Commentary: Do 'trend' risk premiums explain CTA performance?

The diversification benefits of commodity trading adviser hedge funds have been proven over two decades. In recent years, however, many investors have questioned whether the typical hedge fund fee structure consumes too much alpha. In one example, a U.K. hedge fund manager appears to have made $2 billion to $3 billion in fees over five years on one fund alone, while investors actually lost money.

This raises the question for investors: Is there a lower cost, higher alpha way to access CTA performance?

One approach promulgated over the past five or six years has been to build simple "trend" models — the notion that investors can capture excess returns by buying securities that have been rising, and shorting those that have declined. Banks create indexes and offer over-the-counter swaps that track their performance; some asset managers, including CTAs, offer static trend-following models in managed accounts or other vehicles. The thesis is that "trend," broadly defined, is a key driver of CTA performance; hence, if you can access this key driver cheaply, you'll get most of the value of CTAs — analogous to the passive vs. active debate. More optimistic investors might hope that lower fees will translate into better performance, just as index-based exchange-traded funds tend to outperform more costly active mutual funds.

The question for investors, then, is whether this approach works. The short and unsatisfying answer is, not really. Why is this? There are three reasons:

1. One trend product might look nothing like the next one, which undermines the notion that "trend" is an identifiable and predictable beta that can be captured easily.

2. Trend products have relatively low correlation to actual CTAs, suggesting that static trend models fail to explain a significant portion of CTA performance, particularly before fees.

3. Trend products on average fail to improve returns over high-cost hedge funds, so investors might benefit from daily liquidity but fail to see better performance over time.

Now let's turn to the data.

Most large investment banks offer derivatives linked to risk premium indexes. (Risk premiums are defined as trading strategies like currency carry or merger arbitrage that can be broken down into relatively simple rules.) We reached out to sophisticated allocators for recommendations on which products we should include in this study. The list we compiled held eight indexes.

There are several issues with this list. First, the track records are relatively short — surprising given that a key element of the marketing pitch is that excess returns from momentum has persisted for decades (to be crystal clear, virtually all the academic research supporting the products is back-tested). One of the products, Citi, was discontinued last year, presumably because of poor performance; an ongoing issue with any index-based product is that firms tend to shut down indexes when they underperform and replace them with new, back-tested indexes that look better. We exclude both the Deutsche Bank Cross Asset Trends index and SGI Cross Asset Trend Following index since neither has a live track record of three years or more. Consequently, we are left with only five eligible products. A final complication is that index performance typically is reported before fees — something no asset manager would be permitted to do.

We first examine the correlation among different products and how they correlate to the SocGen CTA index, which most allocators would agree is representative of the broader CTA sector. Note that the correlation among, for instance, similar equity indexes often is well above 0.95. By contrast, over the past two years, the correlation among the risk premium indexes has been quite low: 0.39, on average. The next question is how the products correlate to the SocGen CTA index; here the correlation ranges from 0.15 to 0.78, with an average correlation of 0.55.

Of the trend products, only four have live five-year track records, further underscoring the difficulty of finding products with reliably long track records. The four returned 1.6% a year, about half the net of fee returns of the SocGen CTA index. However, the standard deviation of the products varies widely — 6.7% to 16% — which further complicates the comparison of the reported performance to the SocGen CTA index.

Given the variability in both performance and volatility, one solution is to invest in each of the live products on an equally weighted basis. The line chart below shows the performance of such a portfolio consisting of equal weights of the live products (initially, four with new positions added when the subsequently launched products went live), scaled to roughly the same volatility as the SocGen CTA index. Over the past five years, an equally weighted and volatility-scaled portfolio would have delivered comparable performance with a correlation to the index of 0.79.

The analysis above highlights two serious issues with risk premium products: short track records (and unrealistic back-tested numbers prior to launch) and wide variations in products designed to capture the same "risk premiums." An additional issue is implementation: in this case, an investor who seeks a portfolio with daily liquidity and lower costs than investing in hedge fund CTAs would need to invest in OTC swaps with multiple counterparties.

Is this a satisfactory result? Despite lower fees, the risk premium portfolio would have failed to improve performance. Further, over the counter swaps introduce counterparty risk and the flood of capital into such products creates a real risk of trade crowding. Arguably, this is two steps forward and (quite possibly) two steps back.

Andrew Beer is founder and managing partner of Beachhead Capital Management, New York. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.