ffirs_gregoriou.qxd 7/27/04 12:12PM Pagei Commodity Trading Advisors ffirs_gregoriou.qxd7/27/0412:12PMPageii John Wiley & Sons Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and mar- keting print and electronic products and services for our customers’ pro- fessional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals, as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio manage- ment to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more. For a list of available titles, visit our web site at www.WileyFinance.com. ffirs_gregoriou.qxd7/27/0412:12PMPageiii Commodity Trading Advisors Risk, Performance Analysis, and Selection GREG N. GREGORIOU VASSILIOS N. KARAVAS FRANÇOIS-SERGE LHABITANT FABRICE ROUAH John Wiley & Sons, Inc. ffirs_gregoriou.qxd 7/27/04 12:12PM Pageiv To my mother Evangelia, and in memory of my beloved father Nicholas—G.N.G. To my parents Virginia and Nikos—V.K. To the ones I love—F.S.L. To my parents Jacqueline and Jean, and in loving memory of my grandfather David—F.R. Copyright © 2004 by Greg N. Gregoriou, VassiliosN. Karavas, François-Serge Lhabitant, and Fabrice Rouah. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. 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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data Commodity trading advisors : risk, performance analysis, and selection / [edited by] Greg N. Gregoriou...[et al.]. p. cm. ISBN 0-471-68194-6 (cloth) 1. Commodity trading advisors. I. Gregoriou, Greg N., 1956– HG6046.5.C66 2004 332.64'4—dc22 2004007925 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 ftoc_gregoriou.qxd 7/27/04 12:17PM Pagev Contents Preface ix Acknowledgments xi About the Editors xiii About the Authors xv Introduction xxiii PARTONE Performance 1 CHAPTER 1 Managed Futures and Hedge Funds: A Match Made in Heaven 5 Harry M. Kat CHAPTER 2 Benchmarking the Performance of CTAs 18 Lionel Martellini and Mathieu Vaissié CHAPTER 3 Performance of Managed Futures: Persistence and the Source of Returns 31 B. Wade Brorsen and John P. Townsend CHAPTER 4 CTA Performance, Survivorship Bias, and Dissolution Frequencies 49 Daniel Capocci CHAPTER 5 CTA Performance Evaluation with Data Envelopment Analysis 79 Gwenevere Darling, Kankana Mukherjee, and Kathryn Wilkens v ftoc_gregoriou.qxd 7/27/04 12:17PM Pagevi vi CONTENTS CHAPTER 6 The Performance of CTAs in Changing Market Conditions 105 Georges Hübner and Nicolas Papageorgiou CHAPTER 7 Simple and Cross-Efficiency of CTAs Using Data Envelopmennt Analysis 129 Fernando Diz, Greg N. Gregoriou, Fabrice Rouah, and Stephen E. Satchell PARTTWO Risk and Managed Futures Investing 149 CHAPTER 8 The Effect of Large Hedge Fund and CTA Trading on Futures Market Volatility 151 Scott H. Irwin and Bryce R. Holt CHAPTER 9 Measuring the Long Volatility Strategies of Managed Futures 183 Mark Anson and Ho Ho CHAPTER 10 The Interdependence of Managed Futures Risk Measures 203 Bhaswar Gupta and Manolis Chatiras CHAPTER 11 Managing Downside Risk in Return Distributions Using Hedge Funds, Managed Futures, and Commodity Indices 220 Mark Anson PARTTHREE Managed Futures Investing, Fees, and Regulation 233 CHAPTER 12 Managed Futures Investing 235 James Hedges IV ftoc_gregoriou.qxd 7/27/04 12:17PM Pagevii vii Contents CHAPTER 13 The Effect of Management and Incentive Fees on the Performance of CTAs: A Note 248 Fernando Diz CHAPTER 14 Managed Futures Funds and Other Fiduciary Products: The Australian Regulatory Model 259 Paul U. Ali PARTFOUR Program Evaluation, Selection, and Returns 275 CHAPTER 15 How to Design a Commodity Futures Trading Program 277 Hilary Till and Joseph Eagleeye CHAPTER 16 Choosing the Right CTA: A Contingent Claim Approach 294 Zsolt Berenyi CHAPTER 17 CTAs and Portfolio Diversification: A Study through Time 307 Nicolas Laporte CHAPTER 18 Random Walk Behavior of CTA Returns 326 Greg N. Gregoriou and Fabrice Rouah CHAPTER 19 CTA Strategies for Returns-Enhancing Diversification 336 David Kuo Chuen Lee, Francis Koh, and Kok Fai Phoon CHAPTER 20 Incorporating CTAs into the Asset Allocation Process: A Mean-Modified Value at Risk Framework 358 Maher Kooli ftoc_gregoriou.qxd 7/27/04 12:17PM Pageviii viii CONTENTS CHAPTER 21 ARMA Modeling of CTA Returns 367 Vassilios N. Karavas and L. Joe Moffitt CHAPTER 22 Risk-Adjusted Returns of CTAs: Using the Modified Sharpe Ratio 377 Robert Christopherson and Greg N. Gregoriou CHAPTER 23 Time Diversification: The Case of Managed Futures 385 François-Serge Lhabitant and Andrew Green REFERENCES 399 INDEX 417 fpref_gregoriou.qxd 7/27/04 12:16PM Pageix Preface T he idea for this book came about when we realized that a collection of managed futures articles dealing with quantitative and qualitative analy- ses of commodity trading advisors (CTAs) could be a useful and welcomed addition to existing books on the subject. The chapters that follow intro- duce readers to many of the issues related to managed futures that we believe are vital for proper selection and monitoring of CTAs. These issues include performance assessment, benchmarking, and risk management of managed futures investing, evaluation and design of managed futures pro- grams, CTA management and incentive fees, and regulatory considerations. All chapters in this book are written by leading academics and practi- tioners in the area of alternative investments. Although some chapters are technical in nature, we have asked the contributors of those chapters to emphasize the impact of their analytical results on managed futures invest- ing, rather than to focus on technical topics. We, therefore, believe this book can serve as a guide for institutional investors, pension funds managers, endowment funds, and high-net-worth individuals wanting to add CTAs to traditional stock and bond portfolios. ix