CTA Fund Performance Report – 30 September 2020 – Controlling Risk to Optimise the Path to Wealth

As you may now be well aware, the Diversified Systematic Trend Following fraternity refer to themselves as risk managers as opposed to profit pundits and I thought I might spell out why we are so eager to take a controlling hand in our market fate by managing risk. Now most of you would automatically assume this is simply a statement about mitigating adverse risk….but the notion of risk control is a far deeper concept that lies in optimising our future path for the benefit of compounding returns..

What we apply is a technique (that may appear to many to be sacrificing immediate returns) in order to deliberately shape a return stream by limiting downside risk which dilutes all the hard work from the magic of compounding. In effect, like sculptors we take a direct role in mitigating adverse risk events to create a better trajectory for wealth building. This is what we mean by ‘taking the bull by the horns’.

So let’s use an example to demonstrate.

Here is the current untreated path of the S&P500TR series for the last 20 years. This equity curve is a reflection of a simply long only buy and hold strategy in the Index over the 20 year period. On closer examination you can see a CAGR for the 20 year period of 6.56% but most importantly (as risk managers) what stands out to us are the two significant drawdowns in 2002 and 2008 that have materially compromised the overall net wealth result. The impact to net wealth over the entire return stream is to raise an initial $1 investment in this Buy and Hold Strategy in 2000 to $3.74 by the end of the 20 year period.

This can also be visualised as a table of monthly returns.

In this table I have used conditional formatting to highlight adverse returns in red that warrant attention.

Now a risk manager reviews this ‘untreated’ overall result and through the evident risk weakness in the equity curve signature or the monthly table of returns knows that a better result could be achieved through the application of methods that reduce the impact of adverse risk events.

By cutting losses short or by applying tail risk insurance (such as buying puts) we use the positive returns of the ‘untreated’ return stream to fully fund the risk management technique….. which significantly reduce the overall adverse returns of the return stream. When we ‘buy risk protection’ the cost of the insurance is overt but when we cut losses short by applying a tight stop, the cost is more subtle as the cost lies in partially sacrificing the ‘untreated’ positive trajectory.

Let’s put this into action to see what I mean. In the following example we will be using a tail risk strategy such as buying puts to protect the strategy from adverse exposure.

Step 1) So the cost of the insurance (hedge protection) is clearly seen in the following equity curve (in red) before we take the impact of the hedging technique into account. Without taking into account the beneficial impacts of the hedging strategy, the cost of insurance appears significant and material in nature. In fact our overall result at the end of the day is to raise an initial $1 investment in this Buy and Hold Strategy in 2000 to $2.28 by the end of the 20 year period.

Step 2) So now let’s look at the benefits that were imparted into the process by the hedging mechanism itself. We have already seen how the costs of the hedge have significantly diluted the overall result but the hedge itself was used to mitigate adverse drawdowns, so let’s now see the overall impact of these mitigated drawdown events on the Net Result even after taking into account the material costs of the hedge (refer to equity curve in blue).

Despite the impact of the cost of the hedge we can now clearly see how net wealth has sky-rocketed by mitigating adverse drawdowns which prevents the compounding effect from being materially diluted. The impact to net wealth over the entire return stream through this deliberate risk management intervention is to raise an initial $1 investment in this Buy and Hold Strategy with a Tail Hedge Strategy in 2000 to $5.92 by the end of the 20 year period. Also now look at the monthly return table . You will notice that those red adverse return streams have been eliminated through the hedging mechanism.

So this is the overall impact of our risk mitigation tactic.

Untreated from $1 in 2000 to $3.74 by 2020; and
Treated from $1 in 2000 to $5.92 by 2020.

Can you now see how we have deliberately improved our overall net wealth over the series through our risk treatment method? The reality is that we have actually sacrificed the untreated positive returns of the return stream to fund the hedge but produce a superior risk-adjusted return.

Now this example has an assumption built into it. Provided the cost of the risk mitigation is exceeded by the benefit of the mitigation on compounded returns, then there is a net benefit in applying this risk mitigation measure. So if there are not material future risk events, then there is no net benefit received from risk mitigation. But what are the chances of less risk unfolding somewhere in that infinite path ahead of us?

You see it is always about ‘risk-adjusted return’. Risk and return are dual aspects of market returns. You cannot treat them separately. They are forever entangled. While we have no power over future profits (as we can’t predict the future) we certainly have the power (right now) to mitigate adverse risk events. So take risk management seriously…..as it is actually your most direct path to long term wealth.

Now to the monthly CTA Fund Performance Report for September 2020

We use NilssonHedge for reporting purposes which allows us to expand our performance coverage to include a broader array of long term established FM’s who occupy the CTA space and have been in operation since 1 January 2000 to the current day. This performance report focuses only on those funds with a long term track record (approx 20 years). The reason we adopt this long term horizon for reporting purposes is that to survive in these financial markets over such a long timeframe and still be alive today offering absolute returns to the client takes a special breed of Fund Manager who has expertise in surviving the turmoil of a variety of different market regimes. We like these guys and that is why we focus on them. As the years roll on we will progressively expand our coverage to include those FM’s who narrowly miss out in their inclusion when they reach the 20 year performance track record horizon.

So far for the month of September 2020 we have 50 CTA’s reporting and within that grand total we have 33 Systematic Global Trend Following funds. We have to draw the line somewhere and the slow coaches unfortunately miss out.

For those that like the detail, below are the index constituent performance results for the CTA Composite Index (50) and the TF Global Index (33).

The CTA Composite Index 50 was down -2.81% for the month with the calendar year offering modest growth of 4.52%….and the TF Global Index 33 was down -3.84% with a YTD contribution of only 0.74%. Barely a breakeven result for a difficult and volatile year so far.

Now as ardent trend followers ourselves, we like to narrow our focus to the Systematic Diversified Global Trend Following community of CTA’s.

Top 10 by CAGR since 1 January 2000

Below is a performance table and an equal weighted performance chart of the top 10 performers of the Long Term Trend Following Index Composite in terms of annualised returns to investors (net of all fees and expenses) since 1st January 2000.

Here is a scatter plot that highlights where the top 10 sit in terms of their Compound Annual Growth rate (CAGR) and Maximum Drawdown over the performance monitoring period.

Below are the performance metrics of the Top 3 from this Top 10 list by CAGR. Just look at those returns. It might be a bumpy journey along the way….but when these guys nail it…they hit it out of the ball-park.

Top 10 by Risk Adjusted Return (using the MAR ratio) since 1 January 2000

Now onto the risk adjusted return category. This category is for those that get ulcers when riding the drawdowns of leveraged volatile equity curves. Here are the results of the Top 10 in this category.

….and the top 3 from this Top 10 category.

Top 3 Equal Weighted Combination Portfolio – The Blend of Blends

Now as great as the individual risk adjusted returns of the Top 10 in the prior category are….we can do better when we look at the performance of possible combinations from the TF list. We iterate across the TF Index to find the Top 3 in terms of Risk Adjusted returns as a combination portfolio each month. So for those avid readers looking for the best risk-adjusted result of a possible equal weighted threesome….here is the result for the month.

Just look at those risk adjusted metrics. With a bit of leverage we can reach for the stars with this combination.

The 3 contributing funds for this month based on an equal weighted blend are as follows:

Top 10 for the last 12 months

So how are the guys going in the short term? There is enough style drift in this camp to observe significant variation in performance returns over the short term. Some of the mob have performed strongly over the last 12 months.