This article is part of our series of regular pieces where we will discuss recently issued exchange-traded products (ETPs) which are seen to be innovative or otherwise attempt to improve upon existing strategies available within an ETP wrapper. Our intention is to give the reader a better understanding of those products and highlight potential benefits and risks for investors.
Last time, we examined equal-weight ETFs from Dutch provider ThinkCapital and French provider Ossiam.
RBS Market Access CTA ETF
In our recent article about commodity trading advisers (CTAs) we highlighted the benefits and the risks associated with investing in this asset class.
Despite some of the flaws discussed in the article, managed futures strategies have some merits. Many academics agree that managed futures, in particular trend following strategies, have historically produced returns that were uncorrelated to traditional asset classes.
We also highlighted in the article a study from the CISDM Research Department (2006) showing that discretionary CTA’s and systematic CTA’s have historically exhibited relatively low correlations between one another, pointing to potential diversification benefits in combining the two strategies in a combined CTA portfolio. Furthermore, a study from the Yale International Center For Finance (Yale ICF) shows, that the average standard deviation of an individual CTA fund is about double the standard deviation of an equally-weighted CTA index, suggesting additional diversification benefits stem from holding a portfolio of CTAs.
In this article we will be analysing the RBS Market Access CTA Index ETF. This ETF, which offers access to the strategies of commodity trading advisers was launched in mid-September 2011. The ETF tracks the RBS CTA Index which itself is comprised of equal parts of the RBS Discretionary CTA Index--which is a benchmark for discretionary trading strategies--and the RBS Systematic CTA Index--which is a benchmark for model-driven systematic trading strategies. This is the first-ever ETF tracking the performance of CTAs, a fast growing part of the broader hedge fund universe.
Index Construction
The RBS CTA Index is comprised of equal parts of the RBS Discretionary CTA Index and the RBS Systematic CTA Index, thereby providing access to a wide range of CTA strategies. Adherents to the discretionary strategy try to forecast prices by analysing supply and demand factors and other market information. This strategy is mainly commodity focused. The second strategy--systematic trading--typically uses computer programmes to conduct quantitative analysis in an effort to exploit price trends. The index’s weighting between the two sub-indices and their component managers is reset monthly. The managers in the indices are re-assessed every 6 months. As of this writing, the RBS Discretionary CTA Index includes 6 managers and the RBS Systematic CTA Index is comprised of 12 managers. The exact allocation to each manager is determined by a ranking based on historical returns, correlations and volatility. To avoid over diversification, the number of constituent managers per index is limited to 12.
RBS Discretionary CTA Index and RBS Systematic CTA Index
The index construction process for both component indices is essentially identical and is based on a two-stage methodology. The first step involves screening the market for eligible funds, using several selection criteria. The first criterion is that the hedge fund must be accessible through the RBS Managed Accounts Platform. The second criterion stipulates that the hedge fund must be managed or advised by an investment manager who has employed the required investment strategy (discretionary or systematic) for at least 3 years and who is currently employing this strategy. The fund must provide at least 12 months of historical data pertaining to its current strategy. The hedge funds must also be willing to disclose all necessary information in order for the Index manager to conduct appropriate risk management and stress testing on the index. In addition, the hedge fund is required to accommodate redemption at least twice a month and, in exceptional circumstances, daily redemption must be possible. The first step towards determining the weights of the individual constituents is to rank them by historical returns, volatility and correlation. Funds with the highest trailing 3 year average return will have the highest return ranking score. With regards to correlation, eligible funds will be ranked by their average correlation coefficients, from low to high. Correlation is calculated based on the average correlation coefficient to the other eligible funds based on their prior three years’ monthly returns. The same methodology is applied for the volatility ranking score. Hence the funds with the highest returns and lowest correlation and volatility compared to the other eligible funds will earn the highest scores.
Within each index allocation score ranking the index fund manager then identifies the top 12 (or fewer) managers and divides them into the top (the top quartile), middle (50%) and bottom (25%) segment which will determine the final weights. RBS calculates the average weight by dividing 100% by the numbers of funds, i.e. there are 12 funds in the RBS Systematic CTA Index so the "average weight" = (100% / 12) = 8.33%. Afterwards, the weight for each fund in the top segment is 1.5 x the average weight, in the middle segment 1.0 x the average weight and 0.5 x the average weight for the bottom segment. Funds with a low level of assets under management will generally be in the bottom segment so will those funds that are unwilling to disclose their holdings.
On top of the TER of 0.75%, the underlying index carries another 0.35% of annual fees, representing index management agent fees for the operation of the two sub-indices. Though there are no additional swap or collateral fees, the individual CTA constituents charge an average 1.29% annual management fee, an average 22% performance fee, and there is a 0.50% annual risk monitoring fee for each managed account (each CTA is run on an individual managed account without recourse to the other CTAs). The performance fees are calculated on a high water mark basis. The all-in average fees (excluding the TER) of 2.14% plus 22% performance fees are embedded in the index calculation.
Fund Construction
The RBS CTA Index ETF uses swap-based replication to track its reference index. RBS uses a funded swap for this ETF. Under this model, investors’ cash is handed to a swap counterparty, in this case Royal Bank of Scotland Plc, in exchange for the index performance. The counterparty then posts collateral assets in a segregated account with a third party custodian. The account can be opened either in the name of the fund (in the case of a transfer of title) or in the name of the counterparty and pledged in favour of the fund. In this case, the segregated collateral account is in the name of the fund (i.e. transfer of title applies).
Counterparty exposure is monitored daily by RBS (Luxembourg) S.A., the management company. The collateral basket is composed of highly liquid large cap securities listed on recognised regulated markets. Typically this means stocks from Western European countries, the US and Canada. The collateral is held in a ring-fenced segregated account by the custodian, RBC Dexia Investor Services Bank.
Summary
The RBS CTA Index ETF is most suitable for use as a diversifier within a well-balanced portfolio. Given the complexity of the strategies underlying this fund, it is not suitable for most retail investors.
As mentioned earlier, managed futures have delivered exceptional returns during bear markets. However, Ramsey and Kins suggested in their 2004 paper that despite their resilience in tumultuous markets managed futures strategies are not suitable as a portfolio hedge, but should rather be viewed as a source of non-correlated returns. Exogenous events like the failed Russian coup in the 1990s or September 11 are prime examples where managed futures have not proven an effective hedge as they experienced losses alongside other asset classes. Much like stocks and bonds, CTAs are vulnerable to rapid reversals or the sudden onset of volatility.
The ETF provides liquid and low-cost access to a portfolio of CTAs--as compared to investing in individual funds. The product is therefore beneficial for investors seeking a diversified exposure to this growing market.
The back-tested returns provided by RBS should however be read with caution as some of the biases we discussed in the article “Commodity Trading Advisors (CTA) explained” do apply, in particular the backfill bias. The simulated returns are calculated based on the past performance of the managers used at the fund’s inception. Recalling the selection criteria, the simulated returns are therefore bound to produce good results almost by default.
However, given the interesting risk/return characteristics and the low correlation to traditional asset classes, we think that these strategies can serves as a good diversifier in a well-balanced portfolio.
