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.

The Problem

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”.

Stay Tuned:

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..

Risk Disclosure:

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.

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  • David

    CTAs tend to exhibit non-normal distribution of returns, which makes the volatility (i.e. the “risk” measure embedded in the Sharpe ratio) a poor assessment of the true risk of a CTA, and therefore the Sharpe ratio of a CTA a poor assessment of its quality.

    When selecting a CTA, past performance could be used as a guidance of what to expect in a given market environment (i.e. how this CTA behaved during a bull market, during a bear market, during a low/high volatility market, etc.). Past performance is also useful to ask a fund manager “what happened back then” (for either strong returns or poor returns).

    However, this “expected behavior” based on the past behavior of a CTA has to be put into context: what was the size of the CTA by then from now (if the CTA had much less AUM by then, it might not be as reactive today), were the markets traded by then the same today, did the CTA change its models, what about their margin to equity then and now, etc.

    In order to invest in CTAs, just as in any other investment vehicle, one should understand precisely how the manager trades, how does he control risk, etc. and of course look at the operations. Understanding how models work (even at the high level – no need of the secret sauce) is mandatory in order to understand what to expect. But this is far more work (and required expertise & experience) than just sorting out a database and throwing a mean-variance optimization at it… :-o

    • Dean Hoffman

      Hi David,

      Thanks for the feedback…

      I am aware of the arguments against using the Sharpe Ratio when evaluating CTAs but they don’t hold water with me. You might want to check out this interesting study:

      I have also studied most all the other measures and they too lack any predictive ability (on their own). One of the stats packages I use computes over 100 performance statistics on each manager! At first that seems great until you realize you’re now wasting your time x100 rather than x1! These statistics suffer from horrible multicollinearity.

      I also don’t like the vague discussions about “understanding how a manager trades”. I want to be able to cut every aspect of a manager and his performance down to a number. The benefit of this is that you can then go back in history and create hard and fast mechanical, non subjective, non hindsight biased rules based on how you evaluate CTAs and test those rules to see if they work! I know from experience with my trading systems that most hunches and opinions about what should work don’t! This is why you need a way to test your ideas.

      I am aware of far too many advisers and consultants who tell lovely, well polished stories about the depth of their due diligence and experience when evaluating CTAs, but if you look at ALL their historical recommendations often times their suggestions and timing are sub-par (at best).

      There is a loophole in the regulation that allows CTA “recommenders” not to be required to produce a disclosure document that shows every single recommendation they have ever put out, and the exact outcomes. As a result, you often tend to see selective memory or “cherry picking” taking place when you talk to them.

      If I were working with a consultant I would demand a list of every single recommendation they ever put out (and some kind of proof to validate it). This would include the suggested entry and exit dates. Then I would compute a composite performance table based on this data.

      For example, one of the brokerage firms I work with is Attain Capital Management. They are a reasonably sharp group (above average from my perspective), but I don’t like how they present CTAs. The use a flag system that changes all the time. How hard is it in hindsight to put many flags next to the CTAs who recently did well? I think they should be required to keep a copy of EVERY iteration of their flag system so I can look back and see if they recommended good CTAs BEFORE they did good or AFTER. I would also create a composite track record of every CTA they ever recommended, and the precise entry and exit dates. It is my assumption that if they did this that their track record would show a net loss! (I don’t know this for sure, it is just an opinion). Part of my opinion stems from the fact that my own CTA was successful during the time I worked with them*, yet almost every one of their clients lost money trading with me! I have to honestly ask if they are good at timing me, or other CTAs.

      These are all things to considered….



  • John Marc

    This is a big problem throughout the whole investment industry. It is a human nature problem in that everyone wants to pick a winner. It has been reported that in two of the most successful funds in history, George Soros’ Quantum Fund and Fidelity’s Magellan Fund, many of their investors lost money. In the 1980-2000 time period, the average stock portfolio is said to have only gained an average of 3%, while the overall market itself went up over 17%. Investors have a very bad habit of chasing yesterday’s returns. Many investors would buy after seeing a big run up and sell on the subsequent pullback.

    What investors need to do is look around the curve and is gain a better understanding of their investments. I believe the best time to enter a trend-following CTA is during a drawdown. The drawdown suggests that commodity prices have been fairly stable and the CTA recently has not had many opportunities to make a profit. However, that will inevitably change as we live on an unstable planet filled with unstable people. Supply and demand will not stay in balance forever and as that slips, prices will shift creating a more profitable environment for the CTA.

    What I like to do is look at the CTA and try to determine if this manager has a profitable strategy. If I believe the answer to be a yes, then I will look at the investment environment and enter when I believe good periods of returns are coming. Once invested, I usually like to stay with them knowing overtime their edge will pay out.

    • Dean Hoffman

      Great comment John…….I would not be at all surprised to find out that most Soros investors lost money despite his spectacular track record!

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