Principal Component Analysis: A Tool for Analyzing and Describing CTA Programs

In constructing a diversified portfolio of equity managers (stock-pickers), the approach generally used is to bucket managers into “style boxes” based on market capitalizations (Large Cap, Mid Cap, Small Cap) and the fundamental characteristics (Value, Growth, Core) of the investible universe of stocks, then choose one or more managers from each style box to achieve diversification. In the case of CTAs, it is not as simple to come up with this type of classification. CTA programs differ from each other in terms of the markets they trade, the time-frames over which they trade, as well as their trading styles (trend-following, spread-trading, discretionary trading, contrarian, pattern recognition, etc.). Although most CTAs provide convincing explanations to help distinguish their own trading program from others, the differences among trading styles are often not as apparent as investors may expect.