Stockholm (HedgeNordic) – In the investment management arena, 2022 was the year of trend-following CTAs. Twenty of the world’s largest CTAs tracked by Société Générale booked a record gain of 20 percent for the year, outpacing the previous record set in 2008. Right when it was needed most, CTAs provided the crisis alpha they are expected to deliver. Following the rally, are institutional investors looking to allocate to CTAs too late to the party?
Citing research by systematic asset manager AQR Capital Management, Velliv’s Head of Alternatives Christoph Junge sees no reason to fear being too late. “Trend-followers do not tend to underperform the year following a strong year according to AQR,” points out Junge. His own research on alternative investments during times of crisis conducted in 2020 found that “CTAs as a group have been the only asset class in our study that consistently performed in each crisis since 1980.” The market environment of 2022 proved his research conclusions right again.
“We are not expecting high standalone returns from CTAs but we expect them to perform when we need it the most.”
CTAs have become a common allocation in many institutional investment portfolios, including Velliv, one of Denmark’s largest commercial pension companies. “We view CTAs as a strategic allocation and use CTAs as a portfolio diversifier,” says Junge. “It is just a matter of time before the next crisis will happen. Therefore it is beneficial to have CTAs in the portfolio as they tend to outperform during periods of heightened volatility,” he elaborates. “We are not expecting high standalone returns from CTAs but we expect them to perform when we need it the most.”
Optimal Allocation to CTAs
The optimal allocation to trend-following CTAs varies on a case-by-case basis and depends on each investor’s broader portfolio, according to Junge. “The optimal allocation depends on the rest of the portfolio. If the portfolio only consists of equities and bonds, CTAs should perhaps be a larger allocation in the range of 10 to 15 percent to really move the needle,” argues Junge. In a more diversified portfolio similar to the one maintained by Velliv, a smaller allocation to CTAs can still offset the impact of equity and bond market drawdowns.
“The optimal allocation depends on the rest of the portfolio.”
“We have a very diversified portfolio to start with, with the portfolio including a range of asset classes such as real estate, private equity, alternative credit and infrastructure,” says Junge. With equities and bonds accounting for a lesser share of the overall portfolio, a smaller allocation to CTAs can successfully offset some of the public market losses in times of crisis. The optimal allocation to CTAs is a “trade-off between total returns and portfolio protection,” according to Junge. “While CTAs attempt and do deliver crisis alpha, they also can have longer periods of sluggish performance.”
Current Environment for CTAs
Junge does not expect 2023 to be a year of sluggish performance for trend followers. “While we do not expect 2023 to be such a strong year for CTAs as 2022, we see no reason to believe that 2023 will be a particularly negative year for trend followers,” he says. “And even if 2023 will be a negative year, CTAs will play their role when the next crisis comes.” Some investors have stayed away from trend-following CTAs due to their lagging performance throughout the 2010s.
“CTAs may have faced a difficult market environment between the global financial crisis and the COVID era due to central bank activity, which resulted in too little volatility and no trends that were long-lasting and strong enough,” argues Junge. “With central banks being less accommodative in the face of higher inflation, we could witness more macro volatility, which should be good for CTAs.” Following the on-and-off performance of CTAs, Junge has been evaluating the possibility of timing the allocation to CTAs by defining a regime-switching model that identifies trendy or non-trendy environments.
“After longer periods of close to zero or even negative performance for CTAs, I am curious to research whether one can forecast the performance of CTAs,” says Junge. “Similar to the regime-switching models in other markets, we want to investigate whether we are in a friendly environment for trend-followers or we are in a non-trendy environment.” Until Junge and his team find a time-tested regime-switching model for timing the allocation to CTAs, Velliv seeks to maintain exposure to the asset class as part of its strategic allocation.
Optimal Number of CTAs in Portfolio and Selection Process
Another important decision allocators face focuses on finding the optimal number of CTA strategies in a portfolio to balance the trade-off between diversification and idiosyncratic risk stemming from this asset class. Research by multi-boutique asset manager Hermes Fund Managers concludes that the optimal number of CTA managers to exploit this trade-off is between four and eight.
“We have settled for four because there is also the trade-off between diversification and the effort to monitor the number of managers in the portfolio,” argues Junge. “We have to follow each manager very closely, and it obviously takes a lot more time to follow eight managers than four,” he continues. The bigger allocation tickets to a smaller number of managers also enable more attractive fee structures for institutional investors such as Velliv.
“We have settled for four because there is also the trade-off between diversification and the effort to monitor the number of managers in the portfolio.”
While most CTAs share similar investment goals, the nature of their trading strategies, the markets they trade, their models and investment horizons, as well as their trading styles are all different. As Velliv’s Head of Alternatives responsible for building the CTA allocation, Junge opted to invest in more simple, lower-cost trend-following CTAs. “When we submitted a traditional request for proposal (RFP) in 2021-2022, we got about 50 proposals from diverse managers that we ended up dividing into two groups: beta and alpha managers,” says Junge.
The Beta bucket comprised traditional trend-followers running cheaper products, typically with a fixed management fee and no performance fee, according to Junge. The Alpha bucket comprised trend-following managers that “employ trend-following plus something on top, which could be a macro overlay or could involve some more alternative markets.” Velliv prefers, for now, to invest in Beta managers that offer exposure to pure time-series momentum at a lower cost, according to Junge. “We like Beta managers with plain-vanilla trend models that do not have so much secret sauce overlay,” says Junge. “Managers differ in how they construct their portfolios and implement their strategies. We believe we can get everything we like about CTAs from the Beta pocket. We value simplicity over complexity.”
The manager selection process involved both quantitative and qualitative considerations. “On the quant side, we obviously evaluated measures such as the Sortino and Sharpe ratios, the skewness and performance during certain time periods,” according to Junge. “In addition to the quant measures, we also looked at qualitative measures such as the quality of organizations, stability in the team, the background of the team, and how long they worked together.” The operating lifespan of these strategies has been another important component of Velliv’s decision-making process. “We have considered CTAs with a minimum lifetime of three years” that have navigated the changing and volatile markets of recent years.
After going through a longer period of relatively poor performance since the financial crisis of 2008, the CTA industry “didn’t play as big a role as they should in investors’ portfolios in recent years,” according to Junge. “Given the heightened volatility from last year and especially given that both equities and bonds posted losses at the same point in time, institutional investors will realize the need to look for some other diversifiers,” says Velliv’s Head of Alternatives.