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Quantifying CTA Risk Management

A simple factor-based framework

Risk management is often cited as a key to success for CTA strategies. Despite this claim, the process and tools for validating this statement have remained somewhat elusive for CTA investors. This paper uses a simple factor-based framework to quantify CTA risk management. Mirroring the approach in Greyserman and Kaminski (2014), a baseline equal-dollar risk strategy and four risk management factors based on liquidity, correlation, volatility and capacity are constructed. The factors measure the impact of shifting risk allocation among markets in response to a particular aspect of risk management (liquidity, correlation, volatility, and capacity).

From 2001 to 2015, the liquidity and correlation factor returns have been positive on average. The correlation factor returns have been relatively positive post 2008 and the liquidity factor post 2011. This suggests that risk management approaches that allocate to more liquid markets and incorporate correlation into portfolio construction have recently outperformed an equal-risk approach. Since 2001, the capacity factor has experienced negative returns with a realized Sharpe ratio of -0.30. Despite the overall negative performance, there are periods where a capacity constrained portfolio outperforms the equal-risk strategy (or benchmark). This indicates that although capacity constraints may have the potential to reduce performance over longer time periods, adjusting risk in response to capacity constraints may also increase variation in performance relative to a benchmark.

To examine the explanatory power of this approach, the risk management factors are applied to the Newedge Trend Index from March 2001 to May 2015. The index has significant positive exposure to three of the four risk management factors, especially correlation and capacity. For the correlation factor, this is consistent with CTA managers shifting risk in response to correlation across asset classes. For the capacity factor, this is consistent with CTA managers shifting risk in response to capacity constraints based on position limits. The risk management factors are then applied to a set of Managed Futures 40 Act mutual funds with daily returns from January 2014 to May 2015. In this sample set, many individual CTAs also hold significant loadings to the correlation and capacity risk management factors. The analysis in this paper demonstrates that risk management decisions may help quantify both aggregate and individual CTA performance.

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About The Hedge Fund Journal

INFORMING THE HEDGE FUND COMMUNITY With access to some of the industry’s biggest names and an astute and talented group of writers and contributors, The Hedge Fund Journal has established itself as a trusted source of information on the hedge fund industry. Highlights of Issue 106: Championing Customization: Amundi Alternative Investments Tackling UK Farming’s Funding Shortfall: Helping reform UK’s agriculture and alternative energy industries Shareholder Activism as Private Equity Allocation: The resurgence of the strategy a decade after first rising CME Group Crude Oil Spread Options Suite: Volumes advance with screen-based trading growing fastest Adding Dynamic Beta to Double Alpha: UBS Equity Opportunity Long Short UCITS