Twice this year commodity trading advisers, which use trend-following strategies, haven’t lived up to their promise to protect investors during market downturns. Their disappointing performance is the result of changes many CTAs have put in place in the last decade, according to critics.
They were hard hit when equity markets went down in early February, and in May, when Italy’s political crisis infected markets around the world, CTAs bombed. The SocGen CTA index tumbled 5.19 percent this year through May.
Since the financial crisis, the enormous amount of liquidity pumped into global markets by the Federal Reserve and other central banks around the world has essentially chased away volatility. “As a result, CTAs have adapted their trading techniques to be more profitable in the recent market environment and as a result they’re less capable of hedging equity corrections,” said Nigol Koulajian, founder and chief investment officer of quant hedge fund Quest Partners. Among other moves for the current environment, many CTAs have changed their time frames to sell when markets turn down.
The hedging issue is an important one for allocators. A growing number of institutional investors have been getting defensive in the face of a long-running bull market in stocks, bonds, and other assets. For example, the Utah School & Institutional Trust Funds Office last year implemented a downside protection strategy that included CTAs.
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Style drift is a longtime concern of investors, who fear managers will make changes to their investment processes at the worst time. “What we have shown in our research is that some of these factor drifts, as we call them, actually extend their trading time frames,” Koulajian. “Instead of trading short term, they are trading much longer term. Another way of putting it is that their stops are further away from the market. It used to be as the markets went down, CTAs would sell quickly. Now they’re taking their time, because corrections have been short lived and the market has been rallying quickly.” CTAs are now waiting for a two-month correction, say, instead of a two-week downturn before they start selling.
Commodity trading advisers have also changed the way they use fixed income, which historically has provided a good hedge against equity downturns, says Koulajian. His firm offers the AlphaQuest Original Program, designed to hedge equity and fixed-income corrections.
In the past, CTAs generally held long positions. Now that fixed income has not been as strong in the down trend, CTAs have been shorting the asset class. As a result, CTAs are losing both on the turnaround in their positions in stock indexes, and on the turnaround in their short-term fixed income. “Fixed income goes up, but they’re short,” said Koulajian. “Equities go down, and they’re long. They’re losing on multiple fronts.”
Koulajian says CTAs are also doing more carry trades. For example, they’re going long Italian bonds and shorting German bonds against them. Carry trades do well in a risk-on environment and are typically more correlated to equity markets. When the events in Italy brought down global markets, carry trades were hard hit. “Italy is another example of a risk-on trade malfunctioning,” he said.
Stephen Scott, partner at BRI Indexes, adds that active CTAs are changing their strategies in part because an increasing number of investors are getting exposure to them through passive funds. With the surge in passive, active managers are looking to differentiate themselves.
“With passive strategies capturing more of the factors that active managers used to deliver, traditional sources of alpha have been reduced,” said Scott. He adds, though, that the environment has been a tough one for CTAs to negotiate because of the sharp reversals in multiple markets at the same time, including equities and fixed income.
