In Conversation with Mike Harris, Part 2

Trading programmes, adding models and risk management

EXTRACTS FROM TOP TRADERS UNPLUGGED PODCAST EPISODE #040

Niels Kaastrup-Larsen in his podcast, Top Traders Unplugged, interviews some of the most successful hedge fund managers in the world. In episodes 39 and 40 (sponsored by Swiss Financial Services), he speaks with Mike Harris, president of Campbell & Company. Campbell is one of the oldest CTAs still active, with a 42-year track record. The first part of the interview can be read in the last issue or on the Top Traders Unplugged website.

Niels Kaastrup Larsen: I wanted to talk a little bit more about the trading programme. I wanted to give you the opportunity to take us where you want in terms of describing it and so on and so forth, but I want to mention one thing that I noticed that I think is certainly an interesting topic and maybe that’s something you want to comment on: that is how you create a strategy, because maybe it’s a bit difficult for many people to understand how CTAs work. Some people look at data and create strategies from there, but you actually look at it from a slightly different point of view. You look at ideas and then you find ways of turning that into strategies, if I’m not mistaken?
 
Mike Harris: I think that your comment about the way we approach research is really key to understanding our strategies and how we come up with them. At our core, we’re really hypothesis-driven. We start the day with what we call an intuitive investment thesis, so someone in the research process comes up with an idea that’s based on a theory of economics, or financial markets, and then from there we use the data in our science to effectively codify that investment thesis. We then run the back-tests. We optimize, we work to make improvements to it, and then only at that point does the research team present it. We’ve got five teams in research, to protect against key man risk. Even though one individual may have come up with that idea, it’s quickly embraced by the team, if they feel strongly about it after they’ve vetted it at that level, and they’ve walked it through and they’ve created a framework for it – when they have a model that they’re ready to present in almost an academic-type framework.

If you think about how a PhD would defend their dissertation, in the same way our research teams have to go in front of all of their peers, and the other four teams effectively get to fully criticize the strategy and talk about the shortcomings, ask some very probing questions, and what we find oftentimes is that this is not an open and shut case. In fact, many times, the quants have to go back and do additional research, and really work on that model to answer some of those questions. They then come back and re-present. So this process can be quite a bit of back and forth and, in fact, sometimes models don’t make it through that very rigorous peer review process. But when they do, it then gets elevated to myself and Will Andrews, our CEO, our head of research, our head of trading, and our head of operations and technology, as well as several members of our risk and portfolio team who sit on our investment committee. Then we also go through a very similar review process, where we’re looking at how this strategy is going to be implemented, how it may fit into our portfolio, and really digging into all of the notes from the peer review process, to ask some additional questions about why we should add this particular strategy into our portfolio.

I think when you think about Campbell, because we’re a very mature manager, having been around for a very long time, we have really diversified our portfolio. At this point in time we’ve got over 30 production models in the portfolio. You have to make a very strong case to add a new model. It really has to be something that’s either unique or is much better than an existing production model in order for it to win a place in the portfolio. The other nice thing from an investment committee standpoint is that if we’re going to add a new model – say we’ll call it model 31 – into the mix, it’s not making a huge change to the overall portfolio, and so at the end of the day we’re able to just make small improvements over time, which once again, to your question about analysing the track record, gives more validity to the fact that we’re not “knee-jerk reaction” changing, taking one model out that’s 100% of our capital and replacing it with another model and then the investor says, “Well how can I believe your track record?” We’re really focused on making those small improvements, as I said, over time.

NKL: Now, let me ask you this question, because this is something that I’m not sure I personally fully comprehend the advantage of, and that is if you would just look at trend following: to me, at least, you can come up with many theses as to why markets move from A to B, but in reality it’s really looking at the data and coming up with models and strategies that are able to capture these price movements – not so much why they happen, because why does coffee move will be different to why do the bonds move. It’s really to me more looking at the data and saying, well we know these markets will move from A to B from time to time. Is there anything that we can develop that, applied using the same parameters even, will capture these moves in these very diverse markets? Can you explain to me the difference between the way you start looking at it and the way that maybe many other people (and maybe even including myself) would look at it and say, “Actually, let me look at the data first and see if I can come up with something that can capture these things in general without me worrying too much about why they move”?

MH: When you think about the overall process and when you think about how we create these strategies with an intuitive investment thesis, really what we’re doing there is saying that there is a thesis behind why we think this model should work. I know that we’ll probably talk about this a little bit later, but this really, from my standpoint, gets us to the core of where this belongs in our portfolio: why should we add it? If a regime comes along it helps us to identify, quite frankly, when models may need to be removed from the portfolio.

There are managers out there – I’ll call them data crunchers – that take massive amounts of data, and whether it’s pattern recognition or machine learning, or other types of technology, they really scrub the data and look for these relationships in markets, and then they trade them. I’m not saying that that doesn’t work; I’m sure there are many examples of people that have been profitable with those strategies. The downside in my mind is when you find one of these advantages you have no idea what’s causing it, which means you don’t know when it’s going to stop working. It could work for a week, it could work for five years.

I think one of the reasons that we’ve been around as long as we have is that we build models based on that economic thesis that we believe will stand the test of time. We won’t have to keep changing and building new models every couple of days, when maybe a relationship in the market is arbitraged out. In addition, I think you can expose yourself to significant loss when you don’t really know what the material reason is for why a market is moving. Now I’ll agree that time series momentum is something we’ve been working on for 40 years, so it’s probably more difficult for our researchers to come up with a new form of trend following, other than just changing the “look-backs”, than it is, say, in the non-trend-following part of the portfolio where there are many more degrees of freedom. So I think that we don’t have as many “ah-ha” moments where we’re adding new alpha sources.

I think the key for us, as I said is really twofold: one part is that we’re making small improvements to existing models. I think one of the important things to point out in that regard is that when we do that, we don’t let the researchers make just willy-nilly changes whenever they feel like turning the dial. They actually have to go through that same robust peer review process just to change one parameter in an existing production model. In fact, to safeguard against that, we actually years ago removed the production models from the research department and have them residing with a team called daily operations that sits on the trading floor and takes care of our strategies so that the researchers, there’s not even the ability for them to change production code. They’re forced to go through that very robust process.

Now on the other front, we also have projects that I would consider to be much more high-impact, if you will. That might mean we want to diversify so that, yes, we have momentum in the portfolio. And, yes, it was market-based for a very long time, but as I walked you through it in the last five years, we’ve actually found two new ways to trend-follow using baskets of markets in sector and factor. So even there, with enough thoughtful research, we were able to find a new form of an existing alpha source in the portfolio. And it applies the same way whether it’s carry, or cross-sector, or mean reversion: we don’t want to have all of our eggs in one model having that the mean reversion allocation. We want to have multiple versions of mean reversion to be trading in the portfolio, because we know that there are many different degrees of freedom that we can experiment with.

Other examples might be a new form portfolio construction or a new way to approach risk management – even as you alluded to, the information source or data that you are using. There are many different places to get data from. There’re different ways to approach the data, to clean the data, and so all of these I would see as much more of a high impact. They don’t happen as frequently in the research department as making small improvements to existing strategies.

NKL: I think that’s a great answer, and I think the point about also being able to easily identify when a model is not working any more, I think that’s a really, really important point. It’s something that I’ve seen many of my listeners come to me and say: “You really should make sure you ask people how they know when their models are not working.” So I appreciate that. I have a follow-up question on this about thesis. Take short-term interest rates: they’re pretty close to zero. Would this constitute something where you would say, “We’re not going to trade them from the long side any more”? Or maybe you just obviously could move them out further in time to give some more room in terms of the short-term curve? Is this, just to visualize an example, something that could constitute a change like that where you say, well, the thesis is, “Interest rates are not going to go below zero,” so we’re not going to continue to buy it at 99.9 when it gets to that point?

MH: It’s a great point to make, and in fact, that’s actually something that happened here at Campbell in the last few years during that quantitative easing cycle, where it was the race to zero by many central banks. So, because we had that investment thesis, we were able to go back and look at some of the strategies that were trading short-term interest rates, and to your point, in some cases we made the determination that we didn’t feel that the investment thesis allowed for trading short-term interest rates in the current regime, so we actually removed short-term rates from those portfolios. In other cases, we may have moved them further out the curve where there was liquidity – and things like euro, dollars and Euribor certainly have deeper liquidity moving out the curve. With the market expectation that interest rates were not going to rise until 2015, instead of trading maybe at 2013 euro dollar contract you move it out eight quarters to something closer to when the market believes there’s going to be a change in interest rate policy. That would be a great example.

I did want to mention, since we already started to cover this very important topic of when do you remove a model, and I mentioned that if the validity of the investment thesis is challenged: if we move into a regime where we feel that it’s not going to work, for us, there are three reasons why we would remove a model, and that’s actually one of them, but I do want to comment on the other two. The first would be that every model when it’s presented to both the peer review and the investment committee for approval has a certain set of performance expectations. Many people in the marketplace would define this as “the worst historical drawdown.” This gives you a metric to say, if the model is trading at this volatility, and we believe it should make this amount of money, and its worst loss should be this, then once again, just as our entire approach is rules-based, we can very clearly say, “These are some of the metrics or stops that we’re going to use as an investment committee as to when we’re going to pull a model or de-allocate it from the production portfolio.”

Then the third reason would be really just what I’ll call capital preservation. There may be an instance where if something happens very, very quickly – say a model loses or makes a significant amount of profit or loss in five days – and so you don’t have the time to really say, “Have we changed regimes? What’s happening in the world?” You can’t really potentially invalidate the investment thesis. Maybe let’s say the worst drawdown in the history of the model is 40%, and you’ve lost 25%, so you haven’t hit your stop effectively from a drawdown, but there’s something really interesting and unique and different about this so it’s causing you to say, from a capital preservation standpoint, “There’s something unique happening here that we don’t understand; maybe we want to de-allocate to this for a time until we get more clarity on that.”

I think that the important thing that I try to stress there is everyone thinks about removing a model from production when it loses money. We try to be very absolute when we think about performance, so if a model makes more money than you expect it to, particularly in a short period of time, that’s just as much reason for you to put up the hood and take a look at the engine as when you lose money, because both can be indicators that there is something happening with the model that you had not expected. The way that we do this really, our investment committee meets every single morning forabout an hour to look at our positions, what’s changed overnight or in the last 24 hours, to look at the risk in the portfolio and constantly reviewing the performance – both short-term and historical – of all of our strategies so that if we see something developing, we can address it quite quickly.

NKL: Very important point. Thanks for that. Now there are many secrets, I’m sure, to the success of your systems, but I wanted to ask a specific question about position sizing, because I think often people believe that it is where we buy or where we sell that really makes the performance. I would challenge that a little bit, because I think that position sizing and risk management is actually playing a really important role in the success of these strategies. What do you think about this topic?

MH: Well we think about risk, and I do, I think position sizing is just one of the elements within how you risk manage your portfolio. We define risk in two ways. We look at what I’ll call the vertical risk, which is really maintaining a stable level of risk within the portfolio. We do that using the systematic risk targeting framework, which is a model that helps you achieve your annualized risk target. We also look at what I’ll call horizontal risk, which is balancing the composition of your risk. And this is really where it comes into limiting your risk by market, limiting your risk by asset class, by strategy, and even looking at the correlations and looking into the key risk factors – things like flight to quality and global equity exposure, global bond exposure, commodities, some of the more common risk factors, to make sure that you don’t have all of your eggs in one basket.

One of the beauties of systematic traders is that we can trade 80 to 200 markets, and we are spreading our risk across many different positions. That in itself, that diversity, helps but you have to be careful because when you’re running a portfolio of 30 strategies, if 29 of them like a particular market and you don’t have systematic controls in your portfolio construction, they may all load up on one particular position and you would have outsized risk that you weren’t expecting.

So when it comes to specifically the market, we look at three factors: first we’re looking at the risk of that market, and there we focus on a VaR limit. We also have to look at exchange limits. We are a multi-billion dollar CTA and so in some cases we may, particularly in areas like commodities, be close to an exchange limit, so we have to monitor for that. Lastly – as I’ve talked about and something that is near and dear to my heart as a former global head of trading – we have to be careful about liquidity. So we’re always looking at how liquid is that market? What does the turnover look like? What are the trading costs associated with the bid/offer spread? We don’t want to be too big in a particular market that may not be as liquid, so in analysing those three – risk, liquidity, and exchange or regulatory limits – we’re always using the lowest of those three. So for any given market it’s different for us with regards to which one of those three we’re utilizing, but always constantly focused on that framework.

NKL: If you look at the example models that you were just giving there, if 29 out of the 30 models like a particular market, how does it work in practice? Do all 29 get allowed to get in, but then each has to take a smaller position and you adjust it accordingly? Or are you more focused on giving the models that identify a market opportunity in a particular market first full allocation of risk, and then you just cut it off after 15 markets, for example? How does that work in practice?

MH: There are really two ways: the first layer is that we do take the limits for each market and effectively spread them out across all of the strategies so that every strategy has an opportunity to trade a portion of our total aggregate position. So that’s kind of where we start. But there may be an environment where a number of strategies start to build a position in a market or maybe, as I said, risk can change. I’m sure that there were people a few weeks ago that had a certain sized position in, say, equities or currencies and then volatility triples overnight and the model is quickly saying, “Oh, I don’t need to have this big of a position on.” So you start to see some changes, whether it’s volatility spiking or going down, your positions can change quite rapidly.

Here the real benefit of having an independent risk model is that that model can effectively take what I’ll call offsetting positions to a strategy. What this does is it protects the efficacy of the strategy and its return profile, because the model said it wanted to put on 100 crude, but because of your total limits you’ve said that it can only take 90. So the risk model effectively takes a short position of 10 crude to reduce Campbell’s aggregate to only 90 in that strategy, but the model in its back-test and in its simulated returns still has on that 100 lot crude position. So that if that’s the decision that the model wanted to make, we can still validate that the investment thesis is working, and know what its true return profile would have been.

The other nice aspect is that the risk system effectively has a P&L so you can see over time how it’s doing. How much of a cost is it on your strategies, or how much has it saved you? We like to say that over time we like to see that line isolating around zero, where there are periods where it hurts you and there’s a cost associated with risk management, and then there are periods obviously where it helps you. And you don’t want to see it trend to that line: you just want to see it constantly slightly positive, slightly negative, but it’s important because I think that many people – and I think that this is where you have human beings doing your risk management and the construction of that committee changes over time, or people’s attitude about risk change – they may not have a P&L associated with the decisions that they make to curtail risk, and that can certainly have a real degradation of Sharpe ratio over time. So it’s something that we focus on, and it is very important to us to have that systematic approach to risk management.

NKL: I have a philosophical question now, and that is: often when managers first start, and when their AUM is relatively small, they have a certain attitude towards risk, and then suddenly they become bigger and they become successful, and very often what happens in any business (not just the trading business) is that people become more risk-averse, because suddenly there’s much more to lose. How do you think it effects our space, and is this the reason maybe that we see sometimes firms that when they do become bigger, suddenly their targeted value at risk or their targeted volatility drops significantly? How do you look at that? Do you target the same return, the same volatility that you did when you were significantly smaller, or how does that play in?

MH: It’s a great question. If I look at just Campbell as an example, one of the things that happens as you grow and develop as a multi-billion-dollar CTA, I think the natural tendency is that you do more research, you come up with more ideas. We believe, at our core, that diversification is what we’re selling as an industry. In many ways that low correlation of traditional assets is one of the main tenets that we already described. So we believe that not only are we diversifying our clients’ portfolios by adding our investment to the mix, but we also believe in diversity so much that we want to also really kind of spread out the risk within our own portfolios.

As we go through that research process, and we add new models to the mix that have a low correlation to the existing ones, that in itself, if you’re not doing active risk targeting, will bring down your risk profile. It’s one of the reasons that in the post-2008 period where we did a lot of active research, particularly around the area of risk management, we decided to employ this systematic risk targeting, where we’ve decided that 15% annual volatility as a target that we’re looking to achieve. We let this model, despite the offsetting positions of various lowly correlated models, effectively lever up and lever down the overall portfolio so that we can achieve that desired risk going forward. That 15% from Campbell’s perspective was arrived at because we felt that many investors are comfortable with the equity markets, as an example.

If you look at the long-term annualized volatility of the stock market, it’s about 15%, so we felt that that was something that investors had a reasonable comfort level with. Of course, when we talk to people and make that comparison, we’re very quick to point out the fact that risk in the equity market is an outcome; it’s not being targeted. Though you may arrive at a 15% annualized volatility, you may have an up 30% year and a down 40% year, whereas because we’re managing the risk in an active fashion, hopefully our tails are not going to be nearly as large, and at the end of the day we’ll come much closer. I think it’s about knowing your client and knowing what their risk tolerances are.

NKL: Sure, good point. Now, part of volatility, unfortunately, is downside volatility, and that brings me to my next topic, which is drawdowns. I want to try and help investors and potential investors and other traders aspiring to be the next Campbell to deal better with drawdowns, so I have two particular questions I would like your comments on. One is just from your own personal perspective: how do you handle the emotional roller coaster when you go through a drawdown? The second thing I’d like to ask you is how do we better educate investors so that they understand and feel comfortable with a drawdown? I think many people think of a drawdown as kind of an open-ended risk, and if they’re down 20% in a manager it’s never going to stop. What we know about these strategies is, it will stop, and it will turn around very quickly, and it will recover very often very quickly. So it’s such a shame to see many investors bail out at the worst possible time. How do we better help them?

MH: I think it’s hard because we care very much about our clients, and when the phones are ringing and they’re nervous and upset, that emotion sometimes gets carried on to myself and those around me at the firm. That said, I think we have the benefit of 40 years of experience, and we’ve done countless bits of research to show people that, in fact, drawdown recovery in managed futures is historically much better than traditional assets. I think the average drawdown that we’ve seen just in managed futures as an asset class is typically around seven months. If you compare that to traditional assets, we haven’t heard a lot about the lost decade for some time (because stocks have been on this tear for the last five years, up 130% in the United States) but prior to that we had 10 years of negative returns in the S&P 500. So it took literally 10 years to get to new high water. The drawdowns happened in all asset classes, in all strategies, and I think the important thing is that you’ve got to continue to stay the course, and have focus that the reason that there are back-tests, the reason that it’s a systematic process, is to take the human emotions out, because we continuously talk about the fact that human beings don’t make the best traders, and so we get someone to embrace that, and effectively allocate to asystematic investment process so that they’re not trading those markets themselves.

But then we get people who stop trading the markets – what do they start doing? They start trading managers. Instead of the P&L of gold, they’re seeing the P&L of the manager, and they start to get nervous as they see losses. What I try to tell people is that things you should focus on, just like when we do risk management on our existing strategies, when you invested in the product, what were the performance characteristics that you were sold on? What were your return expectations? What were your drawdown expectations? Have you exceeded or not achieved those? That should be number one on the list. Then, has there been style drift? Does this manager claim to be a medium or long-term trend-follower, and they’ve got a negative correlation to the Barclays Newedge Trend Index?

I think also, as people are doing more and more due diligence, you also have to focus on the operational side of the business. Are there concerns there about the management team, or about the way that the firm is organized, of their long-term viability? To me those are more of the things you should be focused on. At the end of the day, there are countless examples that you need to just stay in the investment, because you never know when that turn is going to come. Oftentimes we see that people sell at the absolute worst time, which is at the bottom of a move. We have focused on some interesting research recently on what I’ll call drawdown control models, to try to see whether or not we ourselves can put an overlay on top of some of our models to help control the amount of what I’ll call volatility of returns. As we’ve gone out and talked to our investors, the findings were that, yes, they can potentially work and they limit some of your drawdowns, but they come at a cost. So as we talked to (particularly) institutional investors, what we find in many cases, they recognize this. They see a degradation in the Sharpe ratio as a result of a drawdown control system, and most of them say, politely, no thank you.

That said, there are some investment products out there with investors seeking less volatility, and we see this as something about which in the future we may continue to talk to clients, and with which we may experiment – effectively providing that utility to clients to keep down the noise of whether it’s daily P&L, weekly, monthly, quarterly, or annual P&L, to smooth out the ride a little bit. One of the popular anecdotes I’ve heard from some of the investors on the institutional side in the United States was, “Don’t get me pulled in front of my board. If you’re down 2%, I don’t get pulled in front of my board. If you’re down 4%, we’re having a conversation, and people who are less educated about this than I am are going to demand that they pull the money from the strategy, and I’m sure that will be just the time when you guys recover from your drawdown.”

So, at the end of the day, as I said, the jury is still out. We believe that for some clients it might make sense. For others it does not, but the example that I use with many investors is a little bit like an equity investor: you can go out every year and buy puts on the S&P to give you some portfolio protection, but you’re going to pay the premium to do that, and that may degrade your long-term return. If you are, in fact, a long-term investor who’s comfortable with the equity market and the risk that is the outcome of it, then maybe you just put the trade on and hold it and not sell when it goes down 20% or 30%.

NKL: Now speaking about risk management, just a final question I had here: because clearly you spend a lot of time managing all parts of risk in your business, in your strategy, etcetera; is there anything when you go to bed at night and you put your head on your pillow that you think, “I wouldn’t want that to happen”? Is there anything that could keep you up at night from that point of view?

MH: There are plenty of things that keep me up at night. Fortunately, because we’re systematic, the markets are usually not what keeps me awake. In fact, we run a 24-hour-a-day operation in Baltimore. We have teams who trade the Asian markets and the European markets for us, as well as operational and support staff, so for that regard I don’t have to stay awake worrying about the markets. Both our systematic modelling approach and our approach to risk management in a rule-based fashion allow me to not worry in the same way a discretionary macro trader or manager would have to worry about, “What’s the BOJ going to do tonight at their meeting?”

The things that keep me awake are other forms of risk. Certainly systemic risk, whether it’s a terrorist attack like 9/11 or more of a natural disaster like the earthquake and tsunami in Japan that created a nuclear crisis. As an investment committee we don’t have to intervene very often. It usually happens every couple of years, but that was an environment where we had to move in and take action, where we actually took our positions off in all of the Japanese markets because we were hearing from the market participants in Tokyo that they were fearing a nuclear cloud coming from the meltdown, and that many of them were leaving Tokyo, and that there was fear that the Japanese exchanges were going to close and not re-open for a period of time.

The models with their data can see almost everything, but things like those systemic risks they can’t see, and there are times when we have to step in and take action, so those types of things keep me awake.

Counterparty risk? We haven’t heard about it a lot because as we put more and more distance between us and Lehman Brothers it’s not as focused on, but I do think there will be another time where we will face the failure of a counterparty, whether it’s a big bank broker-dealer, or somebody – a smaller player in the futures or in the FX markets. I like to tell our clients that we have a very robust framework for monitoring all of our counterparties, and that we’ve worked over the years to spread out our counterparty relationships so that we’re clearing accounts at multiple firms.

When I say that, I mean not that we as a firm have multiple relationships with different clearers, but we actually take large accounts and split them so that they have open accounts at two different clearing firms, so that in the event that we have to move business, not only is the documentation papered up, but the pipes are open and flowing and tested and we can literally do that in a day. I think that’s important, because if you think about it, Lehman Brothers unwound in about two months. MF Global took about two weeks, so if the next counterparty goes down, in two days, people will have less time to respond.

The last one that I’ll just mention is redundancies. I don’t think that really people focus enough on their business continuity plans. I think that having things like a secondary location, if you only have one primary building like we do, having back-up power, having generators, having back-up telecoms, the various infrastructure hitting your building – in some cases in multiple places – taking multiple routes to get to wherever your destination is. I think that those are things that I worry about. I worry sometimes that other industry participants take those things for granted, but we live and breathe this stuff every day.

NKL: What about regulation, Mike? I’m thinking here as something that would not necessarily keep you awake at night, but certainly here in Europe we’ve seen from time to time that regulators, when equities go down, decide you can’t do short selling anymore. Do you foresee or could you foresee regulators really making it difficult for us to trade these kind of strategies at some point?

MH: I think there’s always that risk. One of the real benefits of managed futures is that we’ve always embraced trading on regulated exchanges, and so in that sense, in many cases, I’ve told people that the current regulation that I think the marketplace is dealing with – specifically things like Dodd Frank – may actually be a benefit to our industry. Because if you think about it, what they’re doing is taking all of the OTC interest rates, swaps, and CDS, and they’re forcing them into a central clearing model, so they’re pushing them onto exchanges which is making data more available. It’s certainly upping the regulation and the control around those markets, and it may actually open up some new opportunities for the managed futures space to be able to trade a wider array of markets. Most of the regulation in its current form is not focused on us, but I’d be lying to you if I said that that’s not another thing that keeps me awake at night, because we’ve seen certainly the pendulum swing in the last five years from an unregulated marketplace to a much more regulated one.

From an industry standpoint, it’s a bit upsetting to me because I love the fact that three guys could leave a particular firm or a bank and go out with an idea and start their own CTA, and unfortunately I feel that the barrier to entry has become so great. I’ve seen some wild estimate that at a bare minimum you need $50 million to $100 million to get a business started, and in some cases more in order just to hire the legal and compliance folks to help you. As a large manager, Campbell’s very fortunate that not only are we heavily regulated in the United States and abroad, and have been for years, but we’ve built up a team to be able to deal with this. So as a business person, I worry about running the company, just like our head of research worries about creating new strategies and looking at our production portfolio. Even though I seem to be inundated with it every day, I don’t have to live and breathe and read every single rag, because I have a team of people doing that for me. I think that’s unfortunate for our business, but it’s just a consequence of some of the bad actors that the marketplace has experienced in recent years.

NKL: Sure, Absolutely. Now my “final research question” is somewhat broader: we’ve had 30 years of essentially falling interest rates, and I know that you have done some looking into this and some research about how these strategies tend to perform when interest rates go up, so perhaps you could share a little bit of insight to what your findings have been?

MH: Sure. We actually did the research and wrote a white paper on it last year. I have to say, because it’s such a topic in the global marketplace, that the uptake on it has been incredible. I’ve never seen a white paper have this much shelf life. eVestment in the US did a study a couple of months ago of all of the various categories of institutional investors, and I don’t think it was surprising that every single category listed, as their number one macro risk that they feared, higher interest rates. Hearing this from the larger audience and from our clients in particular, we did this research going back 40 years, not looking at Campbell per se, but looking at the performance of a very simple basic trend-following model during periods of higher interest rates. We found that in a period of higher interest rates, CTAs were historically more profitable than in periods of declining interest rates, which is a bit surprising given all the money that CTAs have made from declining interest rates in recent years. We found that there were really three important drivers for that performance.

The first one is probably the most obvious to investors in the space, and that’s because we’re accessing the futures markets, there’s that implied leverage, whereby 80 cents of the dollar invested with us effectively goes into a cash account and is sitting in treasuries. While that’s gotten us very low yield – just a matter of basis points in the last few years – as interest rates go higher the interest income associated with managed futures will go up and provide a tailwind to the strategy.

I think, more importantly, the other two major takeaways were for many investors who aren’t familiar with managed futures. They don’t realize that as an actively traded long/short portfolio, we don’t have a bias to be long fixed income like many managers do. So as effectively the trend changes and we start to see interest rates trend higher, obviously bond prices are then trending lower, our strategies will pick up on that, effectively enabling us to go short which, once again, is something that, unless you’re investing in a CTA or a global macro manager, is probably not something many strategies are doing. We’ll effectively – like equities in a downward-moving price environment – create a little bit of a diversifier hopefully in people’s portfolios for the fixed income that they’re not going to be able to exit in their portfolio.

The last thing is that we found in our research that in many of these periods where interest rates go higher, there was at some point an equity market correction. I think that makes intuitive sense. Central banks are raising rates to effectively tap the brakes on growth, and sometimes they tend to tap them a little too hard and things slow down. Spending both on a retail and on a corporate level is reined in when interest rates go up, which leads to lower corporate earnings, less consumer spending. That in part can lead to an environment where equities may turn over. Our ability to be short both bonds and equities in that type of environment can be a real benefit.

NKL: This podcast, essentially Mike, is allowing me to ask questions of the best minds in the business that I’m personally interested in and curious about, but I wanted to give you a chance and say, if you were to ask a question of my next guest or peer in this business to you, and maybe even the guest would be the biggest in our business, David Harding, what would you be curious about asking him?

MH: I think more than anything the question that we always feel is not asked enough in our industry is around how a manager approaches risk management. I think that you’re very well versed in our space, so you’ve asked a number of questions about it, but just in using recent due diligence visits as an example, we tend to spend multiple hours just describing our strategies, how we build them and the alpha that we’re seeking to extract from the marketplace, and we spend almost the entire day focusing just on the strategies right in that process. Then literally in the last 15 minutes before somebody has to leave to catch their train or their flight, at the very end of the list they say, “And tell me about your risk management process.”

I just think that that’s a real oversight by many people. Some don’t ask it at all, others don’t leave enough time, and so I would spend a lot more time focusing in on the risk management both the process, how it was built, what you’re doing as far as future research goes. Because at the end of the day it doesn’t matter what alpha strategies you have in your portfolio, we really believe that risk management is the difference between a good manager and an OK manager. So if I were to ask a question to another manager, if I was doing due diligence on a CTA, I think that that would be my number one question: tell me about your views on risk management, and how you believe you have a competitive edge in this space?

NKL: Fantastic, great stuff. Now last section that I have is what I tend to call general and fun, so a little bit different to the more strategy-specific questions. I wanted to ask from your experience, if there’s someone sitting out there who really would like to find out what it takes to become a great trader or build a great firm, or whatever it might be, what are some of the things that you think a manager or a person needs to possess in terms of traits or crafts in order to become successful?

MH: I think without a doubt humility is at the top of the list. You’re going to be humbled in this business. You’re going to be humbled in the markets. You’ll be humbled as a business owner, as somebody approaching difficult environments, so I think that’s at the top of the list. In addition to that, you have to have integrity. You have to have passion. I tell people it’s one of my favourite interview questions: “What gets you out of bed in the morning?” and there are people that absolutely live and breathe the financial markets and love it. I tell folks that one of my loves as I mentioned was sports, and in particular I love to play golf. The reason I like to play golf is the same reason I love the financial markets, and that is until I go out and shoot a perfect score of 18 (which between you and me is probably never going to happen) I’m always motivated, because I know that there are always things that I can do to improve, and financial markets are no different. If we’re up 15% this year, I’m going to be asking myself, “Why weren’t we up 16%?” and I’m sure our clients will too. So it’s a problem that you can never solve. I think that having that passion, that competitive spirit, is crucial to being successful in this business. Then without a doubt I think communication. You have to be willing to be open and transparent. Hopefully, you like speaking with other people around the world, and you do a good job of communicating your message.

NKL: Now, based on everything that you’ve learned, Mike, if you could go back and start and talk to your younger self, what would you tell yourself? What would you do differently based on everything you’ve learned in this business?

MH: It’s funny you should say that, because I clearly remember in the early days of my career in New York, I’m sitting on a trading desk and probably working a double shift between the European markets and the US, and I remember one of the older guys on the desk saying to me the words “work/life balance”. It was the first time that I had heard that, because having read all of these books and started my career on Wall Street as a young, hungry individual, I only knew one word out of those two, and that was the work, not the life portion. He said to me, you’re going to be a happier employee, you’ll be a more productive employee, and you’ll last longer both on this planet and in this industry if you remember to always have that work/life balance. I think that when I think about the life portion I would really break that into health and family.

I think it’s so important that you take the time. It’s really easy to get busy with all of the things that we do, to fall into the trap of eating poorly or not working out. We all know in this industry that with all the travel that’s involved, trading 24-hour-a-day markets, that it’s easy to not spend enough time with your family. That’s time that you never get back. I have two young children with whom I really enjoy spending time, as well as my wife, and even in the last 10 years I wish that I had done a better job of managing that work/life balance. As a leader it’s something that I talk to my employees about on a regular basis. I want to make sure that they try to live that out, since maybe I didn’t listen as well in my early 20s.

NKL: I asked earlier that if you could ask a question of someone that investors fail to ask you or don’t know to ask you, but let’s also turn it around to me: what have I missed today?

MH: No. I think that you’ve done an incredible job of covering not only the industry, but Campbell & Company, its history and where we are presently. I think the most important questions to ask at this point, which I’m guessing is your last one, is what does the future hold for Campbell and for managed futures?

NKL: Absolutely, that is my last question, so please go ahead.

MH: Great. Listen, I get this question, as we all do in the industry almost daily, and you alluded to the fact that during that tough period of performance over the last four to five years many folks in the world asked the question, “Is managed futures broken? Does it work? Will it work in the future?” Not only am I pleased that in the last six to 12 months that performance of managed futures has gotten considerably better, but it’s done so in a period where traditional assets aren’t doing nearly as well as they were the last five years. So I think people are starting to wake up to the fact that they do need to have diversification in their portfolio, and that there is a value to having lowly correlated strategies in the mix.

We started doing some research in recent months asking the question, “What do the next five years hold for managed futures?” and obviously that includes Campbell & Company. I thought it was interesting that the national economic bureau put out some findings recently where they were making an observation that if you consider September 2009 as the low, we’ve effectively just hit the five-year mark in this business cycle. They made mention of the fact that this is the longest business cycle in the post-war period of positive growth, so asking ourselves, is there something magic about that five-year duration?

Looking at different asset classes over a five-year duration, we found that certainly equities have had a great run in the last five years – up 130%, as I mentioned before, and then as I also mentioned, the five years before that unfortunately were a negative period, so were the five years prior to that – 1999 to 2004 were also negative. Then I’m sure we all remember that equities did incredibly well in the late 1990s with the NASDAQ and the tech boom, so we saw this cyclicality every five years or so in equities. Then we started looking at managed futures and other alternatives, like commodities in real estate.

What we found is that over those four five-year cycles, the last five years haven’t been particularly good for managed futures. All three of the five-year periods prior to that, including the two where the equity markets were negative, were very positive for managed futures, so as we look to the future and we think about, from a macro standpoint, that central bank intervention is decreasing, that though we are still continuing to see stimulus in places like Japan and Europe, certainly the UK and the United States are in the process of removing the stimulus and, in fact, contemplating higher interest rates. So as we’re moving back to a “more normal period” and there’s a shift in the regime out there, maybe this leads to a bit more volatility or even some loss for traditional assets.

I feel that, at least in recent times, it has certainly created a number of opportunities. One example would be in the foreign exchange markets, which haven’t produced a lot for managers like ourselves in recent years with the lower volatility as central banks all have the race to zero. But recently, as we start to see this deviation between the Fed and the Bank of England raising rates and the ECB and the Bank of Japan cutting rates and providing more stimulus, we’re seeing realdivergences – not only in interest rate policies but also currencies, as people globally are trading the carry and the imbalances there.

I’m very optimistic that there are some great opportunities out there on the horizon for managed futures, and I just hope that people recognize that and start to allocate early and often – as opposed to waiting like so many did to invest in January of 2009 after the performance came, after the traditional assets suffered (and then the media writes the article to say managed futures did such a great job and people said, “I don’t have that in my portfolio, so it’s time to add it”). I think people need to remember that period and learn from it. If they don’t have diversification right now in the portfolio in whatever form they choose to embrace it, I would highly recommend that they move in that direction.

NKL: Well said. I think what many people don’t, or maybe haven’t really noticed, is that a lot of these well-known managed futures firms are actually getting back to close to or at new all-time highs. That’s gone pretty unnoticed in the last six months, so it is a very important point. That only leaves me to say thank you ever so much for taking up your time. It has been great fun, incredibly educational, and very inspiring to talk to you, and I hope that we can do this at a later stage again.
 
MH: Thank you very much. We really appreciate you doing this on behalf of the industry. We have, as you said, been educating people about the benefits of managed futures for over four decades, but we need help, and you’re doing such a great job of that.

NKL: Great stuff, thank you so much, Mike. Take care.

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