Authored and courtesy of Ryan Fitzmaurice and Christian Lawrence of Rabobank
- Global markets are becoming increasingly intertwined as systematic flows from CTAs and passive investments gain more and more market share from active discretionary managers.
- Equity markets have passed an inflection point with passive investing AUM surpassing active investments for the first time in history. This has major ramifications for asset price action.
- CTAs typically implement similar trend and momentum strategies across asset classes using liquid futures contracts in fixed income, equity, commodities, and FX markets
- The majority of CTAs are doing the same thing but perhaps on different timeframes or with different leverage profiles.
The “Long and short of it” rationale…
On these pages is the first release of “The long and short of it“ – a new series of reports from RaboResearch focusing on cross asset and systematic investing. Given this is the first cross-asset report of its kind from RaboResearch, we will begin the series with a number of primers covering a range of topics from systematic CTA flows to factor investing and beyond. Of course, cross-asset analysis is nothing new but shifts in the structure of the market and the rise of systematic trading and passive investment have major implications for more traditional forms of asset management and in turn for market price action.
In short, the idea behind our cross-asset reports is to tie together different asset classes in a world where no market is an island and reflexivity and interconnectedness are key. The core thesis behind our analysis is that global markets are becoming increasingly intertwined as systematic flows from more ‘rules based’ investors such as CTAs (Commodity Trading Advisors) and passive investments such as index funds and smart beta ETFs gain more and more market share from active discretionary managers. In fact, as of summer of last year, passive investments surpassed active investments in the equity space for the first time in history and this trend shows no sign of letting up. We are certainly not suggesting that active management is disappearing altogether, but discretionary management is certainly losing market share and the rise of passive investment is shaping the structure of markets. While it is not the case that the rise of passive investment is the root cause of the continued decline of volatility over recent years, it has been a key part of the vicious/virtuous cycle that continues to compress financial market volatility despite rising real world risks. Indeed, a flood of liquidity from central banks and monetary policy that seemingly provides somewhat of a backstop to asset prices, coupled with a changing regulatory landscape are probably the main drivers behind the structural short volatility dynamic we see across markets. That environment, alongside advances in technology and computing power, have helped the proliferation and success of passive investment which in turn has helped suppress volatility further.
That said, while passive investment has risen, so has systematic ‘rules based’ investing and it is in this area that we can extract some valuable insights that allow for more accurate forecasting and more successful risk management.
It is not just equity markets that have undergone this transformation - other asset classes have followed suit, and given the rules-based nature of these funds and strategies, trading behavior and market flows are becoming more predictable for astute market practitioners. While our aim is to cover the wide universe of systematic strategies – our initial focus will be on CTAs given our deep understanding and knowledge of this particular "strategy”.
In our view, forecasting and understanding market flows from CTAs can provide a strong edge in today’s highly systematized markets and our goal here is to help our readers understand these dynamics to help navigate market risks more effectively. As the name suggests, CTAs have long been key in understanding price action in commodity markets but their role in other asset classes is still important. Even for markets such as the government bonds and FX, while at first glance it might appear the futures market is so small in comparison to the cash market as to be irrelevant, in fact, the futures market is highly leveraged and so the volumes at stake are much larger than the notional amounts imply – at the margin there can be some valuable information gleaned from CTA positioning and flows. Of course, the US Treasury market and the FX market are two of the deepest, most liquid markets in the world and US Treasuries are heavily impacted by structural dynamics such as regulatory requirements, but at the margin, even in this market, CTA flows can provide some interesting insights. These two markets are the most extreme example but for smaller markets, the role of CTA flows can be significant. Furthermore, CTAs are one of the most dynamic categories of traders in their approach and therefore can be a powerful force on the margin and especially when looking at shorter term moves where there is no clear fundamental catalyst at play. At the very least, readers should understand what it is that CTAs do, the strategies that they employ, and their potential market impact across sectors and asset classes.
To that end, in “The long and short of it” reports we will look to highlight “crowded” trades, forecast weekly flows using a theoretical CTA model, and identify key market inflection points where we expect the herd of CTAs will likely reverse positions.
CTAs and Managed Futures
As previously noted, CTA stands for commodity trading advisor, however, that is a bit of a misnomer given that CTAs trade not only commodities but also other major asset classes spanning the global futures markets. CTAs or “Managed Futures” programs as they are also known, are often dressed up as a magic black box full of secret sauce but they typically implement similar trend and momentum strategies across fixed income, equities, commodities, and FX markets. Indeed, despite fancy pitch books suggesting otherwise – most CTAs are doing the same thing but perhaps on different timeframes or with different leverage profiles. While a full understanding of CTA strategies is well beyond the scope of this primer – what we will say is that the strategies generally trigger off of price movements such as moving average crossovers or percentage returns over a predetermined lookback period and no fundamental inputs or information is taken into account. The fact of the matter is that there is only so many ways to trade trend or momentum which results in herd-like behavior. This is very apparent when looking at the correlation of publicly available CTA funds and Managed Futures programs which is quite high as is clear from the chart below. It is precisely this herd-like behaviour that can move markets in the short-term and especially in a “short” covering or “long” liquidation scenario when the “crowd” is caught wrong-footed in the market and forced to reverse positions. We will look to capitalize on this behaviour in our new “Long and short of it” report and we detail in the pages below exactly how we intend to do that.
The Rise and Fall
While CTAs have been around for decades, they rose to the forefront after the global financial crisis of 2008 when they performed extremely well in the face of sharply falling markets and then gained further fanfare in 2014 after another standout year. Since then, however, market conditions have been sub-optimal for this type of strategy given the low interest rate environment, central bank intervention, and a host of other factors which have led to poor performance and investor outflows. Further compounding the struggle for CTAs has been the fact that global equity markets have performed extremely well over this same period. This steady increase in equities with very little in the way of sustained pullbacks has led investors to pull money out of actively managed funds and into passive index funds that generally cost a fraction of the fees that active managers charge. While this strategy has largely worked up until now, it is worth remembering that most of these passive investments have only existed during periods of low interest rates, low volatility, and generally stable markets while CTAs, on the other hand, have traded through many market cycles. The real test for passive investing will come when the current trading regime changes, as it always does. When it does in fact change, we suspect CTAs will rise to the forefront yet again and investor dollars will follow as they have in the past. For this reason, we see CTAs as a powerful force with the potential to gain more market share and influence as we look ahead and especially if the slowdown in US and global economic activity that our own Philip Marey, Rabobank’s Senior US Strategist, is forecasting for 2020 is realized.
Despite the reduction in assets under management in recent years, CTAs and “Managed Futures” programs continue to play a very dominant role in terms of speculative positioning in global futures markets which is quite apparent from the charts included below. Figure 6 overlays the positioning from our theoretical CTA trading model for both WTI Crude oil and Soybeans with the corresponding positioning data from the “Managed Money” category of the CFTC’s Commitment of Traders report.
For clarity - our theoretical CTA trading model is a proprietary quantitative model that is run in real-time across asset classes. The model incorporates various asset-weighted trend and momentum strategies that include volatility adjusted position sizing and daily rebalancing - modelling the behaviour of real-money CTA funds. The model uses historical price data for signal generation and no fundamental inputs are incorporated.
Back-testing our model has shown it to be a good fit to reality and it has performed especially well at key inflection points. To be clear, the CTA model is not expected to account for all of the variations in positioning from the “Managed Money” crowd given that CTAs only make up a portion of the traders included in the category but the fit implies that the role of CTAs in this category is absolutely critical. Perhaps unsurprisingly, this is especially true in commodities markets where our CTA model tracks the speculative positioning data extremely well as can be seen in Figure 6 below. The same can be said for other asset classes as well, however, the data can be a bit noisier given the large number of players involved as well as the nuances of each sector.
Given that our CTA model is a good fit to the realized behavior of “Managed Money” futures traders, we can use it to predict weekly trading flows, identify “crowded” trades, and perhaps most importantly, detect key areas where CTAs are likely to reverse direction. On top of our CTA model, we will also use other tools such as correlation analysis to identify key positions that CTAs currently hold. An example of this can be seen in Figure 7 below, running correlations of CTA performance against equity indices implies that CTAs accumulated a sizable “long” position through November and December of 2019 and are now starting the new year off with outsized exposure to global equities given the strong positive correlations to the aggregate CTA index.
We have focused on providing a primer on the role CTAs play in financial markets and how they can be used to provide insights as to potential direction of price action across asset classes. This is just the first in a series of primers that cover topics we think can provide additional insight into market dynamics and give our readers an edge in navigating financial markets. Going forward, we will publish more primers covering our new toolkit including risk premium strategies, factor investing, volatility strategies, smart Beta ETFs, as well as other systematic trading programs. More importantly, we will of course update our readers with the results of our models both in terms of forecasts and risk signals.