CTA’s Vs. Hedge Funds – Competing Terms?

Financial advisors Japan CTA's vs. Hedge Funds

here is often confusion surrounding the labeling of funds and in particular that of the “Hedge Fund”. The lack of practical understanding of the hedge-fund universe at client level, along with their common misrepresentation in media means that their value is seldom fully understood in the context of diversified portfolio construction and alternative investments. Commodities Trading Advisors, or “CTA” are commonly misunderstood, even by financial professionals.

Hedge Fund, noun.- …investment vehicles that explicitly pursue absolute returns on their underlying investments. The appellation “Absolute Return Fund” would be more accurate, not least as not all hedge funds maintain an explicit hedge on their portfolio of investments. However the “Hedge Fund” definition has come to incorporate any absolute return fund investing within the financial markets (stocks, bonds, commodities, currencies, derivatives, etc) and/or applying non-traditional portfolio management techniques…”
Eurekahedge, Independant Alt. Investment Data Provider

Before addressing the relation between CTA’s and Hedge Funds it would be prudent to establish exactly what constitutes each. Firstly, to “hedge” is to manage or mitigate risk. In the context of a fund, a manager can achieve this using a number of methods- essentially allocating capital or taking a position on the other side of his speculative position, in a sense allowing him to take both sides on the same bet. Depending on the type of fund this may be achieved with short-selling, cash, swaps, options, FX, commodity futures or any other technique permissible in line with the regulation of the fund. It is essentially this ability, utilizing techniques often outside of the remit of traditional long/short funds, that enable hedge funds to produce dynamic, or “absolute” returns via the ongoing mitigation of downside risk.

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Contrary to popular misconception, hedge funds are not inherently aggressive or ‘risky’. A thematically true hedge fund would be less aggressive and less ‘risky’ than a traditional long/short fund by virtue of its capability to dynamically protect itself against downside risk. This being said, there are in existence extremely aggressive hedge funds which aim to target extremely lofty returns in exchange for a high risk premium. The corollary of this being that there are also hedge funds (absolute return funds in the truest sense) that pride themselves on an unexciting ride, low market correlation and slow steady returns. There are even hedge funds which in actuality, aren’t even hedged at all and take a long-only stance on equity and use their hedge fund passport to leverage to the hilt in aim of maximizing returns. (You can see more about the positive effects of managing volatility in our article about variance drain.)

At present, the term “Hedge Fund” alone does not provide enough insight to enable prudent decision making at portfolio construction level. The strategies and techniques employed by “hedge funds” are so multitudinous that without looking inside the box it is impossible to know which one is in line with your investment objectives. Between broad categories like long/short, market neutral, event driven and arbitrage it can become confusing to evaluate performance without help from analytical ratios and some basic mathematical calculations, but luckily this information is always provided by the fund distributor in their fund literature to aid in the selection process.
Hedge funds are utilized by many types of people, usually labelled “professional” or “accredited” investors, and range from Institutions, corporate treasure and private banks down to individual investors. Previously, due to high minimum-investment requirements (100,000 – 10,000,000 USD) the hedge fund investment universe was reserved only for the extremely wealthy but now, due to the prevalence of personal portfolio bonds provided by regulated life insurance companies, small investors are able to benefit from the dynamic returns produced by hedge funds with a much smaller initial investment (often from as low as 10,000 USD). Due to this hedge funds will continue to permeate into the investment portfolios of normal people who seek the diversification and returns offered by alternative investment instruments, the likes of which populate databases like EurekaHedge.

In recent years CTAs have gained notable attention and knowledge of their existence has finally made its way to non-professional investors. Where we encounter confusion is where CTAs are brought into the conversation alongside hedge funds; often being introduced as opposing terms.

So what is the difference between a CTA and a Hedge Fund?

CTA, noun.,(Commodity Trading Advisor)-“…an individual or organization which, for compensation or profit, advises others as to the value of or the advisability of buying or selling futures contracts, options on futures, retail off-exchange forex contracts or swaps.” National Futures Association.

Simply put, 9 times out of 10 a CTA is in fact a hedge fund, i.e a CTA is a Managed Futures Strategy incorporated as a hedge fund. Trading physical commodities is not only costly business but problems routed in illiquidity and delivery may impede trading strategies on an ongoing basis. Accordingly, Futures contracts are a cost effective way to mitigate these issues whilst participating in commodities markets, via derivatives.

Somewhat perversely CTA strategies are not limited to trading Commodities markets and we commonly see funds which also participate in equity, indexes, rates and currencies- all of which provide sufficiently deep liquidity to satisfy the redemption requirements of investors whilst adding an extra layer of diversification ( and in some cases inadvertently sacrificing low beta correlation for alpha). Accordingly, the definition of a CTA is (perhaps appropriately) as amorphous (and commonly as unhelpful!) as that of its arguable parent- the hedge fund. If we were to look for defining characteristics of the CTA it would be low correlation and liquidity. Ordinarily you can liquidate your CTA investment in 48 hours. If you’re a CTA offering a managed futures program to investors, you must be registered with the CFTC and NFA as such this subjects them to a wide variety of communication restrictions and performance reporting requirements.

CTA index

Historical performance of CTAs speaks of their value in adding sufficient diversification to investment portfolios in aim of covering downside risk in periods of sustained stress in equity markets. There is a volume of academic material focused on the supposed differences between CTAs and hedge funds and at the more amorphous end of the scale, there is material looking to divorce managed futures strategies from the hedge fund category all together. What can and should be taken from this though, is the importance of correlative measures and the inclusion of alternative investment components like CTAs in traditional investment portfolios to provide diversification and the potential for absolute returns despite periods of negative performance in equity markets.

If you wish to discuss alternative investments further, or would like more information about hedge funds then head over to our Contact page.
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Sources and Further Reading