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558055dc150ba0571c8b4610
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Diversifying with CTAs
Given increased volatility, CTAs can help balance portfolios and diversify. Watch as 4 top CTA experts discuss how investors can use CTA to boost their returns.
Martin Bergin - President of DUNN Capital Management, LLC
Mike Harris - President of Campbell & Company
Larry Kissko - Client Portfolio Manager at Man AHL
Fabien Pavlowsky - Head of Product Development at Lyxor Asset Management, Inc.
Duration:
00:50:05
Transcript:
Courtney: Mike, CTAs trade across four major asset classes: currencies, commodities, equities and REITs. We’ve seen tons of news on all of these, what are the market conditions right now?
Mike Harris: [00:00:09] I think the market conditions are very ripe for all four of the major asset classes from a CTA standpoint. When I think about fixed income the question is whether or not The Fed’s going to raise rates. At this point it’s just a matter of timing. So we’ve actually done some research to look at CTAs in a rising interest rate environment. And we’ve found that CTAs can not only be profitable because of their ability to go short Treasury Bond Futures, but in many of those periods of higher rates, actually perform better than in periods of lower rates. So we’re really excited to see what’s going to come about as Europe progresses. I’ve been thinking about some of the other asset classes, certainly commodities. Many investors already have commodities in their portfolio. But it’s a long only approach, an ETF or an indice. But I think about kind of the supply and demand shifts in many of the commodity markets; it’s also good to have the ability to go short. And if I look at recent years with some of the weakness in the emerging markets, particularly China, being able to be short commodities at large has been a very profitable trade for many CTAs.
Looking at currencies, it’s the world’s biggest asset class that many investors don’t have in their portfolio, 5.3 trillion US dollars per day, which is 13 times larger than global equity volumes. Yet, as I said, many investors don’t have this in their portfolio. And it’s been a real boost to performance recently because of the divergent Central Bank activity. We’ve seen between say the Bank of England and The Fed in the US here who are talking about higher rates as opposed to Europe and the Bank of Japan where they’re talking about lowering rates and increasing stimulus. And then equities for certain, with people like Jenny Hill talking about equity market valuations being too high, I think a lot of investors are concerned whether or not this bull market’s going to come to an end at some point. And CTAs as we’ve seen back in periods like 2008 have been able to come to be a protection if you will, in many portfolios.
Courtney: [00:01:54] Really interesting points. And it seems like CTAs will do well in a rising rate environment, Fabien would you concur?
Fabien Pavlowsky: [00:02:01] I would say my views are probably a little less that, right, than Mike’s. I guess from my perspective I think there’s a big unknown around interest rate moves in that it’s going to probably lead to re-pricing of asset classes across the board. And so I think in the long term I think CTAs may profit from the trade as it’s going to lead to re-pricing at large of a number of asset classes. But in the meantime we may see a lot of volatility in the direction in the market which may potentially be harmful to CTAs. So I think in the long run, yeah, I would definitely think that CTAs will perform if there was a larger pricing of asset classes. But in the short run I think we may see more volatility in most of those asset classes which may be harmful to CTA.
Courtney: [00:02:42] Okay. Marty?
Martin Bergin: [00:02:43] I have to agree on that side of the equation. I agree that with the rising interest rate market we should do very well. What’s happening right now is we’re in a transitional period from falling interest rates, for years CTAs have done very well. When that transitions to falling or to rising interest rates there’s a whole transition that has to take place where we’re going to be trading our positions, getting out of what we’re in and transitioning into a different perspective. The key to a CTA though is we can go short just as easily as we can go long which makes our type of investment structure good for the long haul, just like Fabien was saying, once this transition happens we will be set up to make money during that period of time.
Courtney: [00:03:35] So certainly a better position than a long only vehicle?
Martin Bergin: [00:03:37] Well, not only that but it also goes to point out the timing. Most people in the financial industry, they look at different types of investment vehicles with the idea that they can time them and buy in at a bottom or a good time and then write it and then sell at the high. A CTA isn’t a type of vehicle that you can really time your investment. I mean each of us have been running CTA firms for a long time, and trust me, I don’t know about these guys, but we have our own money in there with this and we can’t time it. Now, if we can’t time it I don’t know how anybody outside the industry is going to be able to time it. So the important thing is, is to get an allocation of CTAs, maintaining that allocation, when you have other investments that are doing quite well you can peel money off, put it in the CTAs and vice versa. But I think over the long haul it’s a great environment for CTAs.
Courtney: [00:04:34] Absolutely a buy and hold strategy.
Martin Bergin: [00:04:35] Oh yeah, for sure.
Larry Kissko: [00:04:38] I would also add too that in … part of the elegance of a CTA strategy is that we’re not just trading one asset class. So as we look for the shift and maybe bonds will be … bond yields are going up and bond prices are going down, that may be a transition period as you noted for CTAs and our models. But we’ll also be benefitting from sort of this reflationary picture or as the economy picks up, that’s what usually triggers these hikes in rates. And so we can benefit on the commodity side potentially as a strategy and also maybe there’s more to go on the equity side if the economy is still looking up enough to raise rates.
Martin Bergin: [00:05:15] Yeah. I mean all of these different sectors work in combination. So the effects of one sector is going to affect the rest of the sectors. And the fact that we have a diversity across all of these sectors it makes for a more robust investment strategy.
Courtney: [00:05:31] Absolutely. And we mentioned rates and you picked up on central divergence. But what about central divergence, what’s the opportunities out there with CTAs?
Larry Kissko: [00:05:40] Yeah. So I think it’s very interesting and because really, Central Bank divergence is that.
Courtney: [00:05:46] Central Bank divergence, yeah.
Larry Kissko: [00:05:47] Yeah, yeah. So I think that we’re seeing some very interesting times now because if you looked right after the financial crisis there was a lot of Central Bank intervention. But in my mind it was very coordinated. So you had a lot of, at least across sort of the G7 or G3 you had the promise of liquidity or liquidity actually coming in, in the form of QE, lots of rhetoric as well supporting economies. But really it was just coordinated enough to push down, I would argue, currencies and to flood market with liquidity. But now as we look say five years on or six years on and we’re in 2015, I think we’re seeing Central Banks and economies growing in different ways, different paths. So you see the US and the UK has been relatively strong, whereas Europe is still, you know, there’s still sort of year on year deflation in Europe, that’s just turning around. And Japan is still flooding the market with liquidity. They’re having their own QE. And so economies are on different paths now which creates sort of macro distensions of macro trends, fundamental trends. We’ve seen that manifest itself in things like currencies first which is really a play on economic strength of different countries or regions. And then because commodities for example are all priced in dollar generally, that stronger dollar may press down the price of commodities. So there’s a lot of interrelated things as there is divergent Central Bank and different growth rates in different economies.
Courtney: [00:07:22] Right. And playing off this, with the Swiss franc, we saw that happen, what happened there Fabien, and how did CTAs work around that?
Fabien Pavlowsky: [00:07:27] It was actually a tale of … I guess there were two pictures in Swiss franc. There were managers who decided to not trade their currency because they felt that it was completely manipulated. And there was the volatility that the market were exhibiting were not sort of real volatility and trading in those markets was too dangerous. Conversely we’ve seen managers mostly on the discretionary side, taking the view that Swiss franc had, you know, further to go and suffered quite a bit. So I would say if I were to separate the impact in between the systematic and the discretionary world, the systematic world was pretty much untouched, whereas the discretionary world suffered a lot more on this position.
Courtney: [00:08:07] So discretionary suffered more from that position?
Fabien Pavlowsky: [00:08:09] Yeah, that’s right.
Mike Harris: [00:08:11] But do you think there was a function more of risk allocation than the actual [inaudible]?
Fabien Pavlowsky: [00:08:14] I think there was … no, I think it’s more of a strategy, people having had the experience of market being completely manipulated and are moving, you know, I can give you the example of Euro Yen in Japan for the longest time, people were … eventually CTAs decided not to trade it. And we’ve seen some of that happening in the front end of the European and the US curve, you know, in 2012 and 13, some people decided not to trade those things. And I think and Swiss franc has gone up in a systematic world. Discretionary guys still had to view it at, you know, it would work and it did not, so. On the back of that I think one of the trends that was actually captured by CTAs, what happened to the equity market, right. As you had a huge re-pricing in currency there was a lot of sort of, as you said market or inter-correlated and interrelated and the equity marked moved a lot on the back of the currency move. And some of the systematic managers managed to take advantage of that.
Mike Harris: [00:09:07] I think this gets us to a really interesting point though which is what are the differences between systematic and discretionary managers? And I think that though there were CTAs that had Swiss franc in their portfolio, because CTAs are able to trade hundreds of markets, systematically when you take … when you have a large move in one particular market it limits some of the downside, whereas on the discretionary side you need to have portfolio managers who are subject matter experts and therefore it kind of limits the opportunity set you have, the number of markets you can have in a portfolio. And I think that’s why some of those discretionary managers have larger losses who had those positions in Swiss franc, because they’re just more concentrated by nature.
Martin Bergin: [00:09:42] Yeah, I agree. I think it really has to do with the way a systematic manager manages risk as opposed to a discretionary manager.
Courtney: [00:09:51] So risk is more of a key point in that case?
Martin Bergin: [00:09:53] I think it’s a key point in systematic trading. I mean we’re all here very focused on the risk that we allocate to the portfolio, not only to individual markets but also the portfolio as a whole. And we’re looking at that every day. I think the other key thing about the divergence is what it’s done to our industry because we were seeing these markets that were very correlated from the financial crisis on everything was acting the same way. This divergence that has come up has meant the markets have become de-correlated, which gives us a lot more opportunities to make money which I think attributes a lot to what happened in 2014.
Courtney: [00:10:36] Let me actually pull up a chart that I think will help illustrate that. So here you can see the Newedge CTA Index in white. And this is the S&P here in yellow. This is going across the past 10 years. So you know, 08 is a great point, a lack of correlation between CTAs and you can see the S&P is down at, you know, right between 08 and 09. Walk us through that, what do you see there, continuing with your thread of thought?
Martin Bergin: [00:11:11] Well, I think what you see is leading into 2008 there is a lot of emphasis on alternative investments, but not so much on CTAs. So everybody was allocating the hedge funds and in every type of alternative they could find. And then you had the crisis of 2008 and what happened is all these alternative investments became very correlated, all to the downside. So alternative investments that had no correlation to equities or very little correlation to equities, and if you actually go back and look at the numbers, there was correlation equities. But you know, people thought they were getting hedges. The reality was when the crisis happens they all act exactly the same way except for CTAs, you know, everybody has a theory. My theory is that CTAs can go short with … just as easily as long with no additional costs. And that was a heck of a trend, we all picked up on it and we all did very well during that period of time. This is the risk protection that everybody should want.
Fabien Pavlowsky: [00:12:19] I see a few other things on that chart. So there is protection, clearly I see it. There’s one more thing which I’ve actually experienced is investor frustration. One thing that you can see on that chart is that the Newedge CTA Index is frontline for almost three and a half years. And then when it picked up people have sold CTAs of, sort of investing in CTAs on the back of the expectation that they will do well when the liquidity market go down. Yet they had one of the best period in a bull market in 2014. So what this chart tells me is that one, you need to be patient, I think it’s key when you invest in CTA. Two, your own market expectations are not necessarily the one that you would expect to play out in a CTA space. And I think this is critical when you invest in this space. Time and time again you sort of project your market expectation and expect to make x, y, z return on the back of that. Unfortunately CTAs are very hard to predict. And I would essentially recommend not to play CTAs on the back of a market view but simply as a placeholder or have an insurance in your portfolio against things that you haven’t forecasted or haven’t predicted. Because clearly the case, that chart shows you, you couldn’t have predicted CTAs to have the best period ever in 2014. If I were to, you know, you guys have managed this money, I have told you that CTAs would have had their best period in a market like 2014, you’d have told me no way and yet this is what happened. So I think it’s an interesting asset class. It shows the correlation to equities which is critical but also shows the need to be patient which I think is key.
Courtney: [00:13:53] Yeah. Mike, your thoughts on 2014, I mean we saw a bull market here.
Mike Harris: [00:13:56] Yeah. You know, I think 2014 is actually a great example, and we talk to investors, Dr. Katy Kaminsky works for us, just joined us recently from the Stockholm School of Economics. She actually wrote a paper called Crisis Alpha back in 2011 which tried to explain that period of 2008 where CTAs were able to come in and help provide protection to many peoples’ equity portfolios. But with that we also try to educate people that CTAs can make money in good times and in bad times. In fact I like to say that CTAs make money when things happen. One of the things that can happen that create macro trends is a crisis. But there are other things that can happen. If you look at 2014 as an example, our five top trades which were probably the five top trades in the industry were being long European and Japanese government bonds, being short New York currency in the Japanese yen and being short the energy complex. And when I look at kind of those five trades, I mean the first thing that jumps out at you is that most kind of private wealth investors and even a lot of institutions don’t have access to those types of trades in their portfolio. This low correlation that we see that’s evidenced by the different trajectories of the lines, in fact if you go back over 25 years the correlation between the S&P 500 and most of the CTA indices is about negative 0.10 which is extremely low and it’s about as close to zero as you can get.
If you look at many of the mainstream kind of hedge fund indices over a 25 year period it’s just north of .5 and over the last few years it’s been as high as 80 or 90% correlated. So you’re getting a lot more equity market beta effectively in other hedge fund strategies where you’re getting that very low close to zero correlation. And that comes from the some of the reasons we’ve already discussed today, the fact that we can be both long and short and don’t have a bias to be long traditional assets. The fact that we’re trading all four of the major asset classes as you started the discussion with; many investors don’t have currencies or commodities in their portfolio. So that helps to diversify. And just the global nature of the portfolios that we’re trading 24 hours a day around all of the developed and emerging markets, most investors in the United States are very domestically focused. So by getting access to Europe and Japan, other parts of Asia, it’s really helping to diversify their portfolio away from traditional equities like the S&P.
Courtney: [00:16:04] Helps them to get them more from their home country bias. So 2008 was an example of crisis alpha right there, right?
Mike Harris: [00:16:10] Absolutely.
Courtney: [00:16:11] And traditionally is it fair to say that CTAs perform well in crises where they produce crisis alpha as well as bull markets, Larry?
Larry Kissko: [00:16:20] Yeah. So we did an interesting study a little bit on the back of Katy Kaminsky’s work and paper that she’s done for in crisis alpha. And it was relatively simple where we looked at again the Newedge CTA Index. And we looked at the period from 2000 through to 2014 and we looked at the quarters of performance for the S&P and we ranked them. So we took the 10 worst quarters for the S&P 500 and we ranked them 1 through 10 and then we overlaid the performance of the Newedge CTA Index for those same quarters. And what we found is that in the 10 worst quarters since 2000, the Newedge CTA Index was up 7 of those 10 quarters. So in the worst quarters you can imagine trading like the fourth quarter of 2008 and the tech wreck in 2002, CTAs are sort of a family or an asset class that perform positively and sometimes some of those quarters were upwards of 15/17%. So I think that’s an example of this crisis alpha. And then we sort of we took a mirror image if you will, and we ranked the 10 best quarters since 2000 for the S&P. And it was really interesting because the Newedge CTA Index was positive in 7 of 10 of those quarters. So I think to me the punch line there is that for the most part CTAs benefit from market movement and trend extension and markets moving to new highs or new lows. And so that’s what you get in these periods of, you know a bull run or these crisis moments as well.
Courtney: [00:17:57] So volatility in either sense. And this is an interesting point about correlation, alternatives are supposed to be less correlated than say other asset classes to the markets. But even within alternatives these are the less correlated. Is there anything that’s … I mean timber, real assets, what’s less correlated than CTAs, anything?
Martin Bergin: [00:18:19] You can’t be less correlated than basically zero. So the only other direction you can go is to be negatively correlated. And negatively correlated, saying that if equities are making money you’re going to lose money. And I don’t think there’s much of a market out there for that type of strategy, so zero is the ultimate.
Courtney: [00:18:40] The ultimate, okay. Alright, I want to pivot a little bit, Fabien to black box, tell me about that.
Fabien Pavlowsky: [00:18:47] Yeah. So I used to actually call CTAs grey boxes, not black boxes. I think there’s a lot of perception that, you know, we’re talking about black boxes, a computer makes a decision, this is sort of no real oversight of the positions, nobody knows what’s really happening in the book. It’s actually not true at all. In CTA world and that’s why I call it grey boxes, the positions are driven by fundamental that the portfolio manager as the people responsible for the strategy are very well aware of. And I’m assuming that, you know, at every point in time they know exactly why they hold such and such position and why the system is behaving the way it’s behaving. So I would say the systematic strategy have gotten a bad rap on the back of them being driven by computers. But I would say that over time I think generally the public and investment communities are warming up to the concept of systematic trading, just know it’s a generational thing, right. My kid is two years old and he’s using an iPad, alright. And so they’re not afraid of computers. And my mother is a little3 older, she’s a little bit less good with the iPad, and then so ultimately I would say it’s just the way to kind of trust computer a bit more over time but with a human oversight. And so I think the human oversight is very well present and so I’ve never seen CTAs as black boxes.
Courtney: [00:20:06] So a secular trend that’s benefitting systematic trading?
Fabien Pavlowsky: [00:20:10] Sure.
Larry Kissko: [00:20:10] I would add to that too that especially when we’re talking about trend following like we are here. And I know that we at AHL consider ourselves to fit squarely in this medium term trend following, which to us is sort of two to three months of timeframe. And so one way to think about that is if you take all of the markets we trade or the major ones like the S&P in the US 10 year. And you pull them up on Bloomberg just like the charts here and you look over the past two to three months if, you know, by and large if that market’s moving higher we will be long. And if it’s moving lower over two or three months we will be short. And so from that standpoint I think that’s very open and transparent. There’s no mystery as to what we’re doing or it won’t be a hedge against something else by and large. And so you can … it can be very intuitive and sort of open sort of framework from that standpoint, easy to get at. I think a lot of the bells and whistles come from our risk management, our portfolio construction, our execution, but the positioning can be quite straightforward.
Mike Harris: [00:21:17] And I think that when you think about it it’s a rules based approach, so it’s very repeatable. That’s why we do what we do. My models, if I ran them 10 years ago on the same side of market data as today we’re going to make the exact same decisions. To me that’s very, very clear, when I think about the opposite which is the more discretionary kind of portfolio management model, to me the human brain is the ultimate black box, because how do I know whether or not that PM is going through a divorce or just went on vacation or has, you know, is sick or has trouble with one of their kids. That’s going to influence the way they make decisions. And just the fundamental emotions of fear and greed will always kind of creep in, even the most disciplined, you know, trading professional, whereas a model based approach is unique and different because as I said it’s very repeatable. And that makes the back test that we want on our strategies, you know, very easy to validate.
Courtney: [00:22:07] It doesn’t have those human emotions that could potentially, yeah.
Martin Bergin: [00:22:12] Well, I think a black box is basically saying that if the data goes in, what comes out the other side, you don’t know why it made the choices you made. I mean all the computer technology that we use is nothing more than a tool. We could do the calculations by hand and come up with the same answers. We just use that to do it quicker and easier. But you’re exactly right, we know exactly why we have the positions we have. I mean you just run the numbers, crunch the numbers and that tells you why you’ve got a long position, why you have a certain number of contracts on, it’s all about risk management and a strategy, choosing whether to be long or short.
Courtney: [00:22:56] And I want to go back to trend following. You mentioned you follow a midterm two to three month time horizon. Is that pretty across the board or are you guys all following around that time horizon or is, you know, Marty?
Martin Bergin: [00:23:08] No. We’re longer term.
Courtney: [00:23:11] What is longer term exactly?
Martin Bergin: [00:23:12] Well, right now it’s like six months holding period. Our strategy has the ability to move between longer and shorter terms. And we are constantly gravitating, after the crisis we gravitated to a fairly long term. And we’ve been [inaudible] back slowly but very gradually. And I think it’s helped us because we haven’t gotten caught in a few transitional periods that turned out to be a fake. And then the markets continued. So we’ve done fairly well since the crisis throughout and I think it’s just because we’re one of the few that really have a long term view. But we are moving shorter.
Courtney: [00:23:55] But moving shorter, okay.
Fabien Pavlowsky: [00:23:56] On our side I would say we invest in a wide range of timeframes, medium term, long term has been always the core of the allocation. This is the one where, right, you know what you’re buying and a sort of response function to a market is, you know, well understood in the shorter timeframe. It’s a little harder to understand sort of the response function of a model to a small move in the market. I find this a little [inaudible]. But ultimately we believe in diversification across timeframe. What we don’t want to do is put a bet on the single timeframe and say, “Let’s hope that at that frequency the market will sort of work well.” We’d rather be diversified across the timeframes and benefit from momentum or trend, whether it’s happening in a short timeframe to a longer timeframe as well.
Larry Kissko: [00:24:41] And I would add to that too, in our program we sort of distil down to this two to three month time horizon or holding period. But we do slice it up into close to 10 different timeframes. So we will have sometimes slices that we’re looking very short term within a week out to almost a year and kind of divide it up to help us trade through different frequencies of different sort of market cycles, as Fabien sort of alluded to.
Courtney: [00:25:08] Is that your diversification internally?
Larry Kissko: [00:25:10] Yeah, it is, in a way, yeah, exactly. Exactly, so we just sort of fight through these different trend cycles, yeah.
Courtney: [00:25:27] Just the liquidity profile, yeah.
Mike Harris: [00:25:28] Yeah. So I think that we certainly had discussions as an industry a few years ago when CTAs reached kind of their peak in their total assets, about whether or not capacity would be an issue for kind of managers in this space. And then certainly as we heard from Fabien, we had as an industry a bit of a struggle performance wise from say the 2010 to 2013 period. And as AUM came out of the space those discussions, you know, stopped. Now, after 2014 assets are flowing back into the CTA space. So I highly anticipate that we will have some conversations about capacity of various managers. But I think at the end of the day as we were saying earlier, you know, the rising tide does lift our boat. So as more assets come to the space as more CTAs are trading these very liquid exchange traded markets, we will see volumes go up across the board. And it will bring down transaction costs and make it, you know, easier for all of us as an industry to be able to manage more assets. But it certainly doesn’t feel like looking at our strategies, we’re currently handling about 5.5 billion and we’re having absolutely no issues transacting in the marketplace, in fact our costs are staying relatively low in this environment.
Courtney: [00:26:34] Okay. And that’s such an interesting point too. I mean people are looking at liquidity across the board as an issue now. The fact that CTAs, all of their underlying investments are highly liquid, that’s got to be attractive to investors.
Martin Bergin: [00:26:48] CTAs is almost like the perfect world for an investor. You’ve got total transparency, an investor has a managed account, they see every position that’s on. They can value it every single day at a moment’s notice, every day on the close there’s a settlement. You can close out the position within minutes. I mean what else does an investor want? You’ve got total liquidity, total tran…
Larry Kissko: [00:27:19] And transparency.
Martin Bergin: [00:27:19] You have transparency, I mean it’s kind of the perfect world.
Courtney: [00:27:23] It’s ticking all the boxes.
Martin Bergin: [00:27:24] Yeah.
Fabien Pavlowsky: [00:27:24] It is, yeah, but as we saw on the chart, right, there’s long … like there’s a long period of time when CTAs don’t perform and what I would cautious our investors about is transparency and liquidity doesn’t mean that you need to make a decision. I think that’s something the flipside of those attributes of the strategy, right, liquid, transparency are a great instrument. But making a decision on the top of those things is very difficult. And so I would say they’re very good for safeguard type investing when, you know, something is really going wrong and you need to get out or you need to understand where your exposures are. But barring anything else I think it would be tremendously dangerous to make decisions on the back of those things.
Martin Bergin: [00:28:07] Well, there’s two things you’ve got to remember, so the chart that was up, if you had taken that back 25 years, that three year period of losses, that would be the only period of time in that chart that there would be losses.
Courtney: [00:28:22] Okay. That’s a really interesting point.
Martin Bergin: [00:28:23] And the Newedge CTA Index had not lost money until those three years.
Courtney: [00:28:26] Those 2010, 11, 12.
Martin Bergin: [00:28:28] The other thing is, and I agree that you’ve got to be patient in this type of strategy. But if you’re building an efficient portfolio you want that non-correlation whether it’s working or not because it reduces your risk in that portfolio, over the long term your risk adjusted returns are going to be much better.
Courtney: [00:28:50] And with the additional push out your efficient frontier up in to the left with the addition of CTAs?
Martin Bergin: [00:28:56] Absolutely. I mean our studies show that first off you’ve got to allocate it based on risk, not based on AUM. So you want to look, because different CTAs trade at different volatilities, different risk. And our belief is that if you put 20% of your risk into CTA strategies that’s going to give you the most efficient portfolio balancing.
Courtney: [00:29:16] Interesting. Okay, so let’s talk about where do, Larry, CTAs fit in an investor’s portfolio, be it institutional or a retail investor.
Larry Kissko: [00:29:26] Yeah. So I think a couple of things there. And we’ve touched on maybe both already here today. One is that I do believe that it’s a strategy that’s very hard to time. So I think we all believe that we know that we’re good at measuring trends. We know trends exist. We just don’t know when or where. And so by that kind of standpoint we need to have these in a portfolio, sort of a diversifying sleeve for an investor. And I think you know they need to be an amount that’s probably greater than 5% to have an effect on a portfolio. I’d say between 5 and 15 or maybe 5 and 20 is a great number. I think, you know, it goes back a little bit to psychology, and you mentioned the word ‘black box’ and some investors, like Fabien’s mother perhaps would baulk at the idea.
Fabien Pavlowsky: [00:30:18] I’m trying to convince her.
Larry Kissko: [00:30:18] Yeah, so the idea of having so much systematic in the strategy. So I’m always balancing when I talk to clients to try to show them the facts and the crisis alpha and these graphs with their own sort of psychology and mindset to get them comfortable. But I think 5 to 15 is about right to me. And the second point I want to make too is that as we look … we look at the correlations of CTAs to equities, which to my point, I was slightly negative and it’s slightly positive to bonds going back across 10/15 years, even further. And so now I think it’s a very interesting time to think about CTAs because now we’re starting to see that this Fed hike might be finally taking hold for investors. And we have to think about maybe shifting out of our bond exposure if you’re an individual or an institutional investor. And the natural thing to do is rotate into equities. But then you look at this chart and you see that for the last five years it’s gone up, it’s almost gone up a 100% over the last however many years, six years in this Bull Run. And so maybe it’s not, maybe you can’t just put it into equities. And so the fact that we have this asset class that has a positive expected return of, you know, 10 or 15%, depending on your volatility and but almost zero correlation to these markets which look maybe a little toppy or potentially wobbly. I think it’s a very compelling time to at least take a good look at CTAs here.
Courtney: [00:31:40] Right. That’s a great point. I mean to your point, are you having these conversations around the fact that, you know, we’ve seen a three decade fixed income run or you know, maybe at the end of an equity bull market or it’s frothy, it’s toppy as Larry pointed out. Does that make the discussion even more germane around CTAs?
Fabien Pavlowsky: [00:31:58 8] Yeah, it definitely does, right. So the big discussion we have with clients today is about diversification, right. And I think whether they fully understand why or they feel it, they feel that it’s time now to diversify. And a number of interesting statistics you can quote about, you know, it’s time to diversify now, to name a few, the last time the rates were at those level in Europe it was the plague, you know, it’s telling, right. If you think about the bond market and the growth of ETF and mutual fund bond markets, if you compare that to the inventory of banks, it used to be two times in the mid 2000s, today it’s 20 times. Meaning that the [inaudible] for fixed income [inaudible] is reduced dramatically. And then to give you one last, which is really telling for institutional clients, their 50/50 portfolio of fixed income equity is at all time high in sharp ratio. There is essentially, the status quo is not a viable solution. And so if you think about diversifying now is the time. And questioning about how much you need to put in there and how you need to structure it, I think it depends on the client. It really depends on the client. It’s about buying insurance and nobody wants to buy insurance. And an insurance policy needs to be managed as well. So I think it will depend on who the client is. But I will agree with the sort of numbers you’ve mentioned, 5-20%, depending on how much risk somebody wants to take off is important.
And I think the other question is I think the one that’s the hardest to answer is where do you take the money from? I think that’s the big question. Do you take it from equities because you’re afraid of an equity market? Are you taking it from fixed income because you think that, you know, fixed income cannot go higher in price? So this is a much, much harder question. And I would say the way we’ve generally answered that is by saying, “Take a bit from both and again don’t try to have a view on this thing because we know it’s … and work this way.”
Mike Harris: [00:33:48] I mean the hardest part from a portfolio optimization standpoint is that when we have such a low correlation traditional assets that when you try to run the numbers it wants to put a lot of risk into CTAs because of that low correlation property. And so once again it’s kind of hard sometimes because … because it has non-correlation it’s going to zig when other asset classes zag, which means it’s going to have a different return profile. And let’s face it, the average investor, the way they manage their portfolio is they look at the statement and whatever’s red they say, “Get that out of there.” And what we jokingly tell people is, “If you don’t have something that’s red at some point in time in your portfolio then you probably don’t have diversification. You’ve got a whole basket of things that are probably highly correlated. So it’s so important but having that conversation, I think that it gets to the core; people understand that they need diversity. It’s a question of how much can they tolerate versus how much they need in their portfolio going forward.
Courtney: [00:34:41] That’s a really great point. And I want to touch on something you said, people think of it as an insurance policy. Are people primarily positioning CTAs or thinking about CTAs as a pure hedge or are they thinking about it also as an alpha generator, the way its alternative peers would kind of be viewed as both?
Fabien Pavlowsky: [00:34:57] The way I think about insurance company is … insurance … the way I think about insurance is not necessarily about making money when the market is down. It’s about making money when the market is not doing what you expect it to do, namely making money in the continuation of a bull market today is something that CTAs could potentially benefit from. Again it’s not something that the average investors would necessarily believe in, they think that the market has done what it’s supposed to do and then the next leg is down. And so ultimately I think it’s about an insurance about the right tail and the left tail, doing something that you’ve not necessarily expected the market to do. And so in pricing this insurance it’s about understanding the benefit and the cost of that insurance. And I think what’s critical in that insurance is to be able to say, “When I made the money on that insurance premium I need to take some out.” And conversely if I lost money in that insurance I need to top it up. And I think that’s one of the big mistakes investors have made is just to not top up the insurance when they felt everything was good and then the expectations were, you know, is going to be rosy for the next 10 years, those are not valid expectations.
Courtney: [00:36:07] Well, that’s the discipline, we talked about discipline earlier with managers, but that’s the discipline that investors need to be thinking about. Is there any difference there between, you know, what you’re seeing among retail versus institutional in terms of that or just in terms of allocations?
Mike Harris: [00:36:22] Sometimes we see our retail investors actually do better in the long run because I think that they do tend to stick to a long term plan. And they don’t try to manage their portfolios on such an active basis. Sometimes institutions kind of fool themselves into thinking that they’re smarter than everybody else and that they can time these strategies. And so we see them getting out at the bottom and then getting back in when CTAs have a year like 2014 and they don’t have them in their portfolio. And the Investment Committee says, “Hey, why don’t we have that?” And suddenly they jump back in. So what we’re trying to do is educate everybody as you’ve heard from the panel today that the important thing is just to have them in some capacity in the portfolio and to stick with them in good times and in bad.
Courtney: [00:37:02] And you suggested around the 15% allocation?
Larry Kissko: [00:37:05] Yeah. I think I would agree with Fabien, there’s probably a range based on different investor needs and maybe even levels of sophistication or potentially access to diversifying markets as Mike mentioned. And so I think maybe 5-15%, 5-20% would be the right range.
Mike Harris: [00:37:22] The biggest mistakes we see people making is doing the 1-2% allocation because it’s a tremendous amount of work to educate the end investor as to the benefits. And then at the end of the day in a 2008 type scenario, instead of that portfolio being down 27%, it’s down 26%. So it’s not really helping other than maybe having the feel good factor of having one thing that makes money in a crisis. I think the important thing is to have a meaningful enough allocation in a portfolio.
Martin Bergin: [00:37:45] Yeah. I think we’ve told people, “If you’re not going to commit at least 5% there’s no point.”
Courtney: [00:37:52] No point unless it’s 5%, okay.
Martin Bergin: [00:37:54] I mean, you know, this is an investment industry that they don’t have knowledge about. So they have to get educated. It’s going to be a lot of work managing the account. What’s the point if you’re not actually buying any insurance?
Courtney: [00:38:10] Right. It has to be a meaningful amount, to your point?
Martin Bergin: [00:38:12] Yeah.
Courtney: [00:38:13] And what about these, you know, new wrappers like 40 Act Funds and UCITSs, what are you seeing there?
Mike Harris: [00:38:18] We’ve seen tremendous growth there. We launched a 40 Act product in partnership with a company called Equinox about two years ago. And we’ve seen over a billion dollars in inflows. So there clearly is demand out there for people to have managed futures in a 40 Act wrapper as well as I think there’s just a general demand post credit crisis for people to have things that are more liquid. Now, we can debate whether or not we think that that daily liquidity is a good thing because it certainly gives people the ability unfortunately to get out when they probably shouldn’t. But I just think at the end of the day whether it’s for mid month portfolio rebalancing activity, certainly it enables institutional investors to do that, in other cases it just gives people the security to know that that liquidity is there if they need it.
Larry Kissko: [00:38:59] I think it’s … we also launched a 40 Act product last year and have seen excessive flows into it. But I think it’s a very … it’s a great way for retail investors to get access to these various diversifying markets. And things like corn or the Singapore dollar, the Polish zloty, just things that are very hard for a retail investor to get into. And also here within CTAs you’re also able to generate short alpha, which is relatively hard to get or to even in a mutual fund format. So I think that that really helps a retail investor that just may not have access to that style of investing or those means or markets.
Fabien Pavlowsky: [00:39:41] Sure. And I think I would agree with that. I think there’s one more dimension that’s important for retail investors is to have this one placeholder that gives you access to many different markets. I think it’s, yes, they can access corn, but potentially they could buy an ETF that has, you know, agricultural exposure. But finding this one place where in one place you get everything, it’s very, very appealing from that perspective.
Courtney: [00:40:01] Right, how else would you get, yeah.
Martin Bergin: [00:40:03] I think it’s great to make this available to as many people as possible. I mean CTAs have always been considered on the fringes, only the sophisticated investors should get involved. But there’s a benefit to everybody. Now, you know, the 40 Act space or UCITSs, we actually have a UCITS, it’s done very well. I actually agree that the retail investor tends to be maybe a little better at holding a position than the institutional. The institutions are great about talking about that they’re not going to chase the dog’s tail.
Larry Kissko: [00:40:39] They’re all long term investors.
Martin Bergin: [00:40:41] They’re all long term, they’re never chasing performance and every time you turn around they buy at the highs and sell at the lows, it’s a given.
Courtney: [00:40:48] They like to say they’re sticky money.
Martin Bergin: [00:40:49] It’s human nature, and that’s the problem. You get, their emotions get involved. And we avoid that because of the systematic nature that we trade. There is a lot of times I’m sure that we’re sitting in our offices taking a trade that we just think is not a good trade and it turns out to be a big win, so.
Fabien Pavlowsky: [00:41:07] There’s something to say that people like to fasten on their portfolios, there’s a saying that says, the laziest farmer grows the best potatoes. So that’s sometimes actually true.
Courtney: [00:41:20] So I wonder kind of as we’re wrapping up, what are the biggest challenges that you think are facing the industry right now?
Mike Harris: [00:41:27] I think the regulatory environment is definitely a challenge. We’re lucky I think in CTA land because we’ve been a regulated entity for many years. And so I think we’re all very comfortable in dealing with whether it’s the SEC, the CFTC or the NFA or various foreign jurisdiction regulators. But I think that just in general in the money management business it takes your focus away from the most important thing which is building the right portfolio and doing good risk management on your portfolio, when you have to take time out of your day to make sure that you’re complying with each and every kind of regulation. And as we’ve heard we’re so globally diverse, we’re trading in so many different jurisdictions that it just becomes very multiplicative in regards to how many regulations we have to comply with.
Courtney: [00:42:08] Right. I mean just domestically you have twice as many as everybody else. You have this, you know, most people just have the SEC [inaudible], right, you’ve got two more.
Mike Harris: [00:42:16] It’s a double edged sword for, you know, I think it makes our investors feel more comfortable because we are so highly regulated. But at the same time it does mean that we have to commit a lot of bodies to making sure that we’re always in compliance.
Martin Bergin: [00:42:28] I agree, I absolutely agree. I think the regulatory environment has become very politicized, you know, it’s a way to punish people that don’t have the same views. It’s also become a revenue strain for these regulators to where, you know, by penalizing people they’re generating revenue.
Courtney: [00:42:51] For the SROs.
Martin Bergin: [00:42:53] For everybody.
Courtney: [00:42:54] For everybody.
Martin Bergin: [00:42:54] Everybody in the industry. And more and more resources are being used to deal with the regulations. And that’s less resources that are benefitting the investor. And historically we’ve had a great regulatory environment. I mean the NFA and the CFTC, for the most part has done a really good job in our industry. And we don’t have a history of large significant publicized blow-offs. But now our regulatory body is falling under the SEC, so I’m probably going to get in trouble, right.
Courtney: [00:43:35] Both the NFA and the CFTC are?
Martin Bergin: [00:43:36] Yeah, they’re being moved under the umbrella of the SEC. And they’re becoming less smart about what they’re doing. It’s less focused on protecting the investor and more focused on punishing the participants in the industry.
Courtney: [00:43:58] Okay. And where do you see the industry going next, Fabien?
Fabien Pavlowsky: [00:44:01] I think I … so I think that the biggest challenge of the industry, and it’s probably talking to your point about where the industry’s going, it’s about the research, right. So those are system driven techniques, you know, there needs to be a researcher, there needs to be ID generation backing up the ideas. And I think, you know, as technology grows faster and faster, people are getting smarter and smarter, I think so do the CTAs. They have the need to get smarter and smarter over time. And I think this is where the industry needs to go and has to go. It’s been doing really well as far as the tremendous amount of innovation over the past 10/15 years. I think there needs to be an [inaudible], right, technology has grown rapidly between … over the last 10 years I think CTAs have to catch up a little bit.
Courtney: [00:44:53] So you think there’s a little bit of catch up?
Fabien Pavlowsky: [00:44:54] There’s a little bit of catch up, if I compare other sort of systematic strategies, namely in the equity space for instance, I’ve seen technology using equity space a bit more sophisticated, a bit more sort of, you know, using the big words like big data and such. I feel like future space is sort of … it’s taken a backward seat. And I’m starting to see renewal finally, but I think that would be where I want the industry to go, is start to catch up with some of the new techniques, some of the new data pool that people can enjoy and trade on.
Courtney: [00:45:28] So there is a bit of white space right now in terms of technology?
Fabien Pavlowsky: [00:45:31] There is.
Courtney: [00:45:32] Are you seeing that as well, Larry?
Larry Kissko: [00:45:33] Yeah. And so I was going to highlight a couple of different things. I think for one, wherever the industry’s going, I think it is pushing more into the retail space and into this liquid alternative space. And there’s been tremendous growth just in the last two or three years. And I think that’s a challenge for the industry. And it’s a very exciting challenge to meet the needs of retail investors. And there does seem to be quite an appetite for it. And I think that will continue to evolve and will innovate there. And I also think the market is … the future holds a lot of sort of interest … there’ll be innovation in markets itself, finding new markets, I know as a firm we’ve had a lot of success in finding new markets, both on exchange and over the counter markets that have been greatly sort of enhanced our programs, enabled us to extract alpha in sort of previously harder to trade markets. But you know Mike and I were talking just before that the taping here about China for example, those markets are incredibly deep in liquid and the potential there to tap that and bring that to the rest of the world right now, Chinese futures markets are only available to mainland Chinese investors. But if we could tap into that, that potential could be huge for the industry. So just going forward along this idea of new markets, there’s just so much to explore I think.
Courtney: [00:46:53] What about other new markets aside from, you know, China, I know you guys were talking about that, but any other new markets?
Mike Harris: [00:46:58] I think it’s always a challenge because one of the biggest inputs to our systems and probably everyone in the industry is cost. And so you always have to balance obviously the liquidity premium in the markets that you’re trading, how much does it cost you to trade those markets? And you can add, we could probably add another 100 or 200 markets to our portfolios. But they would be very small portions of the overall portfolio. And you could make the argument that they’re not adding a lot of value because it’s costing a lot to trade them, you can’t have a large position on. And so maybe it’s adding to your diversity a little bit but there’s always a tradeoff and I think we’re looking at that on a regular basis.
Courtney: [00:47:31] So it’s a balance?
Mike Harris: [00:47:32] Yeah.
Courtney: [00:47:33] Alright. Well, this has been so interesting gentlemen, I want to go to your final takeaways and I’d like to start with you, Fabien.
Fabien Pavlowsky: [00:47:38] Well, I don’t have one, so.
Courtney: [00:47:42] Alright. Well, this has been so interesting gentlemen, I’d like to go to your final takeaways, and I’m going to start with you Mike.
Mike Harris: [00:47:46] Well, I think you heard it today that we hope that everyone has a long term plan to have a diversified portfolio and that CTAs are a part of that, that plan. But if they’re not I think we’ve talked about a lot of the compelling reasons to add them and how they really do add to a balanced portfolio, whether it’s in good times or in bad times. And certainly as people start to worry about whether or not the bull market in equities has come to an end or whether or not fixed income is going to finally make a turn and yields are going to move higher, these can all be catalysts for macro trends where CTAs can take advantage and potentially help provide some protection in portfolios.
Courtney: [00:48:21] Downside protection, Marty, your takeaways?
Martin Bergin: [00:48:23] I think it’s really amazing considering all the advantages that this industry has that it’s as small as it is. And I think that is our fault as an industry from the education of the investor. And I think the biggest takeaway I can get is that programs like this are to educate the investors and the public about what we do and the advantages of managed futures is going to be a big benefit to this industry.
Courtney: [00:48:50] So education.
Martin Bergin: [00:48:52] It’s all about education.
Larry Kissko: [00:48:54] And I think I might go back to something I touched on earlier, just sort of the … we’ve talked about the diversifying nature of the strategy, the low correlations and the crisis alpha. And at some point there’s a lot of statistics there or that’s sort of captured in academic papers. But to have an application to this current market environment, and you know, we talked about the lengthy Bull Run in both bonds and in equities and where do you turn? And Mike just mentioned, what happens now? It looks like yields will be going up and the US will be raising rates. And so it’s very timely sort of the diversification that CTAs can provide. So I think that a lot of the textbook stuff is interesting but right now the diversification can really sort of come to bear as the market seems to be at a turning point.
Courtney: [00:49:37] So you know, you should always have CTAs in your portfolio, especially right now.
Larry Kissko: [00:49:41] It seems especially interesting right now.
Fabien Pavlowsky: [00:49:45] So I guess my key takeaway is also around diversification. I guess there’s a number of data point in the market which tells you that status quo is not a viable solution, right. I’ve told you a few statistics but the world is getting scarier and there’s a lot of uncertainty around what’s happening in the market. On the back of that I think having a CTA strategy in your portfolio makes a lot of sense. And you ought to be looking at diversifiers to their firm, your traditional equity portfolio, your traditional fixed income portfolio, if anything from a traditional hedge fund portfolio. And CTA is a good place to look.
Courtney: [00:50:15] Smoothing out volatility. Right, well thank you so much, gentlemen, I really enjoyed this. And we want to continue this conversation about CTAs, check us out on our social media pages on LinkedIn and Twitter. From our studios in New York I’m Courtney Woodworth.
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