Hi GAT,
Most of the way through your book. Excellent stuff, complex stuff clearly explained as if it's the most logical thing in the world. Hard to do. Well done. Some questions if I may...
Thanks a lot. That's very kind, especially coming from someone who clearly knows their proverbial onions.
(It's at this point a more pushy person would politely ask for a nice review on Amazon.com... but I'm not pushy)
These are all thought provoking and difficult questions to which the true answer in most cases is "I don't know", but I'll have a stab at putting down some cursory answers.
If you were in a seat allocating to a portfolio of CTAs - how would you judge what you were being told? I'm torn between being sold the 90phds whirring away as worth the 2/20 and then the simpler side, it's a commoditised business where getting it roughly right is enough, particularly if at .5 and 0 - which is the clearing rate now. Are the phds worth it all? Or are they there to trade bigger for EMG shareholders rather than CTA investors? What's a good 'nonsense' flag? I saw systematica drop some 12% in a week last week. Lots of mutual funds in space now, all lower costs than 2/20, although fees often buried. Would be interested in how to approach discerning between them (and traditional CTA structures).
The basic CTA business ought really to be a commodity. But you do need to have people who are experienced - I think it's mostly avoiding dumb mistakes so you need to have people who've made those mistakes. I'd rather see a business splurge on building up the back office so they can diversify across instruments.
Overconfidence is the main nonsense flag. If someone thinks they can do Sharpe 2.0 in the CTA business because they have some fancy machine learning algo, I'd run not walk out the door.
But you get people who are experienced, not dumb, and are not overconfident who happen to be Phds. You also get people who are inexperienced, dumb, and over confident who happen to have Phds. A Phd by itself doesn't guarantee anything either way.
There's some stuff out there on the cost of vol adjusting in trend following. In either the blog or book or both, you mention Winton cutting the vol target in half in 08 crisis. I was around as he did that - it was for system wide panic reasons and fall of exchanges and counter parties etc. fair enough, terrifying time as you note. But you can't get past the fact that it cost his investors huge amounts. Is there anything in the argument that people bought a crisis call - with all the delta and vol expansion that implies - but he delivered a call spread, cutting positions when you needed it. The returns were great - but they 'could' have been better? A toy model of his strategy shows the risk cut - which is no secret. The scale of reduced returns though I haven't seen discussed. Not sure how to view it, in general heat of the moment makes it fine - did very similar thing. But it does make you think.
I think here there is a basic incentive conflict underlying this - should you run your fund for the best interests of the fund investors, or the fund management company? Cutting vol in a crisis: whose interest is that in?
As an economist a nice model for a systematic CTA is that they are like a commitment mechanism. The whole point of giving them your money is that they will do the hard things you can't bring yourself to do; like hanging on to large but profitable positions in a market meltdown.
There is also the fact that most investors don't understand the link between vol and fees. If you cut your vol, you should cut your management fee proportionally.
Have you looked at swapping futures exposure for options depending on underlying level,of implied vol? At a theoretical level trend is like an option as positions go on akin to delta expansion. So if actual implied in say crude was 2% (ludicrous I know but for example) it would make more sense to cut all futures flat price and get the delta for way less risk with options? Floor would have to be a chunk less than normal implied/realized spread inverting, but there is a number.
Yes - I have seen this. The nice thing is that the guy who is hedging your options has to do your stop loss trading for you; you just sit there and watch your delta go to zero and shrug your sholuders. A nice idea to have an integrated system that trades both options and futures; taking views on vol and direction with the cheapest instruments. Similar to how a lot of global macro traders trade. But complicated to build (mentally adds to list of research ideas...).
You mention having run gtaa strategies in the past. How do you think back on these? Given your experience at Man, if I remember they were trying to find the next ahl with a few of these. Come aug 07 and then 08, they got thumped. Bayswater, Auriel, QFS etc. I wonder how much of the capping of correlation benefits in your systems is a reflection of that (e.g. instead of long 60:40 eachin aud and cad vs -100% jpy the unclnstrained models called for 200% long aud vs -100% cad and jpy.
Familiar names... I used to benchmark myself against Bayswater and I remember when they blew up in 2007.
It depends on what you mean by GTAA. The 'predictor' space for GTAA overlaps too much with classic CTA (so if you're a GTAA manager working inside a CTA... you've got a problem as you're constrained to using things like low frequency macro data for which the Sharpe isn't going to be wonderful. And even Bayswater had a mandate not to be correlated with AHL).
Then you've got the portfolio construction, which you described. Actually I used to run GTAA in an unconstrained way, so that didn't apply.
The arguments about whether you should run a different kind of portfolio construction or another are separate from the type of forecasts: you can run momentum in a long only system, and like I said GTAA unconstrained. That comes down to whether you are running this thing as an add on / overlay and you want maximum alpha with low Beta; or your only strategy run for maximum Sharpe.
Leading on from that - How do you think of cutting strategies if they aren't working. I get the theory, acts very differently to expectations, or hypothesis/market structure alters. But in reLity it is harder. You get married to them. Allocators get married to funds. Researchers get territorial to models. Would you talk about your experience in shutting them off?
Actually in my case the theory marries well to what you say. You should have a high statistical bar (p-value) to include a new model, especially if it's more complicated. But this also means you should have a high statistical bar to removing a model. In most cases for slow moving strategies you need decades of evidence to be fairly confident a model is no longer working, unless it's really shocking.
I'd say the easiest strategies to shut off where were live didn't match current backtest; mainly because trading costs were massively underestimated. In that case from a statistical point of view you can be very confident you've screwed up, because the distribution of trading costs has much less noise than returns.
I'd say the territorial thing works in both directions. So for example if a new PM takes over a suite of models then they'll want to throw away pretty much everything the old guy did. And everything they want to put in will be a priori wonderful. [and yes, I've been on both sides of this]
You need consistent internal controls to ensure a robust and consistent statistically based approach to these in or out decisions, which overcomes these natural human instincts.
From your book, and you are clearly right, one is way better off doing the basics right, not over parameterising too much and spending time on uncorrelated diversifies rather than another trend variant. What do you think of equity market neutral as a strategy post 07? that level of crowding was incredible.
Yes, I still think EMN is a good strategy, but the main flaw is not over parameterisation, but running it at a fixed target vol rather than scaling risk accordingly to opportunity. And that's true of any 'hunt for yield' strategy where returns get compressed as they get crowded (see also FX carry). So you end up leveraging up more and more at the worst possible time.
Also...what other hedge fund strategies would you invest in as broad styles? Things you can't do yourself?
Yes, in theory.
But there isn't much I can't do myself in the systematic space, except access OTC markets like swaps, or do something that requires very low latency (for which I don't have the kit). Does that sound arrogant? Perhaps it's my belief that the best portfolio is a set of relatively simple implementations of various ideas, with no dumb mistakes. I know enough about most of the space that I think I could avoid most dumb mistakes (again with the exception of relatively fast trading in any asset class).
And in the discretionary space, I just don't have the time or the skills to do the due diligence to work out who are the good managers (because I know that a purely statistical test of alpha would never give me results strong enough that I'd be confident just on that basis alone).
Thanks for reading, I know it's a lot of questions. A reflection on the thought provoking nature of the book and the space as a whole. Thanks
Danny
You're welcome. Thanks for the interesting questions.
GAT
