CTA returns question

Right, got me a question. I’m reading through the alternative investments portfolio management reading (Reading 34): CFAI mentions in the managed futures section that the derivatives market is a zero sum game and on average you can expect to earn the risk free rate less management fees and transaction costs. It then goes on to show figures for the CTA indices which show relatively high returns for CTA’s. For example CISDM CTA$ earns a return of 10.85% with a standard deviation of 9.96% over the period 1990 - 2004. In the same period CTAEQ is 9.33%, 9.58% and S&P 500 is 10.94%, 14.65%. I does mention that returns higher than the risk free rate less management fees and transaction costs can be earned if the market is made up of mostly hedgers who are happy to earn less than the risk free rate in order to hedge their future income from selling their commodoties or whatnot. That still doesn’t seem to be a sufficient reason to earn such a high return on average though. Can anyone shed some light?

I’ll tell you when I get there…only on Reading 29!

F = S* (1+r)^T So that on average you will earn the risk free rate. But you can earn more if you actively trade futures and speculate. What they mean by hedgers is that hedgers take a position not looking for alpha (excess return) but rather to mitigate a risk, thus in a zero sum game leaving potential profit out there.

CISDM database has self-reporting bias because reporting is voluntary and the primary reason for CTAs to report their data is to raise assets under management. Therefore, they only report their performance if they can expect to raise money. When a CTA has a good track record for a year or so, he starts reporting and back-fills old returns (back-fill bias). A CTA with a bad track record is not going to report to the database (selection bias). Another source of bias - delay is reporting. If a trader loses a lot of money, he can stop reporting and the huge loss is not accounted for. From what I remember academic papers estimate selection bias of 2.5-4% a year.

BS. During much of that period, I worked for one of the biggest CTA’s in the world (so it’s really the Joey bias - not really). I’ve got about 27 court orders that say I can’t tell you how to make money doing it (we averaged about 15% per year during the period with an 8% year as the worst with equity-like risk). It’s not that I have anything all that profound I could say however. I always tell people that to make money as a CTA you need to do about 20 simple things. If you mess up any of them, you’re toast but none of them is very hard. To make money as a CTA you need to manage lots of money, > 100M and < 3B seems to be about the right range. That’s because the key to making money is portfolio construction and risk management. There’s some really good hints in how to make money by simply looking at CTA return streams and thinking about how they get that way.