When lecturing at the London School of Economics, erstwhile Bank of England monetary policy committee member Sushil Wadhwani has argued that monetary policy sometimes needs to “lean against the wind”. The same principle applies to his investment strategy, which sometimes fades the prevailing trend. While Wadhwani uses momentum models, he differs from some CTAs in also deriving trading signals from non-price data. Sometimes, the non-price signals are strong enough to outweigh the momentum inputs.
If 2008 was a great year for momentum anyway, Wadhwani twice traded against the bear trend and successfully captured two counter-trend rallies: one after the rescue of Bear Stearns in March 2008, and one before the failure of Lehman in September 2008. Wadhwani thinks that these non-price inputs have added a lot of value. He points out that his strategy, scaled to the same volatility as the New Edge CTA trend sub index, has out-performed by an average 6.5% per year for the past 5 years. This approximates the contribution from broader inputs, which include economic fundamentals, sentiment, fund flows, inter-market linkages and valuation. This approach impressed Caxton Associates, the well-known macro fund originally founded by veteran trader, Bruce Kovner, who made a significant allocation to this strategy and made Wadhwani a Partner.
Much of the Caxton fund is run on a discretionary basis and, although the Wadhwani fund is primarily systematic, it has occasionally exercised discretion in two main areas: risk management, and model evolution. In August 2007, for example, Wadhwani decided to cut exposure across all markets and strategies traded. The decision was motivated by several seminal policy and market events: the European Central Bank’s first injection of liquidity; the suspension of liquidity by BNP Paribas money market fund; and the widening of the LIBOR-OIS spreads (between interbank and government interest rates).
Wadhwani admits that he was just not sure if his models would be able to cope with the uncharted territory that markets were entering. In the event, 2008 turned out to be the best year so far for the strategy. Nevertheless, Wadhwani remains ready to reduce risk when he and his teams are struggling to make sense of new market phenomena.
The second possible use of discretion is common to most systematic funds, in that Wadhwani’s team of 13 quants do make judgements in deciding which markets and signals to trade. The strategy has sometimes traded single stocks in the past, and it could trade equity sectors, but currently it trades neither. Similarly, sovereign debt spreads were recently fed into some models – but this too could change in future.
The UCITS fund differs from the offshore fund in avoiding commodity markets, and in having a somewhat lower risk target. Its one month, 99% Value at Risk target of between 7% and 9% is also less than half of the 20% ceiling for a UCITS fund. VaR is monitored daily by the Risk Management Committee, which also sets limits that include position size, stop-loss orders and take-profit orders.
Wadhwani, who has also designed investment systems for Tudor and Goldman Sachs, has an optimistic outlook for the strategy. He sees “so many macro-economic disequilibria in the world” that are likely to unravel – and then lead to big trends. The declining yen and appreciating Nikkei represent “stage one” of this process and plenty of other mispriced markets could break out soon, he thinks.
Whatever the short-term prognosis may be for the strategy, Wadhwani argues that CTAs deserve a permanent place in portfolios, as they have historically provided excellent diversification benefits for investors in conventional asset classes such as bonds and equities. His analysis, using data right back to the 1970s, suggests that CTAs have been profitable on nine of the ten worst 12-month periods for a portfolio comprised of 60% equities and 40% bonds. In particular, Wadhwani points out that the 1970s witnessed instances of synchronised falls in bonds and equities; the strong performance of CTAs in that decade demonstrates that they have not provided portfolio insurance merely through being long of bonds.