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In finance, a commodity trading advisor or a “CTA” is an individual person or an organization whose responsibility is to provide sound financial advice to others about the best assets to buy or sell. Commodity trading advisors also provide asset management and buy or sell futures on many stock and commodity exchanges.
Like any other legal entity, a Commodity Trading Advisor is required to register with the National Futures Association—the self-regulatory organization for the industry—before they can start to manage futures or deal with the public. They have to go through Federal bureau checks on their backgrounds and have financial records analyzed before getting the license to trade. Currently there are about 900 CTAs registered with NFA.
This is just the formal definition of a Commodity Trading Advisor but, what is the job of a CTA and what are the activities that they have to do?
Types of Commodity Trading Advisors
There are many types of Commodity Trading Advisors but the most popular and biggest type are the “Trend Followers”. As their name reveals, they follow trends. There are also CTAs that use different investment and trading strategies such as: Arbitrage, Counter-trend, Fundamental Trading, Momentum – which is very similar to trend following, Options, Pattern Recognition, Seasonal and Cyclical Spreading and Hedging traders and other. All these CTAs can also be categorized in Discretionary or Systematic.
Discretionary are these who make the decision-making themselves, while systematic just execute the signals of systems. Some CTAs mix them.
Trend Followers
The trend followers manage futures by using technical or fundamental trading systems to monitor markets a variety of markets. This is because the correlations between markets differ and offer diversification benefits. While losing money in some markets they make money in others. Trend followers also use leverage to open positions bigger than the assets they manage. This way CTAs make profit from various sources with different profiles. Even though they have a low % of profitable trades, usually in the range of 35-40%, they make much more on their winning trades, than their losing and thus offer significant returns. As you can see on the chart below where a trend following index is shown, trend followers achieved very good returns in the last 31 years.
Source: Iasg.com
An Example of a Commodity Trading Advisor Work
A CTA calculates to go long on a futures contract every month when the current price is above the price 200 days ago and will go short if its below. Also referred to as momentum strategies, Trend-following strategies are often based on assumptions that if markets have performed well in the past, they will continue to perform good in the future.
Their strategy is confirmed by the “Jegadeesh-Titman study” of 1993, which observed that winners tend to continue as winners for a year whereas recent losers will tend to continue losing, hence confirming the momentum phenomenon among trend following CTAs. There are many other studies that have proved the same, but risk management and money management are even more important than following the trend.
But this is just a hypothetical strategy. CTA’s employ other complex strategies to analyze market trends such as comparing indicators and market signals to know whether to go long or short.
Systematic Traders
Systematic traders are complex. They use automated computer systems to capture directional waves in the market mainly through interpreting market data including price trends to quantitatively analyze markets and execute trades. Some of them might do several trades per day which is very difficult if a trader is using discretionary approach and doesn’t have an automated system.
This makes Systematic CTA’s quite innovative and effective in managing futures. Commodity Trading Advisors employ strategies that effectively monitor chart patterns and global trends from data to enable them extract market returns.
A learned observer, Dr. Galen Burghardt—a professor at the University of Chicago’s Booth School of Business—speculated that technical trend traders had been dominant in the market in recent years more than any other type of commodity trading advisors. He found a correlation of 0.97 between a sub-set of trend following by CTAs and a broader CTA index between the years 2000-2009. His study shows how closely CTAs that use trend following models follow the broader CTA index performance. This means that the entire CTA sector returns are driven by trend following funds.
Compensation in the CTA Business
Like in most trading and investment industries, Commodity Trading Advisors are paid management fees calculated as a percentage of the fund assets and an additional commission from new trading profits as an incentive. They have a policy not to give incentives to CTA’s that do not generate profit exceeding a hurdle rate or specified targets. Fees range between 1%/10% and 2%/20% (assets/profits) respectively.
The amount of money that a commodity trading advisors could earn depends on their returns. If the investment made by the client thanks to the advice and management of the CTA goes well and the profits generated by the positions are very good, then a percentage of that amount will go to the CTA. However, if a bad investment is made by the CTA and the money invested is lost then, there will be no money going to the CTA. This is why a Commodity Trade Advisor has to have a keen eye on current trends, and should also have the right risk and money management skill sets in order to manage winning or losing positions. This is similar as in the hedge funds business.
History of the Commodity Trading Advisors Business
Commodity trading advisors regulation systems became popular in the 1970s when the commodity market became more accessible to retail investors. The regulatory body- the Commodity Futures Trading Commission (CFTC) -which has been in operation, has gradually expanded the requirements for CTA registration.
The Commodity trading industry in the United States is guided the Commodity Exchange Act. The definition of a CTA was expanded on July 2010 to include ‘persons who provide advice on swap transactions’ by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The checks and balances included the legislation not only adapt to modern times but also improve on transparency and accountability in the industry.
Commodity Trading Advisors Industry
This is a multi-billion making industry estimated to have grown from $0.31bn futures accounts in 1980 to $312bn in 2014. The managed future accounts have grown fast since they were first instituted in the 1940’s.
Chart: CTAs Assets Under Management
Source: Barclayhedge.com
A lot of this advancement can be attributed to adaption of technology in the markets that has integrated global financial markets and created new markets and new trading opportunities. Leading commodity advisors on Barclay’s hedge cites systematic trading as the most commonly used strategy in the industry representing $269.33 billion or 86.5% of the industry assets under management (AUM).
CTA Historical Data
Over the years, CTAs have shown similarities to traditional asset classes trading in equities and bonds.
A good example is the Morningstar Diversified Futures Index that follows pre-defined rules .The advantage of using this index is that it is unbiased compared to other CTA indices.
Other than relying entirely on beta systematic analysis or asset class, CTA managers are adding alpha through more active management. This room for freedom on whether to go long or short n the market yield good returns in the long run.
However in times of market turmoil, correlations tend to temporarily converge despite them being uncorrelated with traditional asset classes.
Analyzing the 2000-2002 and 2008 equity trend ,It was observed that managed futures yielded better returns during the bear markets, and under-performed during the bull run years of (1997 to 1999, 2003 to 2007 and 2009 to 2010) – also known as “crisis alpha”.
Also, some opt to generate returns independent of the current state of the economy or prevailing level of volatility. This may be the reason why managed futures strategies do better than long-only investments in macro events and market dislocations.
The table below compares a number of CTAs that have superior cumulative returns, particularly as compared to stocks and commodities within the last 20 years.
Source: Morningstar.co.uk
It is evident from the chart that trend following CTAs here exhibited good risk-adjusted returns compared to other asset classes in the last 20 years.
Discretionary traders’ returns are much more complex to evaluate and use for performance measurement as their indices are biased. It is practically impossible to create rule-based indexes to assess discretionary Commodity Trading Advisors strategies compared to systematic strategies employed by their counterparts.
In discretionary trading, investors are simply betting on a manager’s skills and ability to identify patterns and imbalances and make good decisions on investment, which is quite the opposite of trend traders.
The manager therefore must be capable of exploiting chart patterns and diversifying global trends and identify imbalances from market data. However, research done on the subject has shown that there is a low number of active managers who are able to deliver alpha consistently after fees. This means that it might be better to just run the systems and do a systematic trend following.
The table below compares the performance of optional CTA’s between the Morningstar Diversified Futures Index versus the Morningstar MSCI Discretionary Trading Index.
Source: Morningstar.co.uk
As the table shows, the discretionary index performed less than the strategic index by 80bps per year within the last 15 years but registered much lower volatility. This probably means that discretionary traders are doing a better job at controlling risk and offer better risk-adjusted returns. It is however difficult to interpret the meaning of this number keeping in mind, discretionary trading indices are pegged by constructional issues.
Having comprehensively compared Commodity Trading advisors strategies it is notable that a good CTA portfolio will likely include both trend and discretionary traders.
These are good pointers to investors looking to work with CTAs. Returns of Discretional traders are often opportunistic in fashion making them completely uncorrelated with those of different investment strategies and trend followers. A good example are passive long-only commodity indices and hedge funds.
A 2006 study by the CISDM Research Department observed how systematic CTA’s and discretionary CTA’s have a relatively low correlation with each other. The study recommended that there are immense promises of good returns when the two are combined in a single portfolio.
Final Thoughts
As an investor, trader, partner or aspiring CTA, we hope the above discussion about Commodity Trading Advisors was useful. Using the comparisons made of the different kind of CTAs and investment strategies, it will be fair to conclude that managed futures actually yield higher returns during bear markets, than traditional assets.
Keeping in mind the complexity of the strategies used, it is better to combine these strategies in a portfolio. Managed futures, particularly trend following strategies, have proven to yield more productive returns compared to traditional asset classes. They are also uncorrelated to them. Therefore, it may be safe to conclude that these strategies combined in a single portfolio could serve as a great diversifier.
Judging by the success of both discretionary trading and systematic trend following, we at OctaFinance believe that combining discretionary research to find asymmetric investment opportunities and market dis-balanaces and systematic trading approach to discipline us, enforce better risk control on us, is the best way to achieve outstanding risk-adjusted returns.