Equity managers long ago had to put up with academic research that showed they did not do as well as a passive index. Now managers of commodity futures funds must put up with the same thing.
Passive investment in commodities using futures has become quite a vogue, and arguably helped to stoke the boom and bust in commodities over the last two years. But now there is academic evidence that such passive investment may still have been a better idea than active management through commodity trading advisers (CTAs).
Officially registered with the Commodity Futures Trading Commission, CTAs are in effect a form of hedge fund, making their returns from managed investments in futures.
But according to a paper by Gary Gorton and Geert Rouwenhorst, academics from Yale School of Management, the average performance of CTAs, after fees, is only 85 basis points above US T-bills – surely not enough to tempt investors, given the volatility and risk associated with commodities.
They arrived at this number after examining the performance of the CTAs that reported their results to the Lipper-TASS database, over the period from 1994 to 2007. The “headline” performance over this period, when each CTA was equally weighted, was an annual return of 12.6 per cent.
But then the academics compensated for “survivorship” bias. Surviving funds outperformed the average fund in the database by 3.2 percentage points (9.4 per cent rather than 12.6 per cent). Then they compensated for what they call “backfill bias” – which occurs because funds are allowed to submit a performance history at the time they first report to hedge fund databases. All funds may have returns of 9.4 per cent; but the funds in the database only returned 4.9 per cent a year while they were reporting “in real time”. The average “backfilled” return, from prior history, was a much healthier 11.3 per cent.
With T-bills returning about 4 per cent in the period, a 4.9 per cent return looks inadequate. It implies that managers are adding no true value or alpha.
However, these numbers are net of fees. Before fees, they returned 5.37 per cent above T-bills. On the academics’ analysis, the CTAs then decided to keep almost all of the outperformance for themselves, rather than share it with investors.
This may merely be a comment on the performance of the underlying asset class. Do CTAs show any skill in outperforming the market, or, in market jargon, “adding alpha”? The academics designed crude indices to mimic several popular futures strategies – playing the “carry trade” of higher-yielding foreign currencies, looking for value by buying international equity markets with a low price-to-book ratio, and a strategy to capture inventory effects, known as “backwardation”, in commodity markets.
These crude indices, according to the research, did better than the CTA. This is not wholly surprising, as CTAs acknowledge they make their living by identifying and then following trends.
The conclusion is damning: “CTAs appear to persist as an asset class despite poor performance, because they face no market discipline based on credible information. Our evidence suggests that investors’ experience of poor performance is not common knowledge.”
It is possible to allege the analysis is self-serving. Gorton and Rouwenhoorst’s published research showed commodities were a “diversifying” asset about three years ago. By showing that adding commodities to a portfolio could increase return without increasing risk, they had much to do with the boom in passive commodity investing.
Their co-author, Geetesh Bhardwaj, is from AIG Financial Products, one of the leading players in offering commodity futures indices, and whose difficulties in recent months are well documented.
And it would be interesting to see whether CTAs were any better than the crude index strategies at escaping the consequences when many of the trends they had been following disastrously went into reverse earlier this year. Anecdotal evidence suggests they were not.
US Congress has held hearings on whether the influx of money into futures caused commodities to correlate more closely with equities and bonds than before. That argument is plausible, but awaits rigorous academic testing.
But the basic point seems sound. Like many other parts of the hedge fund universe, it is questionable whether CTAs have truly added value with their investment management.
Fooling Some of the People All of the Time: The Inefficient Performance and Persistence of Commodity Trading Advisors, by Geetesh Bhardwaj, Gary Gorton and Geert Rouwenhorst. Available at ssrn.com.