A new white paper from Campbell & Company attempts to quantify CTA risk management. The paper says that CTAs often cite risk management as a key to their success. Despite this claim, the process for evaluating CTA risk management has remained somewhat qualitative, the firm finds.
The white paper attempts to quantify CTA risk management by defining four risk management factors: liquidity, correlation, volatility, and capacity.
Factor based return analysis is a commonly used technique for performance evaluation. The use of factors to understand return drivers and portfolio construction has a long history in the equity space, Campbell says.
The Campbell white paper develops a modified framework for CTA factor construction which focuses on risk management. The key difference is that each risk management factor focuses primarily on how risk is allocated in a portfolio, not on how momentum signals are constructed.
The four risk management factors – liquidity, correlation, volatility, and capacity – are examined and subsequently applied to a popular CTA index, the Newedge Trend index, and individual daily return series for Managed Futures 40 Act mutual fund strategies.
In conclusion, many of the CTA returns exhibit positive and significant exposure to the liquidity, correlation, and capacity factors. This suggests that CTA strategies may be shifting risk in response to liquidity, correlation, and capacity relative to the baseline (or benchmark). The analysis in this paper demonstrates that risk management decisions can help quantify CTA performance.
The paper, Quantifying CTA Risk Management, can be found here: Quantifying CTA Risk Management