CTA vs. Hedge Fund Investing
Ernest Jaffarian, founder and chief executive of Efficient Capital Management LLC, is a long-time investor who has allocated billions of dollars. He continues to make allocation decisions to commodity trading advisors for a distinguished group of clients.
Here he compares managed futures with hedge fund strategies and tells us what investors like and don't like. He argues that a portfolio of commodity trading advisors is the better way to invest in a turbulent world and explains why he has confidence in futures.
Mr. Jaffarian has been in the trading and investment business for well over 20 years. He joined Chicago Research & Trading Inc. as a member of the proprietary trading group on the floor of the Chicago Board Options Exchange in 1986. Later he worked for Hull Trading Company, a leading electronic trading business specialized in derivatives.
He was responsible for allocating Hull's own capital to commodity trading advisors. In a management buy-out, the Hull managed futures unit became Efficient Capital. Subsequently Goldman Sachs acquired Hull Trading.
'People are starting to distinguish CTAs from hedge funds and allocate separately. CTAs have always been lumped together with hedge funds.'
Opalesque Futures Intelligence: How many managers are you currently invested with?
Ernest Jaffarian: We have more than 40 managers in the portfolio. Last year alone we visited more than 200 commodity trading advisors.
OFI: What's the advantage of a portfolio of CTAs compared to a diversified fund of hedge funds?
EJ: CTAs have an entirely different risk/return profile than hedge funds, as academic research has shown. The crucial difference is rooted in the fact that CTAs do not try to make money by taking credit risk or liquidity risk. And they don't take volatility risk in the sense of being short volatility. Those are primary sources of income for many hedge fund strategies.
OFI: What is the source of profit in managed futures?
EJ: The asset class on the whole seeks to make money by pure trader skill while being agnostic about market direction. Because of that, CTAs have no correlation to major asset classes or, even better, are negatively correlated on the downside but positively correlated on the upside to stocks. 2008 presented proof of the concept. Hedge fund strategies heavy on market direction beta or alternative beta ˘â‚¬â€ś like credit exposure ˘â‚¬â€ś all got crushed. By contrast, CTAs saw opportunities as result of market dislocation and had one of the best years in their history.
OFI: Do you invest in new CTAs?
EJ: We do not seed CTAs. How long they need to be around for us to consider investing depends on the trading style and the experience of the manager. Trading experience is one characteristic that's pretty important in this space. For us, 20 years of trading and two years in the CTA business is a more valuable combination than someone who's been a CTA for four years and has no other experience.
OFI: Besides experience, what do you look for in a CTA?
EJ: To begin with, we think the person's character is extremely important. We want a world class operation in every respect, whether in trade execution or infrastructure, and an ongoing research effort to improve what they do. Also, we seek managers with trading styles that have some unique feature. It does not do us any good if a CTA has a 90% correlation to other CTAs. That adds no value to our portfolio.
OFI: That must be difficult with trend followers. Don't they mostly follow the same trends?
EJ: We do not rely on trend followers alone. We include as much diversity as we can find. There is a lot of diversity among CTAs. Some traders hold positions for no more than a few minutes, others hold for weeks. You have traders that focus on a single market, you have those that trade every market around the world. There are traders that rely on patterns in the markets and traders that rely on mathematical analysis of economic turning points.
OFI: How come all these different approaches are practiced in futures markets?
EJ: Futures markets are the canvas upon which the traders apply their skills. They use futures because these have desirable characteristics. Futures markets are non-directional, extremely efficient and very liquid. If you have a sense of how to pull return out of markets, you will gravitate to futures because the instruments allows you to express that skill.
OFI: Do global macro and managed futures belong in the same asset bucket?
EJ: If you line up global macro managers that trade exclusively in futures versus global macro managers that trade other instruments as well, you find that they are not very correlated. Global macro as expressed in the CTA world has significant differences from global macro as expressed in hedge funds. For instance, in the hedge fund version people usually pick two to four macro themes that they put into play using an array of instruments and hold for a long time. By contrast, CTAs with a global macro style tend to have a larger range of themes and hold positions with a much looser hand˘â‚¬â€ťthey run very dynamic trade books compared to macro hedge funds.
OFI: Is asset growth the enemy of return?
EJ: It is not necessarily the case that smaller funds do better. It depends on the trading style. Yes, someone who trades in a very short time frame can't manage as much as someone with a longer time frame. That said, two of the largest futures managers, Transtrend and Winton, continue to perform well. It has more to do with the style and infrastructure of the manager than the assets under management. We have no hard rules about the size of the assets a CTA manages.
OFI: What do you try to avoid?
EJ: We don't want managers that take a lot of risk relative to their return, take volatility risk or don't show discipline. There are managers who make fabulous returns by taking inappropriate risks. Frankly, that describes a significant part of the hedge fund world. You'll see hedge funds that make money for 48 months running and then collapse because they took too much credit risk. Our mandate is to avoid those risks and try to generate returns in a different way.
OFI: What do investors want now?
EJ: Investor interest in CTAs waxed and waned in the past. I think 2009 will bring a paradigm change, for two reasons. One, the diversification benefit of CTAs, a point made repeatedly in academic studies, showed up in full force last year and is now being accepted by people who used to resist the idea. Two, people are starting to distinguish CTAs from hedge funds and allocate separately. CTAs have always been lumped together with hedge funds. Investors are now starting to say they want so much exposure to the hedge fund space and so much exposure to the CTA space. In my 20 years in the business, this is a significant change. People are finally starting to take notice of futures!
OFI: What keeps you up at night?
EJ: I sleep pretty soundly these days. In 2008 the volatility of our composite portfolio was the lowest in our history. Frankly, I'm more concerned about events in places like Pakistan or North Korea than I am about our portfolio. Can you imagine the impact of a nuclear explosion in Saudi Arabia? There are any number of possible events that would rock markets, including futures markets. Even with those geopolitical risks, I would much rather have a broadly diversified futures portfolio than own stocks and bonds or be locked into one currency. Futures markets as a system are more stable than stock markets, as we saw on Black Monday 1987 and in the recent crisis. Now the US government is trying to move more instruments to futures exchanges. I have confidence in the integrity of the futures market.