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CTA Investments versus Trading Systems Investments

May 24, 2004

 

If you are reading this newsletter for the first time or as a part of your weekly routine chances are that you have an interest in Managed Futures or Managed Futures products. Each week we write about various Trading Systems and CTA’s (Commodity Trading Advisors) and thought that we would take step back today to examine the difference between the two and determine the types of investors who are involved in each.

CTA’s and Trading System investors are the main components of the $85 + billion Managed Futures industry yet are attractive to two different types of investors.

CTA Investments

CTA’s are a subset of the hedge fund industry, and are individuals/companies who engage in the business of advising others on the purchase and sale of commodities or futures contracts. The CTA then charges a management and incentive fee for the advice and management of an account…typically 2% and 20% depending on the level of investment (All incentive fees are generally based on new equity high marks). The most successful CTA’s have long standing live performance records and are attractive to investors usually understanding of alternative investment opportunities - but lacking time to research and manage the 60+ world markets on a daily basis.

CTA’s are required to be registered with the CFTC (Commodity Futures Trading Commission) and NFA (National Futures Association).

Following proprietary investment strategies most CTA’s attempt to achieve above average rates of return with minimal drawdown (peak to valley points in an equity curve). To achieve their goal of lower risk to reward (Sharpe Ratio – see below) most are involved in multiple investment strategies requiring investors to invest capital between $100k to $5 Million dollars per investment unit. At that time the manager has full control over the investment whereby the investor signs over power of attorney to the manager.

In addition to the fees mentioned above the later is often a reason investors steer clear of CTA based accounts. Many investors require more than a general description of the investment criteria used within a CTA managed account and can become frustrated when they believe that a poor trading decision was made. From our perspective this is why we have found the most success in placing our customers with CTA’s who utilize a 100% mechanical trading approach. We believe that for qualified individuals their involvement in a mechanical CTA can greatly improve the consistency of a diversified portfolio without the required management of the account.

Trading System Investments

A Trading System is a method of investing within a particular market via the use of 100% mechanical entry and exit criteria, based on parameters validated by historical testing on quantifiable data. A system can be as simple as entering a 10-point stop on every new position or as complex as using fractal analysis to signal trades. Most systems are derived from a technical analysis of current and past price action in an attempt to forecast future price direction. Using a computer, these results can be tested through millions of permutations to generate objective trading signals. When a developer's computerized trading signals are combined with sound money management principles, a "trading system" is created. Investors use these systems to trade the futures and/or securities markets to satisfy their individual desire to control and customize their investment program.

System Developers are not required to be registered with the CFTC or NFA, however many of them are now moving in that direction.

With the advent of the PC and new software capabilities, system trading is now a viable option for the individual investor, especially those with a desire to take control of their investment program. This "do-it-yourself" segment of the investing public is growing as evidenced by the dramatic trend toward electronic trading and publications such as Futures Truth.

Two words of caution to those still reading, is to "OVER CAPITALIZE". In our experience, much like the successful CTA’s mentioned above, the most successful system trading investor will look to diversify his/her account across multiple markets, systems, and time frames; however unlike the CTA the system trader has full control over the dollar amount and leverage of his/her investment. This simple fact leads many investors to fall into the social trap of investing only the minimum in attempt to achieve high percentage gains on capital. Without even knowing it an undercapitalized system trader may be leveraging up to 10 times that of a CTA account who is investing with 10 times as much capital hence increasing the volatility of the their account (see table below).

Considering the descriptions above it is possible for us to tie the two sectors together and determine the fundamental draw to managed futures is the ability for investors to mechanicalize their investments. Whether through a CTA or portfolio of Trading Systems profitable trading strategies start with a consistent approach to the market.

Consistency is difficult for many investors because decisions about money can be very emotional. Investors know that diversification is essential, but many have difficulty diversifying a portfolio. Additionally, money management and/or allocation of funds in a portfolio is crucial in order to balance risk. These three elements are the primary reason why so many traders are turning to systems and CTA’s.