Once an investor, whether it be a large institutional investor, a family office or a high net worth investor, decides to allocate funds to managed futures, they begin the process of due diligence. During this process, the investor will drill down to find out as much as possible about a Commodity Trading Advisor(CTA). The investor will want to know about returns, risk, length of track record, fees, investment strategy (systematic, discretionary) and dozens of other pertinent facts about the CTA. With large pension funds, allocations can run into the hundreds of millions (or higher) so you can imagine how particular and detailed this drill down can be. But even smaller investors will often want details about a particular CTA. The purpose of this module is to examine the basics of how to evaluate a CTA and his managed futures program.

Many novice investors look at returns only. We are mesmerized by track records and all aim to obtain the greatest return possible. However, when more advanced investors do their homework, they also look at the risks taken to generate those returns.

We will compare two CTAs: CTA A and CTA B. Notice A generates consistent profits of between 12% and 14% over four years. CTA B has had a few years of stellar returns but also some large negative returns. Both CTAs grew the money to nearly identical sums; but CTA B did so with measurably greater volatility. His portfolio demonstrated substantial swings up and down evident of a volatile portfolio. Although CTA A took greater risk, he was not able to generate greater returns for his investors.

While some investors appreciate the wild ride in search of returns, others wish to reduce volatility in their investments. Investors with CTA B were not adequately compensated for the increased risk. When you take larger risks, you should generally be compensated with greater returns. In the investment world, you want the greatest returns consistent with the lowest risk. CTA A thus compares more favorably.

The Sharpe Ratio is a measure for calculating risk-adjusted return and has become the industry standard for such calculations. It was developed by Nobel laureate William Sharpe. The Sharpe Ratio is the average return earned (i.e. returns in excess of risk free returns) per unit of volatility or total risk. Volatility is generally measured using standard deviation.

Sharpe Ratio = Return - Risk free return/standard deviation

In our CTA example above, CTA B would have a lower Sharpe Ratio than CTA A because of the large volatility, yet identical returns. You are penalized for taking greater risks yet failing to achieve commensurate returns.

The greater the Sharpe Ratio, the greater the risk–adjusted return; investors would like to see this number as high as possible. Usually, a Sharpe Ratio of 1.0 or greater is considered to be good and implies that for every unit of risk you assume, you achieve an equal amount of return. In short, the larger the Sharpe Ratio the better. Negative Sharpe Ratios are also possible.

In the absence of additional information, a Sharpe Ratio alone is not as informative. But its becomes more useful when you compare the Sharpe Ratios of several CTAs.

Another critical item investors look at with managed futures accounts is drawdowns, which are the peak to valley performance of a managed futures account.

Since most CTAs report their performance numbers monthly, investors can look to see the largest losses or drawdowns in any given month. Investors can also look well beyond the drawdowns themselves. They look for length of drawdown: is it just one month, or several months?

They also look for the amount of time need to recover from a drawdown. Ideally you want small, infrequent drawdowns with quick recovery times. A general rule practiced by investors is to have drawdowns representing no more than 50% of the CTAs annualized returns. So, if a CTA obtains 20% annualized returns over time, you would want to see no more than a 10% drawdown in any given month.

Moreover, some investors require greater detail on drawdowns and want information on daily drawdowns.

For example, say a CTA shows a monthly drawdown of 10%. While that gives you some information, it does not let you know how things are going day-to-day. CTAs that take great risks might have drawdowns intra month of far greater than 10%, but you could not glean this from a monthly drawdown report and would need daily data.

Looking at the diagram below, you can see a comparison of returns, risk (standard deviation), Sharpe Ratios and drawdowns.

Notice, both CTAs have very similar 10-year returns. But the risk (as measured by standard deviation) of CTA 2 is substantially higher than CTA 1. CTA 2 took 2.5 times the risk, but achieved a mere 37 more basis points of return than CTA 1. Clearly, investors with CTA 2 were not compensated with higher returns, making the Sharpe ratio for CTA 2 is much lower than CTA 1.

In addition, consistent with higher risk are higher drawdowns. With CTA 2, the drawdowns are substantial (more than twice CTA 1) and are greater than 50% of the annualized returns; a rule many investors do not like to see violated.

Sophisticated investors look well beyond returns on an investment to see what risks are taken to generate those returns, the Sharpe Ratio compared with other CTAs and how steep drawdowns are in relationship to annualized returns.
While there are many other elements that go into choosing a CTA, these make for a solid start. The topic of due diligence is vast and investors, especially institutional investors, will take months, if not longer, investigating a potential CTA candidate for investment.