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COMMENTAR Y


Fig.2 The Long Experience Fallacy


0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 -0.10 -0.20 -0.30


Source: SEB Investment Management AB, Bloomberg


could have imagined that such well performing funds, run by such talented people working for a firm with such a strong brand, could have contained such great risks and could have started to perform so poorly all of a sudden. Prior to the failure, LTCM enjoyed an equally stellar reputation in the hedge fund industry.


020 530 10 15 25 35 40 45


Brand awareness is very much a function of the number of years the brand has existed, you have known it, the way it has presented itself to investors/ consultants, the way it has been interpreted by you and described by the press etc.


NUMBER OF YEARS SINCE INCEPTION OF THE CTA FUND


The positive thing about people who have completed a higher academic education is that they have read a lot of academic research, learned to apply a scientific research methodology and have been equipped with fairly sophisticated theoretical models/tools for solving different kinds of problems. Also, one should not forget that their academic achievement reflects a high intellectual capacity and a willingness to work hard – very important ingredients for success in most jobs.


In a corresponding way as in the discussion about team size, human logic would say that a person with a higher education should have a greater chance of success than a person with a lower educational level. However, nobody seems to have bothered checking this hypothesis in reality. We refrained from calling the 23 CTA funds to ask for this kind of information as we thought they would not be willing to give it to us. However, we would encourage independent researchers to look into this. Our best guess is a correlation of +/-0.10 between educational level and risk-adjusted returns within the CTA industry. If that was the case, titles would be another fallacy that fund pickers may want to watch out for.


5. The Long Experience Fallacy Another human logic is that people with a longer experience should be better at their job than people with a shorter experience. Again, implicit in this logic is the famous ceteris paribus assumption. The hypothesis can be tested by regressing the age of the respective funds to the funds’ respective Sharpe ratios. We have done this in Fig.2.


Whether you include all observations or exclude the two observations with the highest and lowest Sharpe ratios, in both cases you get a correlation of about -0.30. In other words, the longer the fund had existed, the lower its risk-adjusted return turned out to be (on average). The human logic does not seem


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to be particularly helpful when you are trying to spot the best performing CTA funds.


Is the explanation to this phenomenon that the best people may have left the company and started their own funds and that their replacements were not smart enough to keep up with the competition? Or, is it so that some teams – even if the same people remain on board – are unable to keep up with the new competition, in spite of the fact that they have had more time to develop their understanding of markets and to pursue more back-tests?


To be fair, one should not draw any far-reaching conclusions from this negative correlation. The R-squared only amounts to 9%, which is not a particularly high number. Moreover, considering that people may leave one CTA firm and join another or set up a competing firm, the age of the CTA programme is not necessarily indicative of how experienced a certain team is.


In any case, it is probably fair to say that one should not get impressed by the argument, “We are one of the most experienced teams in the industry.” There is no evidence in the real world indicating that CTA managers with 20+ years of experience are doing a better job than managers with seven to 10 years of experience.


6. The Brand Fallacy


Identifying and choosing the best CTA fund is not a particularly easy task. In such uncertain situations, there is a human tendency to prefer funds, teams and firms which you are more familiar with to those you have not known for an equally long time. The human logic goes something like this: “It is better to buy a fund which you know, because funds that you aren’t very familiar with may contain all sorts of risks.”


The story about Goldman Sachs’ quant team 2007- 2011 is a good example of the brand fallacy. Nobody


What is interesting with the brand discussion is that it is much easier for a CTA firm to build a certain brand than to deliver solid performance over time. Clients may want to keep this in mind, so that they do not end up buying the manager’s brand instead of the manager’s ability to generate performance.


7. The Technology Fallacy Considering that people running CTA funds belong to one of the more geeky subcultures of society, clients may be fooled to believe that the geekiest people also are the best investment professionals.


Clearly, in certain areas of quantitative trading (high-frequency trading, HFT) the technological sophistication is indeed a key factor for achieving success. If you were consistently a millisecond slower than the fastest HFT manager when identifying alpha opportunities and trying to take advantage of them (for example a particular tick change in an instrument’s bid or ask level), you would end up making no money at all, even if you were able to identify all kinds of lucrative alpha sources (do not forget, in the HFT field, the size of each opportunity is very small indeed).


In the CTA field, investors should be very cautious about drawing conclusions between apparent technological sophistication and the manager’s ability to deliver performance. To a large degree, the technology show-off is only part of the marketing spiel.


8. The Trading Fallacy Related to the technology fallacy is the trading fallacy, i.e., the marketing pitch that you can only deliver fantastic CTA performance if you have a state- of-the-art trading capability. This story has typically been pushed by the largest players in the industry, i.e., the ones who are struggling with huge assets under management.


You can look at trading from two different perspectives. First, you can have a situation where you have complete flexibility as to what instrument you trade and when you choose to trade it. If you


SHARPE RATIO (OCT 2006 - AUG 2013)


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