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Following decades of solid performance, commodity trading advisors (CTAs)–who are regulated by the Commodity Futures Trading Commission (CFTC) and who may trade or invest in equity, fixed-income, currency or commodity futures–have been in something of a funk. While the compound annual return of the Barclay CTA Index since 1980 is 9.99%, returns have been negative in three of the last four years. BarclayHedge estimates that year-to-date performance is -1.59% through the end of last week.
Generally speaking, CTAs, which fall under the heading of “managed futures,” rely on systematic rather than discretionary approaches to generating returns. In the majority of cases, they employ trend-following strategies. Although methodologies, time frames, and targeted markets vary depending on their knowledge, experience and technical capabilities, trend-followers use historical prices to predict future trends. The approach is momentum-based, as opposed to mean-reversion counterparts such as value or contrarian investing, which seek to profit from pendulum-like reversals after swings in a particular direction.
Perhaps the most common example of a trend-following approach is one that uses a 12-month momentum model, where positioning is based on where current prices are in comparison to a year earlier. If, for example, oil futures are higher than they were 12 months ago, then someone who uses this approach would be long, betting that prices would keep moving higher. Another well known strategy generates trading signals based on where prices are in relation to one or more moving averages. A trend-follower might decide, for example, to sell (or stay short) a futures contract if its current price is below its 200-day moving average.
An unusual and challenging environment
The fact that CTAs can be long or short, and can trade in markets that have historically been somewhat uncorrelated–that is, they march to a drumbeat of their own–to traditional equity and fixed-income markets, has for many years been a key selling point for this approach. That said, it’s likely no coincidence that this strategy has generated subpar returns since the global financial crisis, during a period marked by extraordinary monetary intervention. The combination of ultra-low interest rates and markets that have become fixated on what policymakers might do next, rather than on traditional fundamentals, has created an unusually challenging environment.
More specifically, a range of assets have over the past five or so years become much more correlated than in the past. In other words, their prices tend to move in sync with one another to a degree that is somewhat anomalous. As the following chart from the International Monetary Fund (IMF) illustrates, there is a significant difference between the way that various markets traded before and after the crisis.
In addition, short-term price movements have increasingly assumed what might be described as a binary character, which has been dictated by shifts in expectations about future policy. When participants are optimistic about continued monetary accommodation, the result has been “risk-on,” or an urge to be invested in instruments, sectors and markets that have traditionally been viewed as the most speculative and risky. When they become concerned that the easy-money punch bowl is about to be taken away, the result has been “risk-off,” which is characterized by a sudden and widespread preference for “safer” investments.
Directionless markets and volatile price swings
One result of this post-crisis landscape has been fewer sustained price trends and frequent bouts of range-bound, directionless trading followed by violent swings in prices, all of which has hurt the performance of those who employ trend-following strategies. This has impacted the sector’s assets under management (AUM), which, as the the following chart from BarclayHedge shows, have flattened out in recent years.
It is more than a little ironic that many of those who might consider allocating to this alternative investment category seem to be betting that future returns will mirror those seen recently. Not helping matters, of course, is the fact that anything having to do with commodities seems to be shrouded in the same gloom that has affected oil, copper and other commodity markets,despite the fact that CTAs should be able to profit whether markets go up or down.
Still, one factor which may brighten the outlook for this sector is the very same one that has undermined it in recent years: central bank policy-making. With more and more analysts expecting the Federal Reserve to initiate its long-anticipated move towards interest-rate “normalization” at the December 15-16 Federal Open Market Committee meeting, it is possible that market conditions may soon return to a state that favors trend-following investing.
Michael J. Panzner is a 30-year Wall Street veteran and the author of three books, including Financial Armageddon, which predicted the 2008 global financial crisis.
