MARKET CHATTER: SHOULD THE UNDERPERFORMANCE OF CTAS GIVE INVESTORS PAUSE?
Seth Bancroft, nepc research consultant
Alissa Howard, NEPC Senior Research Analyst
To the frustration of investors, systematic macro strategies—specifically Commodity Trading Advisors (CTAs)—have lagged since 2016.
While there is no refuting their recent underperformance, investors can draw comfort from historical data showing that when CTAs experienced similar, or even worse, drawdowns, they have rebounded, rewarding those who stayed the course.
At NEPC, we believe CTAs are a key contributor in a total portfolio. They offer exposure to a unique risk premium (momentum) with a positive expected return that is uncorrelated to traditional assets. They also provide a conditional correlation benefit, meaning CTAs systematically adjust positioning in response to market movements - a valuable attribute in times of market stress.
In this paper, we will examine the trading methodology that forms the underpinning of the CTA market and analyze the recent underperformance.
CTAs, also known as managed futures, use historical price data to generate trading signals, and are agnostic of the macro environment. While it is simplistic to lump all CTA strategies under a single umbrella, a majority of the managers seek to capture a common factor or trend.
A medium-term trend strategy, for example, may employ a simple moving average (SMA) with a look-back period of 100 days. SMAs are often combined with other signal types, such as a relative strength index, to arrive at an overall trend indicator. Whichever measurements are used, signal speed will drive much of the dispersion among CTAs.
Exhibit 1 shows the price of crude oil and two SMAs, a 200-day and a 20-day, representing long- and short-term models, respectively. The 20-day SMA more closely tracks the price while the 200-day measurement is smoother and slower to adjust. A longer look-back period allows models to recognize trends but not over trade, thus avoiding unnecessary trading costs. The potential downside for longer look-backs, however, is delayed trend recognition, which may lead to lower profits in the long run.
In some cases, as depicted in the crude oil example, trends will be long and strong enough that virtually all time horizons fare well. As the market sold off in 2014, CTAs recognized the trend and initiated a short position that gradually increased as the trend became more pronounced.
However, trend strategies will not always favor investors when a trend is short-lived and the reversal is sharp – a common profile exhibited by many markets in 2016 and 2017. For instance, soybean prices moved lower in the first half of 2017, a trend captured by many CTAs. However, in June, soybean prices reacted to new supply data and jumped higher, fueling large, sudden losses in medium-and long-term trend strategies that failed to capture this shift in prices.
To be sure, reversals have always been a part of trend investing and represent a primary risk of investing in a CTA. Reversals can occur as a result of the release of new data, central bank activity, political uncertainty, or idiosyncratic events.
The difference in 2016 and 2017, as seen in case of the soybeans, was the combination of a lack of trends across markets and then, when trends did develop, they were interrupted by a quick reversal of prices before profits could be realized. Fast-forward to the present, this has been the experience in many interest-rate, commodity and currency markets in the last 18 months.
The current drawdown began in February 2016 and hit a low point of -24% in March. Since 1980, the MLM Index, a benchmark for CTA performance, has had eight drawdowns of -20% or worse, including the current period. The maximum drawdown at those times, on average, was -27% with an average duration of 31 months.
That said, each time, performance recovered in subsequent months. On average, the MLM Index returned 39% in the 12 months following the lowest point in each drawdown. To be sure, this is not a prediction of how the trend-following approach will fare in the near future; rather, it’s the acknowledgement that a recovery would be in line with past performance should the cycle repeat itself
At NEPC, we believe a trend-following CTA strategy can serve as a powerful diversification tool with its ability to short a market that, in all likelihood, is adversely impacting an investor’s long-only portfolio. We understand that trend investing has lately proven to be volatile, frustrating investors. Still, history shows that drawdowns do not last forever and patience is often rewarded.
Disclaimers and Disclosures
-Past performance is no guarantee of future results.
-All investments carry some level of risk. Diversification and other asset allocation techniques do not ensure profit or protect against losses.
-The information in this report has been obtained from sources NEPC believes to be reliable. While NEPC has exercised reasonable professional care in preparing this report, we cannot guarantee the accuracy of all source information contained within.
-The opinions presented herein represent the good faith views of NEPC as of the date of this report and are subject to change at any time.