Operational Risk toward Basel III: Best Practices and Issues in Modeling, Management, and Regulation

CHAPTER 22

A Risk of Ruin Approach for Evaluating Commodity Trading Advisors

Greg N. Gregoriou and Fabrice Douglas Rouah

 

 

ABSTRACT

Loss of investor capital through gambler’s ruin represents the worst possible outcome for investors in commodity trading advisors (CTAs). Investors that choose CTAs with a high risk of ruin might be exposing themselves to operational risk, since those CTAs may be straying from their stated investment objectives and assuming large amounts of risk, or may be too preoccupied with running daily operations and raising investor capital to focus on their investments. While the manager screening and selection process usually involves quantitative analysis that focuses on alpha, the Sharpe ratio, and other measures, the risk of ruin of a CTA and the optimal leverage that the CTA is using are rarely examined. In this chapter, we examine drivers of the risk of ruin and show that CTAs that chase high returns and incur high volatility are at increased risk of ruin. We also show that the risk of ruin is asymmetrical with returns, so that investors are punished with a high risk of ruin when returns deteriorate but are not necessarily rewarded with a decreased risk of ruin when returns improve.

The views expressed by the authors in this chapter are their own and do not necessarily represent the views of State Street Corporation or of any of its subsidiaries or affiliates.

22.1 INTRODUCTION

The managed futures industry has been increasing progressively during ...