Tuesday, November 11, 2008

Trend following CTAs no panacea

Regular readers of my blog are aware of my skepticism about the value of hedge funds as investments. While I have the greatest respect for some hedge fund managers who are capable of adding significant value, aggregate hedge fund returns have been far too correlated with S&P 500 returns and undiversifying for them to justify their fee structure. See my some of my past comments here, here, here and here.

Today, it gives me no pleasure to see the hedge fund industry in disarray and implode. Returns are going south, redemptions are rising and the fee structure is under scrutiny. Investors didn't get the results they expected. In addition, hedge fund industry employment should not have ballooned the way it did in the boom years and now the downward adjustment is going to be painful for a lot of people, many of whom didn't make the obscene amounts of money reported in the press.

Trend following models work…
Recently I saw the news item from the WSJ indicating that trend following Commodity Trading Advisors (CTAs) exhibited positive returns for the year. No doubt some investors will allocate funds to this group of managers in search of a “safe haven”.

There is no doubt that tremd following models add value. I once wrote the following about my experience working for a hedge fund that began life as a CTA:

A few years ago, I managed equity market neutral portfolios at a firm that was mainly known for commodity trading using trend following techniques, which are well described by Michael Covel in his book [Trend Following]. During my tenure there I noticed that while the commodity positions were spread out among various futures contracts they often amounted to a few macro bets (i.e. on interest rates, on the US$, etc.) I came to the conclusion that these models were identifying macroeconomic trends that are persistent and exhibit serial correlation, which creates investment opportunities for patient long-term investors. For example, if the Fed is raising rates the odds are they will continue to raise rates until they signal a neutral or easing bias, i.e. there is a trend to interest rates, which is information that investors can use. The key risk in this class of models is knowing when to exit the trend, as short and long term reversals can be devastating to the bottom line.

…but CTAs have no alpha after fees
Trend following models identify and capitalize on long-dated economic trends, which are persistent. However, academic studies show that an investor can replicate those effects in a relatively simple fashion with techniques that are in the public domain.

In other words, CTAs just don't seem to have any alpha on an after fee basis.

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