Standard Analytical Tools Applied to CTA Programs without Adjustments

Create Incorrect Conclusions

The list of standard analytical measurements that are used successfully to measure and compare the return on investment patterns of traditional assets programs does not fully encompass the unique characteristics of alternative asset programs, especially programs that are managed by Commodity Trading Advisors (CTAs).

Traditional investment program performance is measured by several statistical formulas that have a common element. The short list includes unleveraged deployment of capital and linear returns. Alternative asset investment strategies, which seek uncorrelated returns to traditional asset programs, will employ leverage and may utilize instruments that have non-linear return patterns.

For brevity purposes, the Sharpe Ratio is a standard risk-adjusted returns measure. It is calculated by subtracting the average risk-free rate from the average portfolio return and dividing this amount by the standard deviation of the portfolio. To simplify what this means, the difference between the program return and the risk-free rate is divided by the “risk” factor of the portfolio. Standard deviation is a mathematical expression of risk because it gives a range of possible returns based on past history. The limitations of the method are that if the current risk-free rate of the 90-day Treasury Bill is used, which is below 0.10%, then any portfolio return greater than this will create a large denominator. Another limitation is that standard deviation only considers the greatest frequency of returns in a given time series. Standard deviation is calculated by taking the sum of the differences between all returns and the average return, squaring this figure, then dividing by the number of periods observed, and taking the square root of this figure. If a program gives a constant 1% to 2% month-over-month return for an extended period of time when a significant negative return is experienced, such as 50% or greater loss, the mathematical application of the formula will increase the standard deviation range of the full spectrum of possible returns and adjust slightly the range of where most returns have occurred.

A linear investment is based on a dollar-for-dollar gain or loss. If a purchased asset increases in value by one dollar, then this represents the change in value. When leverage is introduced, this tends to magnify such gain significantly. In managed futures, for discussion purposes, a CTA will enter into a position to buy a contract of corn to be delivered in the near future. The entry price of this contract is $7.00 per bushel. The standardized contract is based on 5,000 bushels. The initial margin to enter this contract is $2,025. This margin is a deposit to perform the requirements of the contract and closely resembles the amount of funds committed to this position. For each dollar the price of corn rises or falls, this translates into a $5,000 gain or loss on this contract. This is a function of the leverage associated with futures trading. It can magnify gains or losses and in this example clearly far above the amount of funds committed to this position.

Options on futures contracts price patterns do not behave in a linear fashion when compared to the underlying futures contract. In the above example of a purchased corn contract at $7.00 per bushel, the call option with a $7.00 strike price may increase in value by 5-cents for a 10-cent rise of the contract price. This is a simplified example of an option delta and gives support to how option strategies deliver non-linear returns due to the varying degrees of price movements in relation to the underlying asset. Outright option buying programs require significant price moves, in favor of the contract structure, to become profitable. Outright option selling programs face limited profit and are subject to unlimited loss in the event of unfavorable price movements. The non-linear nature of options may increase this loss potential as the price of the underlying asset continues to move against the option seller. During this period the rate of price change increases significantly and may, to a point, become equal with the price change of the underlying futures contract.

Individual investors that seek adding alternative asset strategies such as managed futures should consider the degree of adjustment it may take to correctly analyze a program. Reliance on the measurements that are published with any program may not fully consider the risks of the program. Due to the nature of the high degree of leverage involved in this asset class, programs that take a defensive posture to protect the value of the accounts first and foremost will, in the long run, produce better returns. Some tools to help observe this include looking at the downside deviation of returns, the actual length of the drawdown (negative return period) and the length of time it took to recover.

Managed futures programs based on CTA performance do offer the possibility of superior returns and when blended with an overall portfolio of traditional assets, may enhance the overall returns and reduce the overall risk. Before adding such a component as a return enhancing/risk reduction strategy, ensure that you understand the past performance of the program whether the program is fairly young or has been through a wide range of market conditions, before committing any funds. I make myself available as a local advisor to assist in these areas and can be reached at [email protected]

Trading futures and options involves substantial risk that can lead to loss of capital and is unsuitable for many investors. Past performance is not indicative of future results. Speculate with risk capital only, defined as funds you can afford to lose without adversely affecting your lifestyle. These risks remain present irrespective of whether you hire an outside manager to trade an account.