Volatility Exposure of CTA Programs and Other Hedge Fund Strategies

Abstract

This article examines the dependence of trend-following CTA performance on underlying market volatility, both quantitatively and conceptually. While it is generally believed that CTAs have a long volatility exposure, tests conducted by the authors indicate that it is not quite true. The perception that CTA strategies are long volatility came from academic research and became widespread among traders. The notion of volatility exposure is sometimes confused with a dependence on volatility levels. If a CTA makes money in periods of high volatility and loses in periods of low volatility, its performance depends on the level of volatility. Volatility exposure, on the other hand, means that the CTA makes money when volatility rises and loses money when volatility falls. Both effects have comparable strength, are directly related, and thus are quite easy to confuse. By the same token, they need to be studied together, as is done in this article. The authors note that volatility exposure—i.e., dependence on volatility changes—should not be confused with dependence on volatility levels.