DC Spotlight: Portfolio Building – Where CTA Challenge Pays Off
Portfolio Building – Where CTA Challenge Pays Off
The Coquest Advisors CTA Challenge accomplishes many goals, for Coquest, the commodity trading advisors (CTAs) that participate, and ultimately—and most importantly—investors.
We have discussed Coquest Advisors’ processes in analyzing managers for the challenge. We have explained that it is important to determine the risks and rewards inherent in each program and in properly defining the correct strategy bucket every manager falls under. All this work is done with one ultimate goal: selecting the right manager and groups of managers to enhance investor portfolios.
The first step is establishing an all-star cast of quality managers. Every CTA Coquest deems worthy of an allocation has shown to provide strong performance and non-correlation vs. a traditional portfolio. From there, Coquest digs deeper to define the specific strategy bucket each of the programs that participate in the CTA Challenge falls under so that they can begin to effectively build a portfolio.
The Coquest team is able to do this because—thanks to the CTA Challenge—they are not simply reviewing a program’s performance metrics, but seeing every trade a program makes in real-time.
“The CTA Challenge allows us to greatly improve our early-stage due diligence on managers,” says Ryan Hart, CIO and portfolio manager for Coquest Advisors. “Typically, it’s difficult to get a real-time look at a manager’s daily positions and trading activity until after you invest with them. A manager might provide you with [month-end statements], historic attribution by strategy and/or asset class, but that’s about as deep as most allocators would be able to get. With the CTA Challenge, we are able to evaluate the trading activity and risks a manager is taking on a daily basis before a client commits a single dollar.”
“We are able to evaluate the trading activity and risks a manager is taking on a daily basis before a client commits a single dollar.”
While the results of the competition may provide bragging rights among the various programs involved, it is the data that the Coquest team gleans from the Challenge that allows them to define the various strategies and make smart allocation decisions for clients. “The rankings themselves matter less than the underlying data and trading activity,” Hart says. “The qualitative aspects of a manager or strategy are equally important as the quantitative results of even the best ranking system. The risk and trading data we can evaluate from the CTA Challenge goes a very long way to helping us verify the accuracy of our qualitative assessments.”
Building out a Portfolio
No investor comes to Coquest with a blank slate, so it is important to know what a specific investor has exposure to in order to ascertain the precise needs of that investor. While all or most CTAs are non-correlated to a traditional portfolio, some investors may have some hedge fund exposure that affects their overall diversification needs.
“There can be higher correlations between certain CTA sub-strategies and other alternative strategies, says Hart. “For example, I would want to know if a client had a significant allocation to hedge funds, and if so, which strategies are they allocated to. Some multi-strategy hedge funds include components of trend following and/or systematic macro; that [is] useful information when designing a complementary CTA portfolio.”
Many investors come to Coquest with some preconceived notions as to managed futures and need to be educated regarding the diverse strategies available within the managed futures space.
“Where we tend to see misinformation is with regard to CTA strategies themselves,” Hart says. “Many allocators have been incorrectly conditioned to believe that CTA or managed futures means systematic trend following. CTA is nothing more than a structure and the term carries as little information about the strategy deployed as the term hedge fund. Managed futures should really be viewed as a subset of the broader hedge fund universe, and the only information the term itself carries is that the manager is executing their strategy via futures, forwards, and/or options on futures and forwards.”
Non-Correlated Alternatives
As Coquest works to build robust and diverse portfolios, it is important that they choose CTA strategies that not only provide non-correlation to traditional assets but also non-correlation among the various CTA strategies allocated to.
“Beyond trend following, other sub-strategies within managed futures exhibit very low correlation to each other and trend followers,” Hart says. “The combination of quantitatively low correlation combined with qualitatively differentiated strategies is exactly what allows us to build more robust multi-manager portfolios.”
This doesn’t mean that in creating a diverse portfolio of strategies Coquest needs to check every box and make an allocation to every strategy type, just that every allocation provides meaningful non-correlation.
“Beyond trend following, other sub-strategies within managed futures exhibit very low correlation to each other and trend followers.”
“It’s not important to fill all the buckets; it’s more important to ensure that the buckets you do fill are substantially different from each other,” Hart says. “One of the mistakes I see allocators make is relying too heavily on purely quantitative metrics such as historic correlations. While we certainly want to see quantitative diversification across our holdings, we also strive to build portfolios of strategies that are qualitatively different.”
This is important because when trends happen, many relatively diverse strategies can get into the same trades, even though the way they got there is very different.
“We want to understand the strategies themselves; what factors drive positive returns? What tail risks are they exposed to [and] what scenarios might lead to losses in the asset classes they trade,” Hart asks. “Answering those types of questions can allow you to build more robust portfolios that are far more likely to be diversified on a go-forward basis.”
Complementary Investments
One of the strong attributes of managed futures over the years is that it often has proven to not only be non-correlated to equities but actually negatively correlated to stocks during periods of poor stock performance. While this tendency is attractive, it shouldn’t be viewed as a hedge. Adding non-correlated investments to a portfolio is its own benefit.
While stocks may appear overvalued, that is not the basis for seeking alternatives. “I don’t think out-performing equities is why allocators should invest in managed futures,” Hart says. “Even in a healthy environment for equities and bonds, an allocation to managed futures has been shown to improve the risk-adjusted returns of those portfolios, so an allocation is warranted even under those scenarios.”
“I don’t think outperforming equities is why allocators should invest in managed futures. Even in a healthy environment for equities and bonds; an allocation to managed futures has been shown to improve the risk adjusted returns…”
Still, Hart sees managed futures as a superior alternative to fixed income in the current environment. “If one believes that interest rates will remain low for years to come, I would wonder how much return investors are expecting to get from that portion of their portfolio,” Hart says. “The starting yield of a government bond is one of the best predictors of its future return. If that yield is low, future return expectations on fixed income should be similarly low. Managed futures can provide similar diversification benefits, and out-performing low bond yields is a much easier bogey to beat.”
While certain strategies—traditional and alternative—perform better and worse in certain market environments, Coquest focuses more on diversification rather than on identifying or predicting the next market environment.
“Identifying quality managers and building a diversified portfolio of strategies is vastly more important,” Hart says. “Making economic projections and tactically allocating it among asset classes that theoretically should behave a certain way is difficult enough when dealing with well-defined areas such as long-only stocks and bonds. It’s exponentially more difficult when it comes to forecasting long/short alternative strategy returns.”
However, Hart adds, “There are certain environments when we might tilt the portfolio one way or another. For example, trend-following strategies tend to perform better during periods of low cross-market correlations and elevated volatility, so we may tactically adjust that exposure on the margin during obvious market environments.”
Still, the core value is building a diversified portfolio that improves risk-adjusted returns in any market environment. The CTA Challenge is the tool that delivers those results.
“The CTA Challenge allows us to better identify and evaluate quality managers, which in turn helps us build portfolios of diversified strategies which should perform across a wide variety of market environments,” Hart says.
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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.
