Beneath the jargon it is usually possible to discern a straightforward market rationale for most hedge fund strategies.
Long-short equity managers discern value in shares where others have missed it and attack inflated valuations. Global macro traders bet the bank on international pricing discrepancie s. And players in distressed assets exploit poorly considered laws, opaque markets and recalcitrant managers to achieve better prices in struggling companies.
But managed futures run by commodity trading advisers (CTAs), a strategy that occupies about 6 per cent of hedge fund assets of about $1,000bn, is at the more rarefied end of the spec trum. Trend-following, to give the strategy its third title, is the closest approximation to what is going on.
Relying on historical price data, CTAs develop computer-driven models that find trends across a range of markets - any of the 115 markets around the world - and then follow them for h owever long they might go on. The strategy is momentum-based, it looks backwards for inspiration rather than forwards, and is arguably the most quantitatively driven, or mathematical, of all the dozen or more hedge fund st rategies.
As the name CTA would suggest, the business started in the commodity trading pits of Chicago. Richard Donchian discerned patterns in the apparent arbitrariness in pork belly prices, b ushels of wheat and tonnes of copper. The system he developed and expounded after the second world war, in a newsletter entitled Commodity Trend Timing, had nothing to do with market fundamentals and everything to do with statistics.
"What our systems are trying to do is to identify trends across multiple time zones, multiple markets. We are going to be making money in markets when there is a strong degree of dire ctional volatility across a broad range of markets," says Anthony Todd of London-based Aspect Capital, the second largest CTA player in Europe and one of the largest managed future funds.
Directional volatility means the direction of the market is clear with variation either side of the trend. Many traders, not just hedge fund traders and trend followers, claim they ar e disciplined and do not allow emotion to dictate the taking of positions. What distinguishes managed futures from other trading strategies is that the computer or "quant" model is all powerful, allowing no discretionary trading.
David Harding at Winton Capital Management says his managers adjust the model systematically every month, no more, no less. "What you do not want to do is wait until you are in a beas tly draw-down when you are having lots of problems with clients and say: 'What we have discovered is a new thing that fixes the problem'. That's what the marketing people tend to want but that is not the correct thing to do," says Mr Harding.
Through most of 2004, CTAs have had a bad time. In the year to the end of October the S&P hedge fund index was up 0.41 per cent, itself hardly a stellar return, but the managed future s index was down slightly more than 5 per cent. Elsewhere, the Edhec CTA global index was up only 0.64 per cent in the same period.
Investors would have done better leaving their money in cash or bonds, although there was a sharp improvement in October itself.
"CTAs come into their own when the markets go down. In essence they develop a pattern recognition system that says: 'Identify me a trend please'," says Con Keating of the Finance Deve lopment Centre, a financial think-tank. "In 2002 and 2003 they should have attracted a lot more money. The surprise this year is that there wasn't any trending movement," Mr Keating says.
The reasons for poor performance across the CTA universe vary. Some funds benefited from strong Chinese demand for precious and base metals, others suffered. Some have done well in oi l, others have been punished by interest rates. Mr Todd admits that in the first half of the year trading was "very tough".
Harry Kat, professor at the Cass business school at City university in London, does not include CTAs among hedge fund strategies although he points out that many big hedge fund player s such as Caxton and Tudor were originally commodity traders. Unlike other hedge fund managers CTAs are also regulated - by the CFTC in the US.
"CTAs are more attractive than hedge funds in terms of diversity. Hedge funds diversify on the upside but not on the downside. When markets turn down hedge funds turn down with them," Mr Kat says. "CTAs, however, are uncorrelated to shares and bonds. Nor do CTAs have the capacity, liquidity and transparency problems [of conventional hedge fund strategies]. They are just holding futures around the world ," Mr Kat says.
This autumn CTAs and other hedge fund managers, notably global macro players, have found solace in playing the dollar. Mr Todd is optimistic he and Aspect will enjoy a more successful 2005 than 2004. "In the US market you have a monumental current account deficit. It will require major investments by the Asia- Pacific economies.
"With a low savings ratio I think it is building up to some very sharp moves in the dollar and in global interest rates. It is very unlikely that we will see a period of range-bound t rading," Mr Todd says.