Tuesday, August 9, 2016

Clustering CTA's - more than trend-following

Most think that buying managed futures is the same as investing with trend-followers but that is not the case. All CTA's are not alike, but how many styles or classifications actually exist? It could be argued that managed futures and global macro are two of the most diverse hedge fund strategies that exist.

In contrast, merger arbitrage or long/short equity are fairly well defined. There can be wide differences in performance but the foundation of the category is fairly clear. This is not the case with managed futures. CTA's can trade a diversified set of markets or a single sector, a wide set of time frames, and styles that can run between trend-following to discretionary. One approach is develop definition and then place managers with these definition buckets, this is rather ad hoc. An alternative is to conduct a cluster analysis and find bundles of managers that have similar characteristics.

This cluster analysis was conducted by a set of researchers in Ireland over a long period on a large CTA database. (See "Just One Trick Pony? An Analysis of CTA Risk and Return" by Foran, Hutchinson, McCarthy and O'Brien.) They were able to identify eight different strategies with a broad set of CTA's. There are more than just trend-followers in the CTA space. The biggest category is diversified trend which is 23% of the total number of funds. Trend-following in all forms represents about 46% of the total. Based on AUM, long-term trend represents about 50% of the total and trend-following in all forms is about 70% of the total. Trend-followers dominate the AUM and other strategies are clustered with smaller managers. The diversification benefit with smaller managers occurs because the smaller managers are less likely to be trend-followers.

When you look at performance in these clusters, you will find meaningful differences in return and risk. Overall, diversified trend is still the best strategy by return and information ratio on an equal weighted basis. On an AUM basis, diversified trend is best but the short-term trend classification has the best Sharpe ratio. The non-trend-following classifications offer significant diversification but this may only be from their lower return profile. Trend-following gathers all of the assets because it seems to work.

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