CTA Selection: Establish Investment Goals, Realistic Expectations & Risk Tolerance

Establish Investment Goals

Investment goals are specific to each individual investor. Whatever the goal, our objective is to determine whether a particular CTA has the potential to help our clients achieve their investment goals.

Provide Realistic Expectations

In general, investors should choose CTAs who have met their desired levels of return. However, of greater paramount is the investor′s risk tolerance level. From the standpoint of allocating assets to a single CTA, a hypothetical question is, "given a multi-year track record of 40% annual returns, can the investor emotionally handle a 25% loss?" If not, then it is not prudent to choose a CTA who has experienced a 25% drawdown. The odds are that an investor will not stay with the program through a drawdown, even if the CTA is profitable over the long term.

When analyzing CTAs we consider the targeted return supplied at the discretion of the CTA. This represents the annual rate of return that the trader is attempting to achieve. There is no guarantee that a CTA will meet their targeted return and an investor should consider the lower of targeted return verses historical returns when analyzing the return potential of a CTA. There is no guarantee that a CTA who has been profitable in the past will continue to be profitable in the future or will not experience losses.

Illustration of Historical CTA Performance

CAR 1 Last 3 Yrs. CAR Last 5 Yrs. CAR Last 7 Yrs. CAR Last 10 Yrs. Avg 2 Draw Down Worst 2 Draw Down 978 CTAs Reporting to Barclay Hedge, Ltd.(Average)3 11.62 8.59 11.33 9.73 8.91 21.2 978 CTAs Reporting to Barclay Hedge, Ltd.(Median)3 10.59 7.16 10.65 9.29 6.54 15.53 Barclay CTA Index 4 8.35 4.97 7.66 5.63 4.81 15.65 CISDM Equal Weighted CTA Index 5 12.25 8.65 9.95 8.60 4.69 15.39 S&P 500 Index 3 -15.10 -6.63 -3.84 -3.43 6.75 50.95 Lehman LT Treasury Index 3 8.13 6.80 7.71 7.52 4.85 19.92 Compound Annual Return For period January 1, 1980 - February 2009 Data provided by Barclay Hedge, Ltd. The Barclay CTA Index is an unweighted index that measures the combined performance of CTAs that have more than 4 years past performance. For purposes of calculating the Index, the first 4 years of a CTA′s performance history is ignored. The CASAM CISDM CTA Equal Weighted Index reflects the average performance of Commodity Trading Advisors (CTAs) reporting to the CASAM CISDM Database. In order to be included in the equally weighted index universe, a CTA must have at least $500,000 under management and at least a 12-month track record. Individual CTA and multi CTA portfolios performance may differ dramatically from CTA index performance. The regulations of the commodity futures trading commission (CFTC) require that prospective customers of a CTA receive a disclosure document when they are solicited to enter into an agreement whereby the CTA will direct or guide the client′s commodity interest trading and certain risk factors will be highlighted. Past results are not necessarily indicative of future results. Be advised that there is substantial risk of loss when investing in futures and derivative markets, including managed futures, futures options and forex. These investments are not suitable for everyone.

Risk Tolerance

When analyzing downside risk we consider maximum drawdown and worst expected drawdown. Similar to targeted returns, worst expected drawdown is supplied at the discretion of the CTA. It becomes an essential number when evaluating CTAs with a limited trading history i.e., less than 24 months. Worst expected drawdown and actual maximum drawdown often differ and we take the greater drawdown figure into consideration in our analysis.

Even when protective strategies such as diversification, stops, and daily account monitoring are applied in an attempt to mitigate the risk, there is no guarantee that an investor will make money or that the value of the investment will not go down.

Return & Drawdown

The two main components used to evaluate performance are annual return and drawdown. Annualized compound rate of return (ROR) is used to evaluate historic return, while maximum drawdown is used to evaluate risk.

Drawdown

A Drawdown is any losing period during an investment record. It is defined as the percent retrenchment from an equity peak to an equity valley. A drawdown is in effect from the time an equity retrenchment begins until a new equity high is reached. In terms of time, a drawdown encompasses both the period from equity peak to equity valley and the time from the equity valley to a new equity high (recovery). Maximum Drawdown is simply the largest percentage drawdown that has occurred in any investment data record.

Value Added Monthly Index (VAMI)

This index reflects the growth of a hypothetical $1,000 in a given investment over time. The index is equal to $1,000 at inception. Subsequent month-end values are calculated by multiplying the previous month′s VAMI index by 1 plus the current month rate of return. Both ROR and drawdown are calculated using the Value Added Monthly Index (VAMI).

Conventional wisdom would be to seek CTAs with the highest ROR. For example, starting with a VAMI at inception of $1,000.00, a 20% annual return compounded over 10 years would result in an additional cumulative compounded return of over 300% when compared to an 11% annual return compounded over 10 years.

However, with the higher return there is generally higher risk. Risk is defined as the possibility your investment will lose value. Our goal is to seek the highest return with the least amount of risk.

If a CTA experienced a maximum drawdown of 20% and earned a ROR of 12.5% over a five-year period, one viewpoint is to state an investor in that program risked 20% of their money to earn 12.5%/year.

Drawdown calculations compared to a CTA′s past performance helps determine whether a CTA fits our risk tolerance levels. Maximum drawdown is also used in a number of risk-adjusted statistical return formulas.

Step 2: Apply Statistical Analysis