The general industry disclaimer is "Past performance is not necessarily indicative of future results". However, what if we could identify and select CTAs with the characteristics necessary to produce "more" predictable future performance? Rather than simply chasing the hot hand, investors and allocators could improve their chances for long term success by focusing on selecting CTAs with a strong probability of repeating past performance in the future.
More than 20 years ago, when Brandywine developed our Benchmark trading program, we faced the same question. How could we increase the odds that our future performance would match the past tested performance of our trading program? The answer to this question led to the development of our portfolio allocation model (elements of which are referred to today as “Risk Parity” investing).
What we found was that the main characteristic necessary to improve predictability of future results is true portfolio diversification. Our research at that time, borne out by the actual performance of our Benchmark trading program, supported the conclusion that the most consistent, persistent, and predictable investment returns across all market environments are best achieved by combining multiple uncorrelated trading strategies (each designed to profit from a logical, distinct "return driver") into a truly diversified investment portfolio. A return driver is the primary source of the returns for any given investment.
The concept is simple. As the number of valid return drivers in a portfolio increases, the predictability of future returns also increases.
In my book Jackass Investing: Don't do it. Profit from it., I expose the myth that investors can obtain portfolio diversification by spreading their money across positions in stocks, bonds, and real estate. An investment approach based on limited asset classes is not only risky, but it is the equivalent of gambling. This same concept is true with CTAs as well. CTA programs based on just a few strategies and markets (or in some cases just one!), are inherently self-limiting and will likely experience high variability of returns and increased volatility over time.
What Brandywine discovered more than two decades ago was that in developing the model to produce predictable results, a natural artifact was that it also minimized portfolio risk. That is because the primary characteristic that produces the most predictable performance – creating a balanced, diversified portfolio – also reduces risk by decreasing the exposure to any single return driver or market.
Since past performance is not indicative of future performance (and since future performance should be the focus of the investment decision), investors and allocators should consider discussing the following issues with prospective managers during the due diligence process in order to better understand the characteristics necessary to produce "more" predictable future performance:
- What is the firm philosophy with respect to diversification?
- What types of strategies does the CTA employ?
- What are the sources of returns (i.e. the return drivers) of these strategies?
- Which markets are the strategies applicable to?
- How is the portfolio balanced? In other words, does any single strategy-market combination heavily influence the portfolio's risk and return over time?
If the answers to these questions lead you to believe that the CTA's approach is limited or concentrated in any way, you should not expect to achieve consistent, persistent, and predictable performance over the long term. In contrast, programs based on true portfolio diversification provide the highest returns over time with the highest level of predictability of future returns.
About the Author:
Michael Dever is the author of the recently-published book Jackass Investing: Don't do it. Profit from it. and the founder of Brandywine Asset Management. Brandywine is an investment management firm with experience trading in a broad range of markets, including equities, mutual funds, currencies, and global futures and commodities. Today Brandywine focuses exclusively on managed futures. Mike has also been a featured subject of three books, Bulls, Bears and Millionaires, Market Beaters and The Investor's Guide to Hedge Funds.
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE PERFORMANCE. THERE IS THE RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING WITH BRANDYWINE.
