have done research in the high-frequency spectrum of the market and found that you are able to deliver respectable performance from such intra-day trading models, then you add these high-frequency models to the group of models that you are running in your CTA fund.
Any CTA team that has gone down this path has a) already chosen to implement or not to implement such high-frequency models (and they are already part of the observed track record) and b) discovered that the capacity of an intra-day model in any case is only a fraction of the capacity of a short-term model, which in turn is a fraction of the capacity of medium-term or longer-term models. In other words, there is no large CTA in the world that is getting a larger portion of its excess returns from high-frequency models. If there was, they would not be as highly correlated to the other CTAs as they are.
In summary, the more money you are managing in a CTA programme, the larger the transaction costs will be. This is true for any and all CTA firms. To the extent that a CTA firm claims that execution is incredibly important and that they are really good in that area, it should be very easy for them to prove these claims via a superior track record, i.e., that their execution costs are not eating up too much of the alpha in their models.
9. The Transparency Fallacy Imagine a situation where a potential fund investor could get 100% access to all CTA managers’ model specifications, back-testing systems, live-trading systems, quantitative and qualitative decision- making processes, IT development procedures, databases and other IT structures, security solutions, custodian set-ups, regulatory restrictions, detailed CVs of each and every employee and information on all other resources that are used at the CTA firms.
The investor would certainly get a much better understanding of how much or how little it takes to run a CTA fund. The client would be able to notice and record similarities and differences between IT architectures, organisations, processes, models, programming languages etc.
After having dug deeply into the programming code of each CTA manager’s model, i.e., the heart of any CTA fund, it is quite likely that the investor will eventually ask him- or herself: “So what kind of fund performance will come out of all these different models in the end?”
At this point, the investor has two alternative ways to go: a) to compare the Sharpe ratios of the back- tests that each CTA manager has pursued, or b) to compare the historically realised Sharpe ratios, i.e.,
that have come out of their models in the real world (as opposed to the theoretical back-tests).
For this reason, you cannot compare Sharpe ratios of different CTA teams, unless you can secure that the back-tests have been conducted with similar and hopefully very limited amounts of data mining and curve-fitting. This implies that you are back to comparing and analysing past performance. In other words, after having completed your in-depth and all-encompassing research project at the different CTA managers, you are back to square one again analysing the CTA managers’ track records.
Interestingly enough, instead of being leading indicators basically all of the above-mentioned factors seem to be lagging indicators with regard to the CTA fund’s performance. That is, the better the fund’s risk-adjusted performance has been, the larger the inflows and the assets under management, the greater the firm’s revenues, the more people they have employed, the more they have overhauled their pitch books, and the more focus they have put on brand building. It should not be forgotten: the better the track record looks, the greater the expected payoff from spending money on marketing.
Given the above findings, more time should probably be spent on analysing the historically realised track records. By focusing your research on the hard numbers, you also avoid being deceived by the marketing pitches.
Analysing and comparing track records may not be as easy as some people think, however. It is time for the tenth fallacy.
10. The Performance Fallacy Rule number one when comparing track records to each other is to compare them on a like-for-like basis. This implies a number of things:
a) The first thing to keep in mind is that you should compare track records of different CTAs on the basis of the net fees (after potential rebates) that you as an investor would be paying in each case. Some CTAs publish institutional share classes with non-negotiable fees, other CTAs publish retail share classes on which institutional discounts are given.
b) Second, you cannot directly compare the returns of CTA funds, if the time series represent different currency share classes. Since the pricing of currency forwards (which are used to hedge a fund’s currency exposure from the base currency to the respective share class currencies) is a direct function of the interest rates that exist in the respective currencies, you should expect a higher return from the share class whose currency is enjoying a higher interest environment.
This phenomenon can easily be seen when you compare the performance of different share classes that belong to the same fund (and have the same fees). The difference in performance between two share classes over time should basically be equal to the interest rate differential between those two currencies over that time period.
Another way to explain this phenomenon is to look at the way a CTA portfolio is structured. First, there is the base portfolio, i.e., the part of the portfolio that invests the cash received from investors. A prudent CTA would invest this cash into the short-term government bill market and collect a risk-free rate of return on the investment. Second, there is an overlay portfolio consisting of futures and forwards (requiring collateral, but basically without financing need). Via their skills to forecast the direction of different markets, CTA managers are able to deliver some excess returns for investors in this part of the portfolio. When you are currency hedging a share class, you are not only getting rid of the currency exposure to the main/ base currency, but you are also converting the underlying risk-free return from the main currency to the risk-free return that can be achieved in the share class currency.
Thus, when comparing funds, one should ideally use share classes that are hedged to the same currency. If it is not possible to find a share class of the desired currency, one could either try to adjust for the differential in risk-free rates during the period or at least be aware of the effect when analysing the results.
c) Third, even if you choose to use data from the correct currency share classes when comparing two CTA funds, you still run the risk of comparing apples to oranges. We have seen fund selectors calculating and comparing funds on the basis of Sharpe Ratio Since Inception. Clearly, since funds tend to have different inception dates, you would compare numbers that have been calculated over different time periods and potentially draw the wrong conclusions.
d) Fourth, a fund’s net return is also dependent on its risk level. Thus, to assure a like-for-like comparison, the net returns need to be converted into risk- adjusted returns.
Another beauty about risk-adjusted returns like Sharpe ratios is that you can directly compare them even if they have been calculated using a variety of different currency share classes. The reason for this is that the calculation of the Sharpe ratio takes out the currency-specific risk-free rate and only contains the excess returns, which are currency- independent.
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