Saturday, 11 July 2015

Follow the leader & CTAs

15:51 Posted by The Thalesians (@thalesians) No comments

When everything is going well, who doesn't like to bask in all the glory? When stuff is maybe not going quite as well, it's easier to hide and avoid comment. The difficulty with trading, is that you'll be wrong a lot of the time, no matter how successful you might be in the long term.

With strategies such as trend following strategies which CTA (commodity trade adviser) funds typically use, you might actually be wrong *most* of the time, if we measure being right as the proportion of up days versus down you'll have. Yet over the long term trend following strategies are still profitable, if we look at historical data! So why is this the case?

The answer is in the skew of your returns. They'll be periods where your trend following returns are fairly lackluster and the market is devoid of any clear trends or a turning point has been reached. Indeed, in recent months CTAs have suffered because of this. Then when there are large market trends, returns are comparatively large, such as we had in the second half of 2014 and early 2015, which saw record returns for many CTAs. Hence, it's the opposite of the typical "long only" or positive carry trading strategy, where you are "picking up pennies in front of the steamroller". In other words, you get relatively consistent returns followed by large drawdowns (bigger than those typically suffered by CTAs). Plot most equity indices and you'll see this type of behaviour. People however seem comfortable with being long only investors despite this. Potentially one reason is that the trade is pretty simple, you simply buy and hold an basket of stocks.

By contrast CTA strategies, are somewhat more complicated. That's not to say you need a postgraduate math degree to understand the general concepts. It's just that they are made up of many simple concepts, which when joined together seem more complicated. It's like the picture above from Castle Howard. We can all understand how a painter has created such a masterpiece, yet the final result is impressive and requires considerable skill to complete. Also because the return distribution is somewhat more unusual, compared to a long only strategy, investors need to different expectations when they invest in CTAs. In order to get the benefits of a CTA, you need to be invested for a reasonable period of time. Furthermore, because the returns distribution are somewhat different from that of a typical long only investment, a CTA offers some level of diversification for investors who are mainly long bonds and equities. One of the most obvious periods when this diversification effect kicked in was during 2008. Whilst equities sold off considerably, CTAs actually outperformed.

If you choose to "follow the leader" and trade trends, have patience in the strategy and your overall portfolio will benefit from the diversification effects, if you already have long only exposure. Judging a CTA by very short term performance misses the point, that by construction having CTA exposure is like being long volatility.

I'll be speaking on "How to build a CTA?" in Zurich in September. If you're interested in research I've written on CTAs, let me know, in particular on the diversification aspects! You can download PyThalesians code from the GitHub PyThalesians page here - which I've written to do a lot of my research.

Like my writing? Have a look at my book Trading Thalesians - What the ancient world can teach us about trading today is on Palgrave Macmillan. You can order the book on Amazon. Drop me a message if you're interesting in me writing something for you or creating a systematic trading strategy for you! Please also come to our regular finance talks in London, New York, Budapest, Prague, Frankfurt & Zurich- join our group for more details here (Thalesians calendar below)

22 Jul - London - Paul Bilokon - Stochastic Filtering
07 Sep - Frankfurt - Saeed Amen/Yves Hilpisch/Thomas Wiecki/Jochen Papenbrock/Miguel Vaz/Adrian Zymolka - Quant Evening (Thalesians/Quant Finance Group Germany)
08 Sep - Zurich - Saeed Amen - How to build a CTA? / interactive Python demo


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