Estlander & Partners

Delivering alpha from Finland for over two decades

BILL McINTOSH

Few places could be as remote from the hedge fund hotspots of Mayfair or midtown Manhattan as Helsinki, but if anything that has proved to be a big selling point for Finland’s Estlander & Partners. At a time when correlation and tail risk worries top the list of investor concerns, the commodity trading advisor founded by Martin Estlander in 1991 is showing that it stands apart from other CTAs running systematic managed future strategies.

The development of Estlander covers two decades of trading, research and innovation very much outside of the mainstream. For many years, Estlander toiled in relative obscurity. But post-2008 when CTAs suddenly grew in favour with institutional investors, Estlander’s assets undermanagement began to mushroom and have increased fourfold since then to hit the $1 billion threshold.

“Since we are a company based in Finland, we are a bit out of the mainstream for hedge funds,” says Estlander. “Our corporate culture is probably different to London or New York and we also have a different approach to trading to some extent. We are not as homogenous as some other managers that sit in the same locations and perhaps talk to the same people. In general, I think we’ve gone our own way with the evolution of our strategy.”

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Estlander’s flagship is the Alpha Trend investment strategy. Since launch in 1991, it has produced an annualised return of 11.9% (See Fig.1). Alpha Trend is a short term, fully systematic, CTA strategy capitalising on price trends to generate performance in multiple markets covering fixed income, currencies, equities and commodities (See Fig.2). The limited AUM in Alpha Trend and the firm’s other investment strategies makes it easier to offer proportionately greater exposure to some commodities than is available from giants like Winton Capital or Transtrend.

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A very reactive approach
“Alpha Trend is a strategy that is particularly reactive,” says Estlander. “It is very selective, so doesn’t trade in and out of the market all of the time, but when it does trade, it moves fairly quickly. It tries to capture an early part of a move and then not sit too long in the trade. Compared with other CTA strategies, one could say that it is earlier in and earlier out, but not necessarily trading all of the markets we operate in all of the time. It is a more selective approach.”

A key aspect of the programme is pattern recognition. Specifically, it looks for price patterns in the market to assess whether an opportunity is attractive or less attractive. If a particular market juncture is judged to be attractive, then a trade might be set in motion before much momentum in a price trend has become manifest. Once a position is opened, its duration will typically be less than 30 days.

“The programme is really looking at the price pattern in the market,” says Estlander. “If it finds a favourable pattern for a solid trend to develop, then it is very sensitive to this and looks to get in early.” In contrast, a more mainstream CTA strategy would likely wait for a rise in momentum to confirm that a trend has begun. It would therefore get into the trade more gradually and retain a greater exposure at a much later stage of the trend’s life span.

The programme features technical short term triggers for trade timing. In trending markets, it only participates in break outs in the same direction as the trend. However, in sideways markets, the programme can participate in break outs in both directions.

Alpha Trend trades over 70 instruments with four round turns per instrument per year. The strategy thus puts through about two trades per trading day. The average margin to equity is 11%. Due to the relatively low margin to equity requirement of Alpha Trend up to 80% can be notional equity.

CTAs in vogue
Data from Barclay Hedge shows that assets from CTAs rose by just over 50% during 2008-2011, hitting a new peak of $328 billion by the end of the first quarter of 2012. Estlander’s even stronger rate of growth thus offers a welcome validation of the firm’s operating model and development.

“Clearly, the CTA industry has seen a lot of growth and 2008 undoubtedly put CTAs more on the map for investors,” says Estlander. “The growth of the CTA industry has been helping us.That we have grown faster than the industry I would probably attribute to the fact that we are different. Investors appreciate that.” Estlander has also intensified client service and business development efforts, including the opening of a North America office in Stamford, Connecticut in May.

Along with Alpha Trend, the firm has run a strategy called Global Markets since inception. It is a quantitative multi strategy futures strategy trading exchange regulated futures, but also liquid FX forwards. Research since 2004 has taken it into the realm of systematic intraday trading and hedging strategies. Global Markets, which has annualised performance of 11%, has earned slightly lower returns than Alpha Trend.

Global Markets is a multiple model strategy. It trades primarily in a short-term, high-frequency manner with some medium term trades. In comparison, Alpha Trend trades over longer timeframes. The combination means that roughly half the trades use price information to generate signals with the other trades being based on fundamentals-oriented information for taking signals. The result is a combination of multiple time frame trend following and systematic macro.

Some elements of systematic macro aren’t timeframe oriented. Here Estlander looks at factors other than price to determine where investors see the best return related to different risk opportunities. Once those factors are analysed a position is opened in the expectation that investors are likely to move in that direction, which will affect prices in a favourable way and generate performance for the strategy.

A love of markets
In common with so many other hedge fund managers, Estlander began trading on a discretionary basis after finishing university and soon developed an affinity for markets. His educational background, featuring studies in computer sciences and industrial management, provided apt preparation.

An early business move saw Estlander involved in setting up Sophos AB, an options market making business based in Stockholm. It rolled out in Finland, Germany and elsewhere, while linking with a UK partner to cover the London market.

The mix of options market making and his computer sciences background soon led Estlander to begin developing models for different types of trades. From there it was but a brief additional journey to the development of trend following strategies and passage into the emerging CTA world of the early 1990s.

“After we got our first client interested the business gradually evolved,” says Estlander. “We had a continuous focus on trading and research to a much greater extent than on asset gathering and business development.”

Investment process
What stands out in the firm’s systematic approach to markets is its focus on short-term price movements. It also has a different approach to risk management from other CTAs by working explicitly to control drawdowns instead of volatility. This is shown in the Freedom strategy. It combines equal risk allocation to Alpha Trend and Global XL, a double leveraged version of Global Markets. Launched in 2010, Freedom has attracted substantial capital in a brief period of time (See Fig.3).

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“With the Freedom strategy we combine Global Markets and Alpha Trend, providing systematic macro linked with price-driven models and really high-frequency, short-term models,” says Estlander. “I think the combination is fairly unique.” Certainly, the correlation with other leading CTAs is limited (See Fig.4).

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Research and development
What the strategies all sharein common is the firm’s investment in research and development. Estlander has long-standing and strong ties to the academic world and has been contributing university sponsorship in the region since 1998.

“Academically, we have a very strong team,” says Estlander. “Obviously, it’s extremely important to keep on refining and improving the models and looking for new ways of doing that.”

The goal of firm’s research is to develop a complete understanding of what causes phenomena to happen, how it can play out and the best way to design appropriate models. One area of work that has been in focus for a few years is exploring how to adapt and utilise new opportunities that have emerged from rising correlations in markets.

“We’re living in a market cycle of higher correlations and a risk-on, risk-off environment,” says Estlander. “In general, I would say research work is really a lot about coming up with the right ideas and coming up with ideas that are based on actual market phenomena that can be understood and put in a context. With the tools, research platform and highly-qualified team that we have, the implementation of ideas is fairly straightforward and we can be quite efficient. The key issue really is how the research is guided and how the ideas are generated.”

Robust risk control
Portfolio construction is based on a risk budget at position entry of 15%. The maximum historical drawdown for the Alpha Trend strategy is 18.1 %. The worst case scenario is always assumed, and risks are calculated and controlled based on the possibility of the strategy’s open positions being moved against by the market with a correlation of 1 or -1. Each trade also incorporates a stop loss and the aggregate portfolio risk is calculated as the sum of all open positions using the same stop loss methodology.

The way Estlander runs risk management is consistent with the founder’s origin in derivatives market making. Due to this background, more attention is paid to managing tail risk than balancing daily volatility.

“The aim of our risk management is always to make sure that the overall worse case tail risk is within pre-set boundaries, which can vary depending on the products,” says Estlander.

“We always use a proprietary risk management mechanism which is designed to try to identify the worst case scenario outcome. It is not based on a stress test from past events but rather from simulating events that we haven’t seen in the markets before and sketching out the worst case scenario. This is what the risk management is geared to control.”

The process works in a straight forward way. When worst case risk across the book increases, additional sorts of risk in incremental positions are correspondingly reduced. Given the dynamic nature of markets and the portfolio the process is ongoing and continuous. But its affect can vary considerably given different market environments.

In a slow market, the book has low risk as there are fewer opportunities to trade. As markets begin to move, the Alpha Trend strategy can be more aggressive since there is less exposure in the book at that time. As the trend gains momentum and more opportunities are created, incremental exposure that is put on is diminished as the overall exposure of the portfolio has grown.

Pragmatic about regulation
Estlander has been in hedge fund management for long enough to know that regulation is a pervasive and growing feature of global markets. He knows that regulation can’t be negated but instead requires careful management. So far, the Alternative Investment Fund Manager Directive doesn’t look like a game changer even if it looks like new measures to impose the use of depositaries will drive up costs. Higher costs to investors are also a fact of life with the UCITS funds Estlander has established.

“I can’t see that it (the AIFMD) will hinder our trading,” says Estlander. “Obviously I can’t affect regulation so we adapt to it as best we can.”

A challenging environment
The continued floundering of European politicians, the plight of the euro and the relatively modest dollar rally has probably provided fewer opportunities than might have been expected for CTAs.

“In general, it has been quite a choppy and challenging environment (in 2012) and at the end of last year,” Estlander says. “Certainly from the end of the financial crisis, from 2009 onwards, the market has been characterised by participants deleveraging their exposure. Typically this deleveraging phase leads to an increase in correlation and the sort of risk-on, risk-off behaviour we’ve seen in the market. Such periods are typically a bit more challenging for strategies like ours.”

Estlander is certain the cycle will shift at some point. However, he is reluctant to provide a forecast on the timing of this.

“It’s very hard to predict how the markets will develop and how they will evolve,” he says. “I think that the key benefit of the types of strategies we operate is that they are reactive and that they are reactive in either direction. It means they can capitalise in both rising and falling markets. You may not know when that is going to happen, but you do know that the models are prepared and will be reactive to capitalising on the situation as it develops.”