CTA Fund Performance Report – 31 December 2020 – A Tale of Fat Tails

CTA Fund Performance Report – 31 December 2020 – A Tale of Fat Tails

While it is nice to ponder why trends are a persistent feature of any liquid market, the reasons for why trends occur is really not an important requirement for trend following. We just need to look at what the data tells us. You see as a price follower, we are less concerned with the ‘why things happen?’ and more concerned with taking advantage of ‘what actually happens’.

So when you take a large enough data sample of any liquid market you start to see clarity in what the market data tells us. By referring to the market data itself, we can quickly resolve the myriad of possible causes into only 2 possible broad price outcomes where a possible edge resides,….namely the peak of the distribution of returns, where convergent trading strategies flourish, or the left and right tails of the distribution of returns where divergent trading strategies rule the waves.

That’s it dear reader….nothing more. The alpha of market participation either resides in a liquid market’s mean reverting tendency during periods of stability (equilibrium) where price tends to revert to historic averages or the alpha delivered in periods of instability (disequilibrium) when prices diverge away from historic levels.

That is the beauty of a quantitative approach to understanding price data. We are not looking for some derivative cause that leads to this price behaviour. Rather we are simply referring to the behaviour of price data itself (over very large data samples) and quantitatively assigning that behaviour into two broad categories of price movement, namely convergent behaviour (converge towards a historic mean) or divergent behaviour (diverge away from a historic mean).

Now most traders like to think that they understand how markets behave and are looking for consistent patterns that give them the ability to predict future price. They therefore predate on the peak of the distribution of market returns where alpha is delivered from a traders ability to predict future outcomes from a repetitive market behaviour. As a result they adopt ‘convergent trading methods’ that require pinpoint accuracy in entry and exit condition so they can exploit that repetitive market tendency. They therefore are market behaviour specialists and use concentrated trading methods as opposed to diversified trading methods to capitalise on this apparent certainty…..however their techniques are the antithesis to us trend followers. Now during those times of market intervention or during periods where markets display repetitive behavior associated with a particular market condition the convergent methodology shines, however when these market conditions change…then these form of traders sit frantically wondering whether they are entering a drawdown or heading towards ‘risk of ruin’.

Now for those smaller subset of traders who trade the tails of the distribution as opposed to its peak….we adopt a method that is counter-intuitive to the convergent mindset. You see, as a trend follower who attempts to exploit the left and right tails of the distribution of market returns, there is no ‘certainty’ in a tail event. By definition, these outliers are unpredictable in nature….so unlike our ‘convergent cousins’ we cannot use a precise method to extract the edge from uncertainty. We therefore use diversification both in terms of markets and system design as a method to place thousands of very small bets on the possibility that once in a while we will be riding a tsunami event that ‘pays for ’em all’. In fact the entry places a far lower emphasis in our trading decision than the exit. We simply use the entry as a method to avoid trading during ‘normal market conditions’ and also provide a degree of diversification in entry condition to provide correlation offsets and target an array of different possible trend forms. It is the exit that is all important to us as we want to trade the outlier for as long as it lasts…..and we never know how long that could possibly be. In our world….we simply avoid any form of profit target and trail any trend of substance.

Now given that we cut losses short and let profits run and trade in the long and short direction, what does this mean w.r.t the trade statistics produced. Well, it actually means that we produce trade results in which the dominant trade contribution is from either small losses, breakeven trades or marginal winners. We refer to these trades as the ‘necessary grind’ to keep us afloat and allow us to survive while waiting patiently for the ‘unpredictable event’. While participating in every opportunity that meets our entry rules, we never commit to any single trade and we treat all trades as equal. Importantly we never let our losses stray too far towards the negative tail event by always cutting losses short….but we always allow all our trades to extend towards a possible positive tail event by letting profits run….but these outliers are few and far between. There actually is only a very small handful of trades that actually contribute to our long term prosperity and we had no say in selecting these outlier trades. They were just the spoils provided to us by a market that at times displays divergent behaviour.

Is trend following dead?…..well this tends to be a question asked by a convergent mindset that is used to exploiting ephemeral repetitive market behaviour. For us trend followers, liquid markets always have the potential to trend….but we just cannot time the ‘when’ or ‘where’ of these events. We just know that over an extended market data sample there are times when price displays fat tailed behaviour…..so we simply apply a systematic rules based process that simply ensures that ‘if markets’ trend, then we are in a position to participate in these unpredictable events.

Now to the monthly CTA Fund Performance Report for December 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 December 2020 we have 49 CTA’s reporting and within that grand total we have 34 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 (49) and the TF Global Index (34).

The CTA Composite Index (49) was up for the month by a whopping 6.54% bringing the calendar year to a healthy growth of 14.38%….and the TF Global Index 34 was also up a very healthy 6.41% for the month bringing the 12 month YTD contribution to a solid 9.41%.

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 5 Equal Weighted Combination Fund of Fund Portfolio – No Hind-site Bias

Ok I hear you say. Your selection of funds displays hind-site bias. Show me a Fund of Funds opportunity that does not possess any form of selection bias.

To undertake this assessment I interrogated the Nilsson Hedge database and drew on the great CTA graveyard to ensure that the process I adopted did not fall into the trap of peeking first 🙂

Here is how I approached the assessment.

We commenced an annual re-balancing process whereby I simply selected the top 5 each year from the Diversified Trend Following Listing that had a long term track record of at least 20 years by virtue of either Compound Annual Growth Rate (CAGR%) or by MAR ratio (CAGR%/Max Draw%) over the historic look-back. This process was undertaken each year for the last 20 years to identify the 5 top performing funds that would be allocated to each year.

The Funds that met the selection criteria for each category are detailed below. You will notice that the performance result was fairly consistent each year with little alteration in Fund composition throughout the 20 year history.

Below are the performance results based on Net Asset Value (NAV) for each FOF model.

Now whatever way you cut it, the examples above demonstrate how diversified compilations of these Trend Following FM’s with a long term track record produce stellar performance results. There is ample alpha available in these examples to support FOF structures and still deliver exceptional risk adjusted performance returns for clients.

Indeed, the possibility exists to develop FOF structures using this class of investment technique that would have strong appeal to pension plans and the superannuation fund industry in Australia and overseas and provide an opportunity for Retail investor exposure.

But let’s lever up the MAR FOF example as it wouldn’t be too difficult to finance such sustainable diversified assets using Margin structured arrangements. So let’s gear up the MAR FOF example with a 50% Equity and 50% Debt arrangement and apply conservative funding rates to this solution over the period.

We can clearly see how there is more than enough capacity within these FOF models to support additional leverage.

So now let us compare and contrast all three options.

So there you have it. Three fine examples of wealth building structure for different risk appetites that can be achieved with a bit of innovative FOF modelling within this single class of Fund style. There is no guesswork here in the selection process. We are simply letting the track records of these FM juggernauts speak for themselves and then compiling the result.

So if you are scratching your head wondering how to tackle this question of “where I should be allocating my hard earned investment capital?” you really do not need to step outside this well tested domain of diversified systematic trend following methodology.

You can achieve that wealth building ambition of yours within this investment class itself. There is no need to compromise that ambition by allocating towards less robust convergent methodologies that may have negative skew. Stick with the FMs with a proven track record of 20 years plus. Let the experience of a validated track record speak for itself…..after all anything else is just assumption and you know how us trend followers hate any form of predictive assumption.

While this post posits the possibility of developing powerful FOF’s within this investment class…. it should not come as any surprise. After all each Fund we have used in this exercise are globally diversified….so in essence we are just taking diversification to the next level.

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.