CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

30.4 PROFITABILITY OF MOMENTUM-BASED AND OTHER TREND-FOLLOWING STRATEGIES

Having briefly described the three broad strategies followed by most CTAs and the economic forces that affect futures prices, we now examine the potential sources of returns to CTAs. The goal is to go beyond the easy but unsatisfactory response that CTAs make money because they are smart or skilled in identifying trends in futures prices. This is unsatisfactory for a number of reasons. First, as was previously discussed, systematic trend following is the dominant trading strategy among CTAs, which means that pure skill is not an important component of the dominant strategy. Second, if skill is the sole source of return for a CTA, potential investors will have a difficult time separating skill from luck as the major contributing factor behind the historical performance of the CTA. Unless a trader has a long track record and is able to clearly describe his skill set, investors will have difficulty estimating the contribution of various factors to the CTA's ex post alpha. Thus, potential investors cannot be sure how persistent the future performance of the CTA will be. The objective of this section is to see if there are other sources of return that can be verified during a typical due diligence process.

Futures and forwards trading are referred to as zero-sum games, since every price change of a futures contract leads to equal gains and losses. If all futures traders had positions only in futures contracts ...