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Commodity Trading Advisors: Risk, Performance Analysis, and Selection Chapter 18

CHAPTER 18 Random Walk Behavior of CTA Returns. This chapter examines whether CTA percent changes in NAVs follow random walks with drift. Monthly data from January 1994 to December 2000 are tested for nonstationarity and random walk with drift, using the Augmented Dickey-Fuller test. | __J 18 Random Walk Behavior of CTA Returns Greg N. Gregoriou and Fabrics Rouah This chapter examines whether CTA percent changes in NAVs follow random walks with drift. Monthly data from January 1994 to December 2000 are tested for nonstationarity and random walk with drift using the Augmented Dickey-Fuller test. All classifications except the diversified subindex are found to behave like random walks but many of the series show evidence of a positive drift parameter an indication that trends could be present in the series. The effectiveness of CTAs in enhancing risk-return characteristics of portfolios could be compromised when pure random walk behavior is identified. INTRODUCTION This chapter investigates whether monthly percent changes in net asset values NAVs of commodity trading advisor CTA classifications follow random walks. Previous econometric studies of financial time series have employed unit root tests such as the Augmented Dickey-Fuller test ADF to identify random walk behavior in stock prices and market indices for example. The characteristics of CTAs are such that investment into this alternative investment class can enhance portfolio returns but these characteristics are likely to be mitigated if pure random walk behavior is present because that would imply a lack of evidence of value added to the portfolio differential manager skill . Research into the performance persistence of CTAs is sparse so there is little information on the long-term diligence of these managers Edwards This article previously appeared in Journal of Alternative Investments No. 2 2003. Reprinted by permission of the publisher. 326 Random Walk Behavior of CTA Returns 327 and Ma 1988 Irwin Krukemeyer and Zulauf 1992 Irwin Zulauf and Ward 1994 Kazemi 1996 . However it is generally agreed that during bear markets CTAs provide greater downside protection than hedge funds and have higher returns along with an inverse correlation with stock returns in bear markets Edwards and .