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Commodity Trading Advisors: Risk, Performance Analysis, and Selection Chapter 20

CHAPTER 20 Incorporating CTAs into the Asset Allocation Process: A Mean-Modified Value at Risk Framework. Value at risk has become a heavily used risk management tool, and an important approach for setting capital requirements for banks. In this study, we examine the effect of including a CTA in a traditional portfolio. | 20 Incorporating CTAs into the Asset Allocation Process A Mean-Modified Value at Risk Framework Maher Kooli Value at risk has become a heavily used risk management tool and an important approach for setting capital requirements for banks. In this study we examine the effect of including a CTA in a traditional portfolio. Using a mean-modified value at risk framework we examine the case of a Canadian pension fund and compute the optimal portfolio by minimizing the modified value at risk at a given confidence level. INTRODUCTION For the individual or the institutional investor who is simultaneously performance-oriented and risk-conscious the key question is how best to achieve a higher overall rate of return with acceptable risk. The answer may be a diversified investment portfolio with some portion of the total assets invested in alternative investments. According to a survey by Nakakubo 2002 the alternative investment market reached 550 to 600 billion at the end of 2001. Pension funds also are increasing the proportion of alternative investments in their asset allocation. For many institutional investors alternative investments are viewed largely as private illiquid alternative investments that include venture capital leveraged buyout distressed securities private equity private debt oil and gas programs and timber or farmland. However other alternative investment vehicles such as hedge funds and commodity trading advisors CTAs also have observed a dramatic increase in investment and often provide access to 358 Incorporating CTAs into the Asset Allocation Process 359 investment not easily available from traditional stock and bond investment. For instance the Managed Accounts Reports MAR cites an increase in managed futures1 from less than 1 billion in 1980 to almost 35 billion in 1999 hedge fund investment is now estimated to be over 300 billion. Further Lintner 1983 uses the composite performance of 15 trading advisors and show that the return risk ratio of a .