AlternativeEdge Snapshot

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Galen Burghardt
galen.burghardt@newedge.com

Lianyan Liu
lianyan.liu@newedge.com

James Skeggs

How bad has it been? Pretty bad. By the end of 2012, the Newedge CTA Index was down 2.84% for
the year, and had fallen 9.27% from its most recent high water mark, which was hit April 2011. So
the industry has been under water for 20 months, and one hears more and more often that this is
becoming the worst drawdown the industry has ever experienced. One also hears questions about
whether the model is broken or whether the industry is over capacity. The purpose of this snapshot
is to show that while the numbers are right, the comparison is misleading because of the industrys
practice of folding interest income into its total returns. What we want to do here is show that if one
focuses on the industrys excess returns, which are, after all, the industrys true value added, then this
drawdown is nowhere near the worst, either in depth or length. And, when looked at through the
lens of excess returns, it is hard to see that anything is broken or that the industry is overcrowded.
As shown in Exhibit 1, interest income has, for the last three years or so been almost zero, while
in earlier years, CTA returns enjoyed a tremendous tailwind from rates that were 5% or higher. While
the effect of stripping out
Exhibit 1
interest income is a little
Net asset values (total and excess) and the risk-free rate
4500
sobering, we also come
Concatenated CTA Index
away with a more encour4000
Concatenated CTA Index Excess Return
Risk Free Rate Annualised
aging picture of where the
3500
current experience fits in
3000
with past experience. If
2500
we use excess returns to
2000
reckon net asset values
1500
and to measure draw1000
down depths and lengths,
500
we find that the current
Source: BarclayHedge, Ken French, Newedge Alternative Investment Solutions
0
drawdown is considerably
1991
1993
1996
1999
2002
2005
2008
2011
smaller than the -15.54
* Concatenated CTA Index = Barclay CTA Index (January 1990 through December 1999)
and Newedge CTA Index (January 2000 through December 2012)
percent drawdown that
occurred in the late 1990s, and is nowhere near as long as the 38-month drawdown that was experienced in the mid 2000s (and still shorter than the 24-month and 32-month drawdowns experienced
in the early and late 90s. Also, on a trailing return basis, there have been several times over the past 23
years when the 1-year, 3-year, or 5-year returns have been lower than what we have just experienced.
Net asset value

james.skeggs@newedge.com

Well, its much better than it looks!

Prime Clearing Services | Advisory Group

Galen Burghardt
galen.burghardt@newedge.com

Ryan Duncan
ryan.duncan@newedge.com

Alex Hill
alex.hill@newedge.com

Chris Kennedy
chris.kennedy@newedge.com

Lauren Lei
lauren.lei@newedge.com

Lianyan Liu
lianyan.liu@newedge.com

Jovita Miranda

This is, in its own way, good news. When we focus on excess returns, we find that the industry
has produced an annualized compound return of 3.08% over 23 years at a volatility of 9.14%. The
industrys Sharpe ratio has been 0.34%, which is highly respectable, and every possible examination of CTAs returns suggests that they are uncorrelated with stock and bond returns, even during
times of extreme duress. So whats not to like?

jovita.miranda@newedge.com

James Skeggs
james.skeggs@newedge.com

Brian Walls
brian.walls@newedge.com

Tom Wrobel
tom.wrobel@newedge.com

newedge.com

The role of cash in a managed futures investment

Cash plays two roles in the managed futures business. One is to serve as collateral that is posted with
futures clearing houses and their clearing members to guard them against traders losses. The other
is to serve as a plug value in the denominator of a return calculation. By themselves, futures contracts are not assets. They have no net liquidating value, so any gains and losses on futures cannot
be translated into a return. To do this, one has to choose a dollar number to use in the denominator,
and it has been the industrys practice to choose numbers that produce return volatilities that look
like the kinds of volatilities investors associate with stocks and bonds.

10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%

Risk Free Rate

22 January 2013

Well, it s much bet ter than it looks!

Because the values of these arbitrarily chosen denominators are hugely in excess of the cash CTAs
really need to post collateral, the managed futures industry is cash rich. And, as a practical matter, the
return to an investment in CTAs funds is really a value that reflects interest income on the extra cash
and profits and/or losses on the CTAs futures positions.
To approximate what the history of CTA returns would have been if interest income had not been
counted as part of total returns, we assumed two things. First, we assumed that 20% of total cash would
have been posted as collateral and might not have earned even the risk-free rate. So we assumed that
the risk-free rate would have been earned on 80% of the cash. We also did what we could to reconstruct
an index series gross of fees, subtracted the interest income from this, and then calculated a new net
series. In both cases, we assumed a 2/20 fee structure.
The result is shown in Exhibit 1, where we have charted two net asset value series the concatenated Barclay Hedge/Newedge CTA index as it is and one based on CTAs excess returns net of fees. Also
in Exhibit 1, we have charted a history of the risk free rate as published by Ken French at http://mba.
tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.

The industrys Sharpe ratio

Removing the risk-free rate to produce the industrys excess returns has a dramatic effect on the results. As shown in Exhibit 2, the industrys risk adjusted returns for the 23 years from 1990 through 2012
were 0.66 [ = 6.02% annualized return / 9.16% return volatility]. In contrast, the industrys Sharpe ratio was 0.34 [ = 3.08% annualized excess return / 9.14% return volatility]. Still, this compares favorably
with any Sharpe ratio one might expect from an investment in equities looking
Exhibit 2
forward, and without the deep and long drawdowns that equities have experiCTA returns (total and excess)
enced over the past decade.
CTA returns
Annualized compound
Average monthly
Annualized volatility
Maximum drawdown
Risk-adjusted returns

CTA Index
6.02%
0.53%
9.16%
-10.30%
0.66

Excess
3.08%
0.34%
9.14%
-15.54%
0.34

Source: BarclayHedge, Newedge Alternative Investment Solutions

In fact, as we argued in Managed Futures and Pension Funds: A Post-Crisis

Assessment [Futures Industry, November 2011] returns like these, given their
demonstrably low correlation with stock and bond returns, are solid enough to
support an allocation of anywhere from 10% to 50% of a 60/40 stock/bond portfolio. In other words, the tail wind from interest income was nice, but the excess
returns have been good enough to merit investors serious attention.

Historical comparisons
More important is how this past years results look when compared to past excess returns rather than
to past synthetic or total returns. The answer is, not half bad.

30%
25%

Annualized Excess Return

20%

Exhibit 3 shows rolling excess returns for 1-year, 3-year, and 5-year lookbacks. In all three cases, one
can see that there have been better times, but there have been several times over the past 23 years
when the industry has done much worse than it has
Exhibit 3
Rolling Annualized Excess CTA Returns (concatenated CTA index)
over the past 20 months. This past years experience
compares very favorably with the two dramatic loss1 Year Rolling Excess Return
3 Year Rolling Excess Return
es we would have observed in the early 1990s and
5 Year Rolling Excess Return
the late 1990s.
When we recast the drawdown history using
excess rather than total returns, we find a similar
improvement in the comparison. Because interest
has been nearly zero over the past few years, the removal of interest still leaves us with a drawdown of
-9.48%, and the current drawdown is still 20 months
long. But it is no longer tied with or close to tying
the worst drawdowns of the past 23 years.

15%
10%
5%
0%
-5%
-10%
-15%
-20%

Source: BarclayHedge, Newedge Alternative Investment Solutions

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

As shown in Exhibit 4, the two worst drawdowns

Newedge alternative investment solutions

Well, it s much bet ter than it looks!

Exhibit 4
10 Worst Drawdown (by Depth) Statistics
Using excess returns*
Length of Drawdown
Drawdown
(Months)
-15.54%
24
-14.96%
32
-10.71%
38
-9.64%
14
-9.48%
20
-8.30%
19
-7.34%
13
-7.23%
6
-6.62%
18
-6.08%
5

DD End
31-Mar-01
31-Jul-93
31-May-07
30-Jun-02

Using reported total returns

Drawdown
-10.30%
-10.10%
-10.00%
-9.50%
-9.27%
-8.92%
-6.56%
-6.55%
-6.13%
-5.52%

Length of Drawdown
(Months)
20
7
17
13
20
7
18
3
19
2

DD End
30-Nov-05
31-Aug-92
31-Dec-00
31-Dec-91

based on excess returns were both

in the neighborhood of -15%. One of
these lasted 32 months while the other lasted 24 months. The third worst
drawdown lasted 38 months.

This is a much different picture than

one gets from reckoning drawdowns
using the concatenated CTA index.
31-Mar-95
30-Jun-02
30-Sep-98
30-Sep-10
There we find three drawdowns in the
31-Jan-08
31-Oct-07
neighborhood of 10%, and the longest
30-Sep-10
31-Mar-95
31-Oct-96
30-Nov-91
of these was in fact 20 months long.
Source: BarclayHedge, Newedge Alternative Investment Solutions
The difference provides a good illustration of the effect that the inclusion of interest income in CTAs returns has had on both the depth and
length of drawdowns.

A sober look is a better look

Like an actor who has lost his youthful good looks and who must now focus more on the quality of
his acting, the CTA industry now has an opportunity to turn the loss of interest income into a chance
to focus on what it has really been doing all along delivering respectable, uncorrelated returns at a
reasonable risk. The picture that emerges from Exhibit 3 is that of a return engine that seems to be doing more or less what its always done. The current values of rolling returns are in the bottom halves of
their respective distributions, but well above their extreme low values. From the data in that picture,
it would be impossible to conclude that anything is wrong with the model. And from the drawdown
histories we see in Exhibit 4, the current drawdown is bad by CTA standards, but a long way from being as bad as those the industry experienced in the 1990s and the mid 2000s.

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