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How to choose CTAs

Trading advisors are not all the same. That's what you hear again and again from long-time investors. Because there are big variations, good advisor selection is essential to the success of an investment. We're asking industry veterans how they asses managers.

Ken Steben, a pioneer in the commodity pool business, developed his approach starting in the 1980s. Here he discusses the extensive search and selection process his group uses and how it has changed over time.

Mr. Steben is the founder and chief executive of Steben & Company Inc. The firm oversees $1.1 billion in managed futures and additional assets in other investments. It has a high-net-worth client base.

Opalesque Futures Intelligence: How did you get into this business?

Ken Steben: I started as a stockbroker in 1981 and became a licensed commodities broker in 1983, when I realized the value of adding managed futures to clients' portfolios. I researched this area and began to place my customers' money with commodity trading advisors. Then in 1989 I formed my own company and started a fund to invest in CTAs. That first fund is still operating.

OFI: Who are the clients?

KS: My firm introduced managed futures to independent broker-dealers over the 1990s and into the 2000s. Today we do business with more than 120 broker-dealers across the US as well as hundreds of investment advisory firms . We currently have over 12,000 investors in our funds.

OFI: Do you see yourself as a fund of funds manager?

KS: We are not a fund of funds in the sense that we never invest in commingled pools, only in managed accounts. We are a manager of managers. Because we hire advisors to trade money in our funds' accounts, we see what they do every day and can monitor them very closely.

OFI: How do you find managers?

KS: We search repeatedly, every quarter. We comb through databases, look at the materials advisors send us and keep our ears to the ground in the industry There are a couple of thousand companies registered as commodity trading advisors in the US alone. But even with all the searching, the list of advisors we consider doing business with is always very short. For one thing, firms must have at least a five-year track record so that there are enough data points for our quantitative analysis, which is the first step in the screening.

OFI: How do you assess a CTA's track record?

KS: Our quantitative analysis is not about picking the highest past returns. We have found that annual profit has no statistical significance for predicting the future. However, there are elements within the track record that are statistically significant for future performance. In the past several years we've isolated some ratios that are very helpful for understanding how a manager's returns compare to the risks taken. We look deep into the track record, not just at the profit numbers. CTAs that are promising by our measures are put through the qualitative review. We meet the principals, learn their history and understand how they make money. We look at their operational capabilities and talk with their customers.

OFI: How many managers have survived this screening process?

KS: We are currently using seven trading advisors, with whom we feel comfortable. A very large number of advisors are screened out by our quantitative analysis of the track record. We look for consistency in how much profit they can produce relative to their ability to control risk. This is a very stringent screen. We like our analytical approach because we have found it to be a meaningful indicator of future success.

OFI: What other factors make you decide not to proceed further with a manager?

KS: Many of those that get through our quantitative screen don't meet other criteria. There are a whole range of issues. Key personnel may have left the firm, which means that the track record no longer indicates what the team can do. They may not have the operational capability to handle an influx of additional money. Some managers have compliance or legal issues. Sometimes we find they use instruments we're not comfortable with. For instance, in early 2008 we found a CTA that otherwise looked very good but was trading swaps. We want trading limited to exchange traded futures and currency forwards, with no over-the-counter derivatives. Because of our concern with the swaps market, we did not invest with that CTA. As it turned out, the crisis that came later in 2008 justified the concern.

OFI: How would you assess an emerging manager?

KS: We do not invest with emerging CTAs because you can't measure their probability of success. We want a reliable, proven track record.

OFI: Are you still invested with some of the managers you found 20 years ago?

KS: You can't stay with same CTAs-they change, markets evolve. We've changed our whole portfolio completely over the years. Not that we invest short term. We've used some CTAs for 10 or 12 years, others for five years. But we do switch managers. Some of them do not keep up with markets or lose personnel. Other managers come up with more sophisticated systems.

OFI: Has you screening process changed over time?

KS: Our search became more global and our analysis of track records became more sophisticated. These days we search all over the world . Of the seven advisors we're using, five are overseas, two are in the US. By contrast, seven or eight years ago we were investing with only US trading advisors. We've done research to improve our selection process and overall we've done very well for our investors over the years.

OFI: What styles do you prefer?

KS: We have used a wide range of CTAs over time but found that the most reliable are systematic trend followers. So the bulk of our money is with trend followers.

OFI: Managed futures don't seem to be doing well this year. Have many CTAs lost their edge?

KS: It is very short sighted to say, they're not doing well this year, they've lost their edge. It is normal to have down years. As a professional investor, you think in terms of the long-term horizon, don't allow short-term results to influence your view. Overwhelmingly, the data shows that managed futures adds to portfolio performance and is one of the best diversifiers .

OFI: Isn't short selling a good diversifier?

KS: Historically, over the long term equity markets go up, so short sellers lose money. But CTAs can go long & short, not just in stock markets but many markets. They can make money in bear or bull markets, whereas short sellers lose in bull markets.

OFI: What about trend followers' drawdowns?

KS: In my opinion people need to understand that systematic models work in the long run because long-term trends do appear, usually when you least expect them. Good managers keep their powder dry, attempt not to lose too much during difficult periods, then try and take advantage of trends. Managed futures is misunderstood by a large percentage of the financial community. It is seen as riskier than it really is. Although futures trading is speculative and volatile - just like stocks can be - and not suitable for everyone, used properly it is a risk reduction technique. 2008 showed that it complements stocks and bonds in a portfolio. We've seen increased investor interest.

OFI: What mistakes do investors make when investing in managed futures?

KS: You need someone with experience to screen managers and watch the trading. To get in with the largest CTAs, in many cases you have to be a large investor. For instance, some CTAs require a $100 million investment for a separate account. An individual investor may not have access-which we provide.