measure of a CTA strategy’s performance during market stress (i.e., excess risk-adjusted profits from exploiting a persistent trend).
most hedge fund strategies had a negative crisis alpha, but a pure-trend following CTA had the best performance at 6% monthly crisis alpha. Given that the crisis alpha was earned during a market downturn when most other investments performed poorly, it demonstrates the huge diversification potential of crisis alpha.
CTAs have three sources of crisis alpha:
- Trading is in highly liquid markets, so the negative impact on CTAs from the reduced liquidity that comes with financial distress is minimal.
- CTAs do not allocate funds to only one asset class but instead allocate them to multiple asset classes. For example, they can take long positions in expected “winners” during market distress and take short positions in expected “losers” during market distress.
- CTAs trade financial futures, and so there are no short sale restrictions or squeezes, unlike for individual securities.
LO 26.3: Demonstrate knowledge of CTA risk measurement and risk management.
• Discuss considerations involved in the allocation of capital and risk by CTA
managers.
• Compare and contrast the leverage of traditional investments with the implicit leverage of futures positions.
• Discuss the functions of margin accounts and collateral management in managed futures positions and portfolios, and calculate trading level, funding level, and notional level for a given account.
• Describe capital at risk and its relevance for managed futures trading programs and portfolios.
• Describe value at risk (VaR) with regard to managed futures, and calculate VaR for a given portfolio.
• Discuss maximum drawdown and drawdown duration, and calculate maximum drawdown for a given CTA.
• Describe the use of simulation analysis in managed futures investing. • Discuss the use of the omega ratio in the context of a CTA fund or a diversified portfolio of CTAs, and calculate the omega ratio for a given investment.
Risk allocation process (CTAs)
different from capl allocation process
Risk is allocated by taking positions in a variety of futures markets using collateralized margin funds that are transacted with a central clearinghouse.
a significant amount of notional capital is allocated to low-risk assets (i.e., low-risk funding portfolio) and the remaining notional capital is allocated to risk exposures to a variety of asset classes (i.e., active-risk trading portfolio) subject to a risk budget.
four key concerns with the use of leverage for traditional investing
- Borrowing costs (i.e., interest) reduce the overall investment returns.
- If there are losses, then they are magnified in percentage terms because the denominator in the return computation is based on invested capital only and excludes the borrowed portion.
- The leverage constraints are inconsistent as leverage is limited to 50% notional and 150% notional for long and short positions, respectively.
- Counterparty risk exists between the investor and the broker
