Analyzing the performance table
Upon receiving a Commodity Trading Advisor (CTA) disclosure document, the first thing investors usually do is turn to the performance table found in the Past Performance section of the document. This is where the CTA lists the program’s monthly rate of return and aggregate yearly return.
A performance table offers a wealth of data (Table 1); some of the information easily understandable, but most of it needs massaging with additional calculations. Thankfully, there are many CTA databases available that perform the calculations for investors. (Table 2).
One of the most important calculations is also the easiest to grasp: maximum drawdown, which is the percentage loss that a program experiences from its highest net asset value to its lowest value. The maximum drawdown for our sample program (highlighted in red in Table 1), was 11.79% and occurred between April 2004 and February 2005.
Figure 1 marks this drawdown on a Value-Added Monthly Index (VAMI) chart, which shows the program’s performance in terms of a hypothetical $1,000 initial investment. (The program also had an 11.04% drawdown between April 2009 and January 2010.) While the maximum drawdown is no guarantee that the fund will never experience a larger loss, it is a good indication of potential losses an investor should anticipate.
An important number missing from most CTA disclosure documents is the corresponding measure to maximum drawdown called Time to Recovery: how long it took the program to earn back the loss. Table 2 lists websites/databases that are helpful in finding this information. It took our sample program nine months (highlighted in green in Table 1) to recover from its maximum drawdown.
Risk measures
Another important element of a CTA’s performance is the amount of risk the CTA program takes to earn its returns. There are a number of ways to measure the risk-reward ratio, and again, it helps to use the databases listed in Table 2.
Two of the most popular measures are the Sharpe Ratio and the Sortino Ratio. The Sharpe Ratio is calculated by subtracting the risk-free rate of return — such as the rate on the 10-year U.S. Treasury note — from the rate of return for the CTA program and dividing the result by the standard deviation of the program’s compound rate of return. The resulting number represents the risk incurred to achieve the return. In general, higher Sharpe Ratios are better since they indicate more return for the risk taken.
However, one drawback of the Sharpe Ratio is that it doesn’t distinguish between upside and downside volatility. In the real world, we’re more concerned about the volatility of losing money, rather than making it. For that reason, many analysts prefer to use the Sortino Ratio.
The Sortino Ratio uses the same numerator as the Sharpe Ratio (the program’s rate of return, minus the risk-free rate of return). However, the denominator consists of only the standard deviation of the negative returns (unlike the Sharpe Ratio, which uses the standard deviation of all returns).
The Sharpe Ratio for our sample program is 0.30, but since its upside volatility is higher than its downside volatility, its Sortino Ratio is 0.60. Of course, both ratios need to be viewed relative to the ratios of other CTA programs. A CTA program with Sharpe and Sortino Ratios of 1.0 and 1.5, respectively, indicates a better risk-return ratio than our sample. Likewise, CTA programs with ratios less than this (any ratios below 0.30 Sharpe and 0.60 Sortino) indicate worse risk-return characteristics.
