Are CTAs regulated?

Two of the main regulatory bodies for the financial markets in the United States are: The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The SEC regulates equity and bond related securities whereas the CFTC regulates exchange traded futures and options products and foreign exchange.

Commodity Trading Advisors are required to be registered with the CFTC and to be members of the “National Futures Association” (NFA).

Are all CTAs alike?

CTAs differ in their trading strategies, the markets they trade, their experience level and the styles of trading they use. Comparing a CTA that trades 65 markets worldwide against a CTA that specializes in global energy products is similar to comparing a large-cap mutual fund against a utilities-oriented fund. Therefore, it is important to understand the tools available to CTAs for extracting returns from the markets.

The most obvious difference between Commodity Trading Advisors is the markets they trade in. Some managers focus exclusively on a sector or group of markets (such as energy or grains), whereas, others can simultaneously trade up to 65 markets worldwide. The number of markets they trade will have an effect on the trading methodology they take and vice versa.

Trading Methodologies

Traditionally, CTAs have used a combination of “technical” and “fundamental” analysis to identify trading opportunities and implement their risk management strategies. Traders run the gamut in their use of these two forms of analysis, but we generally find that traders will tend to favor one over the over. Both forms of analysis work well for traders with expertise in a market sector or for those following a small number of markets. As a result, the key value driver for both “technical” and “fundamental” CTAs is their trading expertise in the markets in which they have developed a niche.

At the opposite end of the spectrum, many of the CTAs on our platform simultaneously trade over 40 markets worldwide. These CTAs utilize a “systematic” approach in building and managing portfolios of global futures contracts. Systematic traders utilize computer models to identify patterns such as trends on historical market and economic data. Trading and risk management decisions are made with respect to the portfolio as a whole.

Systematic trading for futures contracts borrows many of its trading and risk management techniques from equity portfolio management and allows for scalability and transparency. The value driver for these types of CTAs is their portfolio construction and risk management. Individual trades are not as important as the behavior of the portfolio as a whole.

Trading Strategies

A major benefit in utilizing a Commodity Trading Advisor as an investment advisor is that CTAs are able to trade the markets using a number of different trading strategies. Unlike the equity and bond markets, CTAs can take advantage of both bull and bear markets by entering into long or short positions in the futures markets.

Below are common trading strategies a CTA may implement to extract return from the markets:

Trend following: Trend following is a strategy that simply follows trends based on certain technical indicators (e.g. moving averages, breakouts, etc.). CTAs that specialize in this strategy can profit from both rising markets (by being long) and declining markets (by being short). Trend followers, however, often incur drawdowns during choppy market environments because they often get stopped out of trades.

Counter Trend: : This strategy seeks to profit from trend reversals. If you look at any chart, nothing will move straight up or down. There are often pullbacks and reversals. This strategy looks to profit from those type of moves.

Arbitrage: There are a number of sub-strategies that fall under arbitrage. The most prevalent in the managed futures industry is statistical arbitrage. A simple example of this is simultaneously buying gold on one exchange (for a lower price) and selling gold on another exchange (for a higher price). This strategy looks to profit from the price difference.

Option Writing/Sellers: Option selling is a strategy that focuses on writing options (and collecting their premiums) that are likely to expire worthless. The idea is that the commodity trading advisor will benefit from the premium he or she collects from the buyer. The risk associated with this strategy, however, is that the options will not expire and the contract will go in the money. Within this strategy are naked option writers and spread option writers.

Global Macro/Fundamental Focus: Commodity trading advisors that trade the markets from a fundamental approach will often look at crop reports, weather patterns, economic reports and other fundamental data to determine whether to trade.

There are a number of other different strategies that make up the managed futures sector. What you can see from the above strategies is that the different strategies not only determine when they will transact a trade, but also which type of market environments are most suited for their strategies.

Time Frames

CTAs not only differ in their trading strategies and markets traded but also in the time frame their trading systems generate. CTAs categorize their programs into short-term, intermediate term and long-term.

Different CTAs might trade the same markets from a systematic approach and use the same trading styles, but their returns will differ drastically. Why is that? It has a lot to do with their trading time frames. Traders also differ based on whether they are short-term traders, intermediate term traders or long-term traders. Consider, for instance, two systematic trend followers. Trader A trades the market from a long-trend-following basis; Trader B implements an intermediate trend-following strategy. Over the hypothetical intermediate period, the market is choppy (thus, stopping out the intermediate trend follower on a number of different occasions). From a long-term perspective, however, the market is still in an upward trend. In this scenario Trader A will still be able to profit substantially as the trend eventually continues upward.

Emerging vs. Established CTAS

Another differentiating factor between commodity trading advisors is whether they are emerging or established. There are various opinions of what defines emerging and what defines established. The general definition, however, focuses on the fact that emerging managers typically have less than a three-year track record and less than $50 million under management. At first glance, it might seem that the only difference between an emerging and established CTA is their experience levels. However, this is not true. There are many emerging CTAs that have a substantial amount of experience working for other companies and who have finally started their own shop. Thus, while they might only have a few years experience trading on their own they are established traders in the industry and well-versed in its practices.

The major difference in distinguishing among emerging and established CTAs has a lot to do with how they generate their returns, as emerging CTAs can often outperform established managers. There are two main reasons for this. The first has to do with the fact that emerging CTAs are smaller and more nimble. Because they are nimble, they are often able to make transactions in certain markets that would be impossible for larger, more established CTAs. The second reason is that emerging CTAs are often eager (and more aggressive) to put up numbers that allow them to pop on the radar screen of investors. An established billion dollar CTA might not have that extra incentive to be aggressive.

There are, however, negatives to selecting an emerging CTA over an established CTA. While emerging CTAs might sometimes outperform their more established counterparts, the attrition rate is also higher. Many emerging CTAs often do not make it past their first year in business and some traders that put on the CTA hat do not have any experience beyond trading for themselves.