DC Spotlight: Managed Futures — What is the CTA Challenge?
Managed Futures — What is the CTA Challenge?
In 2011, a young commodity trading advisor (CTA) approached Coquest Advisors Managing Director Maxwell Eagye and posed a question.
“Why don’t you raise assets for me? I have better risk adjusted returns than Winton.”
“Yeah, well prove it,” Eagye replied.
“How do I prove it?”
Eagye thought that was a real good question, and in contemplating an answer, the seed of Coquest’s CTA Challenge was sewn.
Mike Lock, Coquest’s Director of Brokerage and Trade Services Group says of the CTA Challenge, “The original idea for the CTA Challenge was as a way to automate the research process for filtering best-of-breed CTA programs for investors.”
While Lock’s description is perhaps more historical, Eagye’s anecdote highlights the need for the Challenge, as lesser-known managers could never seem to get a fair shake. If their returns seemed too impressive, allocators assumed they used too much risk. The CTA Challenge created a mechanism to measure the risk assumed to achieve the posted returns.
Background
Historically, allocators and investors looking to invest with CTAs would manually go through CTA statements, performance metrics and tear sheets to come up with qualitative and quantitative analysis, according to Lock.
“It was such a manual effort,” Lock says. “We wanted to come up with an idea to put as many programs as possible into a system where we could digest all of the data and rank them quantitatively in an automated fashion.”
One problem was that the way investors and allocators examined CTA programs was flawed and led to misallocations. Performance numbers and basic information provided in tear sheets created a one-dimensional picture. Coquest noted that when it came to researching CTAs, the amount of information to digest can be overwhelming and confusing, even to the savviest investor. Most ranking sites for managed futures programs merely compare monthly or annual returns from a large list of products that only show basic performance data. Coquest concluded that CTA databases do little to show the risks and leverage used to achieve those numbers.
“The thing that the CTA Challenge accomplishes is to provide risk-adjusted returns,” Lock says.
It also allows Coquest to reach more CTAs. “It is a fantastic sourcing tool. The advisors run that process, and we derive a lot of data out of that,” Eagye adds.
And clear data is vital to making informed investing decisions. One of the underlying problems for analyzing CTA performance is the presentation of data. CTAs present performance metrics based on a typical account with a 100% margin allocation (i.e., the stated minimum investment). However, most CTAs offer managed accounts and investors can notionally fund those accounts and only put up the minimum margin requirement set by their futures broker.
“A CTA tear sheet assumes a $1 million account is funded with $1 million investments, but in reality, a futures product holds leverage so a CTA is able to trade $500,000 as $1 million and $250,000 as $1 million. They can offer notional funds, which is implied leverage, but a CTA investment can have any level of leverage built into it,” Lock says. “We have customers that don’t use any leverage; we have other customers running their program at 5x, that is $200,000 trading at $1 million.”
What that means is when you see a monthly drawdown of 5-10% in a CTA program, the typical investor is experiencing a much higher—potentially fatal—drawdown. And, of course, the intra-month drawdown could be higher, which is why Coquest looks at daily data (more on this below).
Leverage levels can be all over the place, which means investors using an absolute performance-based ranking to evaluate a manager opens themselves up to unknown risk.
“You must use a risk-adjusted component,” Lock stresses. “We incorporate the leverage used, the value-at-risk (VAR) used by the CTA. We look at their positions and do a VAR analysis as well as an expected shortfall analysis.”
How They Do It
Coquest uses seven criteria—four position-based and three return-based—to ensure they are not just looking at performance, but also leverage, volatility, and overall risk.
“We want to know what the CTA did — their absolute performance — but we also want to know what they did to achieve that performance,” Lock says.
The seven criteria include: Daily rate of return (RoR), daily RoR vs. daily volatility (Sharpe ratio), daily RoR vs. daily downside volatility (Sortino ratio), daily RoR vs. daily maximum drawdown (Sterling ratio), daily RoR vs. daily margin to equity, daily RoR vs. daily VAR and daily RoR vs. daily conditional VAR.
Coquest compiles all this data directly from the FCMs that are clearing the individual CTA trades so there is no way to massage the numbers. You may have noticed all those metrics include daily data. This is vital because intra-month volatility spikes can knock you out if you are not prepared for the worst-case scenario.
Additionally, Coquest promotes the results of the Challenge throughout the year so everyone can see who is doing well.
“We want everybody else to take a look. Our peers that we compete with might have a client that is looking for [a specific strategy]. We do not covet all of the data for ourselves,” Lock says. “We purposely advertise to as many people as possibleꟷbrokers, wealth managers, people of all sizes looking at managed futures products, either from the buy side or sell side. We want to get maximum exposure for the winners.”
Industry Resource
While the Coquest business model involves making allocations to qualified managers on behalf of institutional investors, they view the CTA Challenge data as an industry resource, not a proprietary tool to use against competitors.
“We are a verifiable research group that is doing a very robust evaluation and ranking of CTA programs,” Lock says. “We verify track records for institutional investors just by having the CTAs participate. You could go to KPMP to verify your track record. The CTA Challenge does it at no cost.”
While sharing this data industry-wide may seem like giving up an edge, Coquest sees this as a net benefit.
“We see this as a way to attract more talent,” Eagye says. “One of the things that helped us is an audited track record; we are not accountants or auditors, but we see the daily equity runs and the trades being placed so we can validate a track record ourselvesꟷthat is a helpful tool.”
While the CTA Challenge provides the tools to investors to make informed decisions, it also helps CTAs, and not simply as a way to get allocations.
“There are quite a few CTAs every year who give us good feedback, they find that they either have too high of an account level or too low,” Lock says. “The CTA Challenge is beneficial in showing them how to raise the maximum number of customers using the CTA challenge metrics as a guideline.”
Perhaps the most remarkable thing Coquest has accomplished through the CTA Challenge is building the trust of existing and emerging managers. In order to participate, CTAs must share their daily trades. Basically, they are sharing the most revealing aspects of the trading.
That trust didn’t come immediately but has been earned over the years. The first CTA Challenge in 2013 included 30 managers. In 2020 there were 115 participants and Coquest anticipate at least that many in 2021.
“We are not looking to poach anything or take intellectual property from anyone; we truly want to find good investments for our customer base,” Lock says. “Over the years we have won over quite a few CTAs who would not open up their books to a third party. We are nine years in and we have not had any complaints about taking the data and using it against the CTAs. They recognize the CTA challenge brand and the Coquest brand.
“We have always looked at the CTA community as a resource,” Eagye adds. “The CTA Challenge allows us to efficiently source and get information on CTAs; it is the beginning of our CTA due diligence.”
It has also helped to democratize the process. One of the worst-held secrets in the CTA space is that too often, large allocations are concentrated in the topmost established managers.
“Part of this is to help the little guy get noticed,” Eagye says. He points at that over the nine years of the CTA Challenge, the top-ranked managers for each year have been an eclectic mix of well-known industry standard-bearers and unknowns like the emerging manager mentioned above, who helped to inspire Coquest to launch the CTA Challenge.
In the process, the CTA Challenge not only produced a more holistic picture of a CTA’s risk-adjusted returns for allocators to make a more informed decision, but it also provided the CTA with a better understanding of its own strengths and weaknesses. In turn, this allows them to better target the type of investors who should be interested in their program and provide to them a template for how to improve their trading strategies.
Next time: a look at the importance of daily data.
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Disclosure: The risk of loss in trading futures and/or options is substantial. Past performance is not indicative of future results. The information in this message derived from third-party sources is believed to be accurate and reliable; Coquest does not guarantee the accuracy or completeness of the information. Opinions expressed in this material are subject to change without notice. This report should not be interpreted as a request to engage in any transaction of futures, options, and/or OTC derivatives. The information contained in this material is not to be relied upon in substitution for the exercise of your independent judgment. Seek independent financial, tax, legal, and accounting advice from your own professional advisers, based upon your particular circumstances.
