CTA Market and Portfolio Diversification

By Gerardo Manzo and Jeffrey N. Saret on August 18, 2017
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Despite Commodity Trading Advisors’ reputation as portfolio diversifiers, a decomposition of the most prominent factor exposures in the SG CTA Index suggests that just four factors collectively explain an outsized fraction of the index’s risk. Additionally, average current long exposures to both equities and bonds are elevated, potentially compromising the amount of diversification CTAs truly offer.

Institutional investors typically view Commodity Trading Advisors (CTAs) as an alternative investment that allows them to participate in multiple global markets as well as to better diversify and improve the risk-adjusted performance of their overall portfolio. Over the past few decades, that has generally proved true. The correlations between CTAs and equity and bond indices has historically fallen below 30 percent.¹

However, long-term averages may mask current risks. The recent, sharp fall in the SG CTA Index—a frequently used proxy for the CTA universe² —seems to have focused the minds of institutional investors on those risks. This performance, and the risk decomposition analysis below, highlights two important considerations for CTA investors:

1. CTAs may invest in numerous instruments and markets globally, but the CTA market seems to have only four major bets right now.

2. The average CTA’s current long exposure to both equities and bonds would seem to offer very little diversification for the typical institutional investor, making the asset class less “alternative” right now than some might hope.

Decomposing recent CTA performance

The SG CTA Index dropped sharply by about 4.36 percent the last week of June 2017. Although it soon recovered some of those losses, performance has remained negative year to date (Figure 1). A factor-based approach to analyze CTA performance may put some more color on the recent trend as it helps decompose it in the main driving risk factors. Four factors, representing the global fixed-income and U.S. stock markets, currency (EUR-USD), and crude oil collectively appears to explain about 60 percent of its weekly performance over the last year.³ During the last week of June and the first week of July, the simultaneous declines in US equity prices, global bond returns, and a weakening of the USD proved especially painful to CTAs.

SG CTA Index Performance January 1, 2017 to August 4, 2017

This is not a short-term trend. As Figure 2 illustrates, index loadings over the past year show elevated long exposure to both the Barclays Capital Global Aggregate Bond Index and the S&P 500 Index—the latter measure being near its highest level of all time. Meanwhile, CTAs exhibit significant short exposure to the EUR-USD and to crude oil prices. The fraction of risk that these four factors appear to collectively explain has increased since 2015 and is the highest since the global financial crisis that started a decade ago.

52 week rolling CTA loading on four risk and style factors

Potential implications

Although the recent performance of the aggregated CTA market seems to point towards reduced diversification benefits for institutional investors, individual CTAs may have different exposures. However, asset allocators seeking diversification through CTA exposure cannot safely assume that such programs necessarily deliver uncorrelated returns at a given point in time. Institutional investors might find it more helpful to consistently and regularly conduct factor decompositions of their overall portfolio and their investment managers, instead of just relying on long-term trends.

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1. See, for example, Schneeweis, Sprugin, and Szado (2013). (Login required.)

2. Managed by Société Générale, the SG CTA Index tracks the daily rate of return for a pool of CTAs that are open to new investment, and whose assets under management are above a certain threshold.

3. Risk exposures in Figure 2 are loadings estimated from a regression of the SG CTA Index weekly returns on the four risk factor returns, using a rolling window of 52 weeks.

The views expressed above are not necessarily the views of Two Sigma Investments, LP or any of its affiliates (collectively, “Two Sigma”).  The information presented above is only for informational and educational purposes and is not an offer to sell or the solicitation of an offer to buy any securities or other instruments. Additionally, the above information is not intended to provide, and should not be relied upon for investment, accounting, legal or tax advice. Two Sigma makes no representations, express or implied, regarding the accuracy or completeness of this information, and the reader accepts all risks in relying on the above information for any purpose whatsoever. For other important disclaimers and disclosures, download the full article.