By: Dean Hoffman
If one had anywhere from $50,000 to $500,000,000 to invest in Managed Futures, what should they do? How should they decide which manager or portfolio of managers in which to invest?
The problem as I see it is that the decision support resources available to Managed Futures investors are severely lacking. In my opinion, what is available to most investors has nearly zero ability to improve their odds of success. Many tools even inadvertently encourage failure.
Part of the reason I say this is attributable to my experiences with my own customers as a CTA. Despite my long term track record being profitable; most of my clients have lost money, and this problem plagues most successful CTAs. The problem is that investors (and those who advise them) tend to use a poor strategy for choosing and then timing entry and exit in those Managed Futures programs.
In some ways, investors can not be blamed because of the inadequate tools and techniques that are available to them. The entire industry uses analysis techniques based on the same general flaw. The flaw is the assumption that past performance is somehow indicative of future results. The Internet is full of websites that allow one to research a programs past performance. These sites also compute a vast array of seemingly impressive statistics. We use one statistics package that computes well over 100 performance measures for each manager!
Without a doubt, the most widely used and well known of these statistics is the Sharpe Ratio. For decades investors have used the Sharpe Ratio as the benchmark or “Daddy” of all performance measures. The Sharpe Ratio compares returns against risk (volatility) thus producing a “risk adjusted” performance metric.
Unfortunately, most investors continuously repeat the mistake of assuming that a decent Sharpe Ratio today will lead to a decent Sharpe Ratio tomorrow, or that substantial historical returns will lead to substantial future returns. One can fill in the blank with any historical measure they want, and chances are it still has nearly zero ability to predict future performance.
As a quick example, below is a list of the top 5 managers in January 2007 as measured by their Sharpe Ratio. Let’s assume an investor decided to invest in those 5 managers at that time, and then let us see how he fared.
What we see here is shocking. During the real time trading period the Sharpe Ratios declined on average by roughly 70% from where they were during the evaluation period! The Compounded Annual Returns declined an average of 62% and the maximum drawdowns rose an average of 30%.
Not only did the absolute values change considerably, but so did the relative peer rankings. They went from peer group rankings of 1,2,3,4,5 to 37, 22, 5, 21, 14.
In the following chart, we look at a larger scale comparison of historical Sharpe Ratios compared to current Sharpe Ratios.
We can see in the chart above that once again there is almost no correlation between past Sharpe Ratios and future Sharpe Ratios (The correlation coefficient measures (-.138) on this series).
This study is consistent with countless other studies we have conducted similar to this (which we will be detailing in upcoming posts). What we consistently see is that most past performance data is nearly worthless in its ability to predict future results.
Thus, if a Managed Futures advisor recommends a CTA or Managed Futures program, ask them how they came up with their recommendation. If they start expounding about the programs terrific performance and high Sharpe Ratios and so on, save your time (and capital) and disqualify them. They are deeply in “The Past Performance Trap”.
In future posts, we will be outlining the data and analysis techniques that we feel DO contain predictive potential. In the meantime, feel free to contact us about a 100% mechanical (non-subjective) back-tested system for picking and timing CTAs.
*** Update 2/8/2012 below is a link to TradingBlox where there is an excellent parallel discussion taking place..
There are substantial risks and conflicts of interests associated with Managed Futures and commodities accounts, and you should only invest risk capital. The success of an investment is dependent upon the ability of a commodity trading advisor (CTA) to identify profitable investment opportunities and successfully trade. The identification of attractive trading opportunities is difficult, requires skill, and involves a significant degree of uncertainty. CTAs have total trading authority, and the use of a single CTA could mean a lack of diversification and higher risk. The high degree of leverage often obtainable in commodity trading can work against you as well as for you, and can lead to large losses as well as gains. Returns generated from a CTA’s trading, if any, may not adequately compensate you for the business and financial risks you assume. You can lose all or a substantial amount of your investment. If you use notional funding, you may lose more than your initial cash investment. Managed Futures and commodities accounts may be subject to substantial charges for management and advisory fees. It may be necessary for accounts that are subject to these charges to make substantial trading profits in order to avoid depletion or exhaustion of their assets. The disclosure document contains a complete description of each fee to be charged to your account by a CTA. CTAs may trade highly illiquid markets, or on foreign markets, and may not be able to close or offset positions immediately upon request. You may have market exposure even after the CTA has a request for closure or liquidation. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.