Arbitrage: The Best Performing Sub-Strategy for CTAs despite being the Least Favoured – July 2014

by Sasha Pickup

  • 08 Jul 2014
  • HF

CTAs have faced criticism in recent years due to their below expected performance which has led to a decline in demand from investors. Preqin’s Hedge Fund Analyst tracks over 1000 active CTAs and according to benchmark data, the five-year annualized returns for all CTAs is 4.47%, which falls significantly short of the Preqin benchmark of 10.71% for all hedge funds over the same period. 

However, when analyzing the sub-strategies of CTA funds it appears that there is a wide divergence between the average returns of each individual sub-strategy: arbitrage, macro, pattern recognition, counter trend, option writing and trend following. According to Preqin data, the most prevalent sub-strategy used by CTAs is trend following, with over 62% of all CTAs utilizing this approach. The five-year annualized returns and five-year volatility for trend following CTAs currently stand at 4.68% and 6.34% respectively. Market intervention by central banks is often cited as being one of the main reasons for the below expected performance of trend following CTAs. 

The second most widely used strategy by CTA fund managers is macro, with 25% of all CTA funds employing this approach. The 2014 year-to-date returns for macro CTAs through May is -0.44%, while five-year annualized returns currently stand at 3.88%. This contrasts significantly with the best performing year-to-date sub-strategy of arbitrage, which has five-year annualized returns of 13.54%. Arbitrage is one of the least utilized strategies, with only 12% of CTAs using this strategy according to Preqin data, which is perhaps unexpected considering that arbitrage has been the best performing CTA sub-strategy over the past five years. The Equity Index Option Programme managed by Arcanum Asset Management, which employs an arbitrage strategy, has been one of the best performing funds over the past five years. 

According to Preqin data, the worst performing strategy employed by CTA funds is pattern recognition, with five-year annualized returns of 2.17%. Despite this strategy being the worst performing, it is still used by around one fifth of all CTAs. Pattern recognition demonstrated strong performance in 2010 with average returns reaching 12.43%, although since this time the strategy has performed below expectations year-on-year. With regards to all of the sub-strategies, the year 2010 represented the best performing year of the past five years, with combined average returns of 14.88%. 

Option writing has been the second best performing sub-strategy over the past five years with annualized returns of 9.69%, although this strategy is sparsely used with only 10% of managers employing the strategy. The counter trend strategy has five-year annualized returns of 4.57%, and is used by approximately 23% of CTAs. According to Preqin data, this has been the least volatile strategy over the past five years with five-year annualized volatility of 4.29%. 

It appears that the sub-strategies less commonly utilized by CTAs, including arbitrage and option writing, have been the best performing over the past five years with positive returns year-on-year. Trend following CTAs continue to fall short of the Preqin benchmark despite remaining the most widely adopted strategy, although we may start to see some changes when interest rates start to rise.

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