Looking Under the Hood, Part 2

Factor-based indexing, innovation, risk premia and IBM’s Watson

THE OPALESQUE UK ROUNDTABLE

The Opalesque 2014 UK Roundtable was sponsored by Salus Alpha and Eurex and took place at the London offices of Eurex. The following article comprises Part 2 of the discussion. Part 1 can be found here. Participants included:

Renaud Huck, Eurex Group
My name is Renaud Huck. I am senior vice president at Eurex Group, which operates the largest derivatives exchange and clearing house in Europe.

Antoine Haddad, Bainbridge Partners
My name is Antoine Haddad. I am the founder and CIO of Bainbridge Partners, a wealth management company based in London. The firm was established in New York in 2001, and relocated to London in 2008. We currently manage close to $850 million in assets, and have a total of 15 professionals on our staff.

Stuart MacDonald, Aquila Capital
I work at Aquila Capital as a managing director. Prior to this, I have worked with alternative investments in a variety of roles and on different sides of the fence, with both single and multi-manager firms.

Akshay Krishnan, Stenham Advisors
I am the head of macro strategies at Stenham Advisors. Stenham has been investing in hedge funds since the late ‘80s. We have got about $2 billion in assets under management split between commingled funds of funds and bespoke portfolios. I am the portfolio manager of Stenham Trading, which is our flagship macro fund of funds that has been running since 1993.

Nacho Morais, Pragma Wealth Management
My name is Nacho Morais. I work for Pragma Wealth Management. The company could be defined as a family office, in what pertains to our investor base; although we are more akin to an institutional allocator in the way we approach our investment activity. I have been a hedge fund allocator since 2001, working mainly at Omega Capital, CM Capital Markets, and, since 2007, for Pragma Wealth Management.

Oliver Prock, Salus Alpha Group
My name is Oliver Prock. I am CEO, Salus Alpha Group, and CIO of Salus Alpha Capital. We have a global presence with 35 people and operations in Singapore, Hong Kong, India, Switzerland, Austria, and Liechtenstein.

Ewan Kirk, Cantab Capital Partners
I am Ewan Kirk. I’m the CIO and co-founder of Cantab Capital Partners, which is a systematic fund based in Cambridge in the UK. We are about 50 people, around 30 of whom are fully dedicated to research and development, so we are a very scientific and technology-driven firm.

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Akshay Krishnan: I would love to hear your views regarding the regulatory environment. At Stenham, we are focusing on three new products that all have a theme related to the regulatory environment, albeit in different ways. We launched a credit fund of funds last year, which is focusing more on just the bank deleveraging opportunity in Europe and invests in distressed managers who can take advantage of that. We are thinking of launching a UCITS macro fund of funds, where we will look at both systematic and discretionary strategies. We have that lined up for later this year, and this fund is also relating to regulation regarding offshore investing in Europe.

But perhaps most interestingly, we launched a healthcare equity fund of funds last year, so that one is based on regulation in a very different context. There is a lot going on in the healthcare space with Obamacare, changes in the approval process within the Food and Drug Administration in the US and plenty of M&A deal activity as well. We are very excited about this healthcare-focused fund of funds we launched last year.

Just shifting tack, maybe this is a question for Renaud, in the macro space when it comes to regulations, I am hearing a lot about swaps clearing, and about dealers not having the appetite for repo financing and what this might mean for people who rely on that. You talked about the launch of repo futures, is that right? I am just curious to hear more about that?

Renaud Huck: It is true that with 2008, the regulators globally, at the G-20 summit in Pittsburgh, decided to implement a new regulatory framework; first to come was the Dodd-Frank Act; in Europe it’s EMIR. In doing so the regulators basically raised their hand and admitted that they didn’t have a very strong oversight of the OTC market condition and situation. The largest asset class is IR swaps, so they decided to mandate these products on both sides of the Atlantic. It has to be said though that, for example in Japan, they are mandated too; other Asian regulators are also looking at mandating interest rate swaps. But as far as Europe is concerned, the European regulator, ESMA, has decided to mandate via EMIR the post-trading element, i.e., the clearing of interest rate swaps.

Stuart MacDonald: So did interest rate swaps close the process of innovation?

Renaud Huck: No, it’s purely CDS-related but – well, CDO/CDSs – but it’s true that because they didn’t have the upper hand, then, well, they had to start from somewhere.

Stuart MacDonald: We had CDOs before the crisis; they were just a symptom rather than the cause of the underlying malaise.
Renaud Huck: You are right, the real estate market with the sub-prime issues in the US was a factor and there were different elements at play as well.

Ewan Kirk: The other thing is that if CDOs would have been centrally cleared, everyone still would have lost money.

Renaud Huck: It is difficult to say so, considering that some of the products that were involved in these circumstances have never been cleared. It is impossible for us to know what the benefits could have been if they had been cleared. In retrospect it is hard to say. The approach that the regulators seem to have taken is to focus on the large asset classes, where on a daily basis a high level of activity and transactions are executed – in particular where from the regulator’s point of view it is difficult to assess and measure key components such as the net asset value, value at risk, etc.

From a listedexchange perspective, we are conscious that there are difficulties when you try to integrate within your existing processes something that is very new to the exchange-traded world. It is very disruptive because the post-trading process and analysis of bond futures is very different from an IRS product. The risk component and risk analysis are very different and, as you can imagine, a clearing house is a very conservative structure, which looks over and over again at the risk parameters. In the case of swaps, CCPs are initially faced with a product that is very different, which has a very different geometry, very different components, and then you have to acquire the understanding on how to clear that instrument.

These were the questions that our clearing house had to ask itself – can we clear those products? Interest rate swaps are perhaps fairly easy to understand in terms of their mechanism, but there are some products, like swaptions, which are far more complex. It’s true that if you look at it from a very holistic point of view, there are products which are easy to integrate within a clearing house, some of which are more difficult, and where one can wonder what the benefits are going to be, and whether it’s really possible, and even whether it is necessary. Not all markets necessarily need to be heavily regulated; some markets do work perfectly the way they are and the way they are structured. We look at it from a service provider viewpoint with a very strong vested interest; the regulators look at it from a very agnostic, a very superficial view. We pay a great deal of attention to this because that is our role – we have been created to serve this industry.

Akshay Krishnan: Do you think that we will see more dealer appetite? As the swaps are being given up to the exchanges, will that mean the dealers will engage more and be more active? What we have heard is perhaps the opposite, that the appetite to take any, even market-making risk, has not really gone up. I am just curious how this plays out?

Renaud Huck: There are two sides to a coin; the first one is that dealers are not charities. Investment banks have shareholders and they make their business decisions with them in mind, looking for the best returns from transactions. A few years ago, they were the dominating force of the OTC space. Also, investment banks are very flexible. Throw them any regulation and they will bounce back. It is interesting for us to see that yesterday they were completely against; tomorrow and today they are more in favour, and are willing to be more active going forward.

However, I do feel that the sentiment is changing. Earlier you were alluding to repo futures. It’s true; the buy side will find difficulties with extending credit lines, refinancing capabilities, so other possibilities will have to be offered. An alternative can be repo futures – or perhaps this is the start of a whole new path.
Antoine Haddad: What I can add is that any time a security or a liquid market moves to a listed venue, you also open up that market to a whole new set of players, including systematic players. Most systematic players are very hungry for data that is clean, consolidated and normalized, and the liquid exchanges do that for you. So in general, listing something on an exchange is certainly a step towards improved liquidity.

Matthias Knab (Opalesque): We had some references in this discussion about the difficulties of discretionary macro managers in this environment. Akshay, you manage a macro fund of discretionary traders, what was your experience in discretionary for the last couple of years?

Akshay Krishnan: To be honest, it has not been that bad for macro. Last year was actually a good year for people. There was obviously the Japan trade and there was the short US fixed income trade in the middle of the year, and EM weakness, which people participated in, so it has not been that bad. I think this year has obviously been a bit more challenging as some of those themes haven’t worked, but I think in general it’s what people have alluded to. I guess we have been in a market regime since ‘09, which has been very pro-risk, and volatility across all asset classes has been very suppressed which has been a headwind for macro.

I guess our view, which may be wishful thinking, we think maybe we are coming towards the end of that regime, and as you kind of have some monetary policy normalization, maybe you have renewed opportunities for interest rates and foreign exchange trading, which is really the major part of the toolkit for these guys. But no one has stood still. I think people have found ways to adapt to the environment, and for us as allocators we have had to be a bit more inventive and just don’t buy the big blue-chip guys alone, but look for emerging managers, smaller managers, people who are a bit more tactical, trading-oriented, focused on specific niche markets. Like in Asia, for example, there have been active central banks and monetary policy divergence over the last 12 months, so an Asian macro fund has found decent opportunities, especially this year.

Matthias Knab: Nacho, you are also an allocator, how have you been navigating those last couple of years?

Nacho Morais: Reasonably well, actually. I think the asset mix that we had helped us here. For instance, we started getting out of EM macro quite early, which was good in the face of the drain in liquidity that happened in the sector, since the tapering was verbalized in May 2013. On the fundamental long/short equity side, I think we have done pretty well, too. We have been able to put together a stable of managers that actually have been able to navigate the regime of 2012-13 well, and take advantage of opportunities, whilst not getting killed in some of the situations that we had earlier this year in their space.

With respect to the latter, at some point earlier this year, the market went short crowdedness. Despite some managers being impacted by it, in general we managed to have a sufficiently diversified portfolio to digest that, and actually some of our managers did well in that environment. I think that also tells you what sort of differentiation you have on managers. For instance, you could see that basically during all of 2013 and the first part of 2014, there was a very clear trend, in the form of outperformance of growth stocks versus value stocks. This was firstly prompted by the expectation of tapering, meaning that you would actually need EPS growth in order for a company to experience share price increases. Having a stable, quiet cash flow would no longer be the asset it used to be. Secondly, some sexy single-stock stories in the hyper-growth camp went parabolic within this environment. All this became a crowded, one-sided market and massively reversed when there was no marginal buyer left for the trade.

You could see a lot of funds actually following that pattern of return, not by the millimetre, but very closely, so a lot of the return could have been replicated. One has to analyse whether this is a situation that happened just in this time frame or if it is something structural to the style of the manager that I can then replicate in a simpler, cheaper strategy. Is the differential in fees that I am paying worth the potential differential of return with respect to the passive strategy?

May I introduce one question on the point that arose on the transition from OTC to exchange-settled markets and how it would also result in clean datasets? Do you think there will be certain effects or consequences for the quant trading sector? Is this more of an opportunity for quant managers to step in on the base of that clean data, or more of a barrier to entry vanishing for those managers who already had their own data from their OTC activity and used that to get a competitive edge, which is now fading?

Ewan Kirk: Let’s take interest rate swaps as an example. Interest rate swaps have been traded for a very long time and there is good data on US swaps, German swaps, and Japanese swaps going back 20 years. Even in the early '90s there was basically a choice market on a 10-year interest rate swap – it was that tight. I am sceptical that the exchange is going to be able to reproduce that. So there is lots of good data on interest rate swaps, but the problem with interest rate swaps, and let’s take US swaps as an example, is that although they are different from the 10-year bond, they are not that different. If the 10-year bond goes down, the interest rate swap goes down as well. They are very highly correlated. If you look at the Eigenvectors in the group or assets, adding interest rate swaps into a typical mix of fixed income futures doesn’t give you any more diversification. Adding in electricity, which is very illiquid – we don’t trade it, but I know some people do – is really different and totally un-correlated to everything else. So it might add some value, but for the things that are being cleared now like interest rate swaps or currencies, those are not the things that we are short of liquidity.

On the other hand, one of the issues of new asset classes is that, unlike with interest rate swaps, there isn’t a 20-year history for power or credit. With so many changes in the regulations, in the structured CDS contracts and so on, this proves to be quite difficult. Meanwhile, in the large established markets you can access a lot of history. Obviously, the one series that everyone knows going back to 1929 which is the S&P – the whole market and academic community knows that 100-year history of US stocks. With controlled currencies and Bretton Woods, currencies are meaningless if you go before 1971. The first commodity contract was heating oil in 1983, and then everything else is post-1980 or 1990.

So we don’t really have a lot to play with. Yes, it’s great that we are bringing new things on like power, heating degree days and frozen shrimps and maybe my children will run a hedge fund based on that in 30 years’ time, but not us.

Oliver Prock: So I think that was a “no” to Nacho’s question if quants would trade new asset classes like listed interest rate swaps. I would also say no, and that is despite allocators wishing for that to happen, but what I wanted to point out here is that we are probably a bit too optimistic on the regulatory side. One of the main issues here is that on the one hand the industry doesn’t have one voice and that on the other hand the regulator seems to be have lost the view on smart regulation and interferes with all aspects of the business in a way that does not really make sense, and I wonder if at the end they will undo and roll back…

I believe the regulator is in uncharted territory, and they don’t know what they are really doing. For example, Germany comes up with this algo trading regulation where they now say that an iceberg order is an algo, whereas with the CME it is an order type, not an algo. These types of things cause real problems and costs and make products more expensive for the investors. Very likely allocators don’t hear so much about such issues, because people don’t talk about it, but these are some of the challenges of today’s environment. Actually you now need to register as an algo in Germany when you are executing an iceberg order which we actually should not even bother since it is a standard order type.

Stuart MacDonald: Such things are more often than not an instrument of trade or other areas of policy rather than being about protecting the investor. And it is clear that vested interests are often at play. But, not all forms of regulation are malign in practice or intent. Some can be inconvenient, but they can also create opportunities. The Volcker rule, for example, has meant that some people who might otherwise be embedded within investment banks are available as talent for the hedge fund industry, so it’s not all bad.

But I agree, regulations are part of the “raising of the bar” that is one of the industry’s most abiding issues: the progressive asphyxiation of the pipeline of emerging managers, since regulatory overheads make it even more difficult for them to become viable in their early stages.

Oliver Prock: Still, if you allow I would like to add one more thing out of my experience that shows how bad the environment is from the regulations side. I was participating in the UCITS public consultations in regards to financial derivatives on financial indices that were set up to review existing rules about indices in UCITS funds, which at that time ended positive for the industry as a liberalization, similar to what the US has now done with the ‘40 Act funds. At that time I was lobbying and also established an association through which I participated in the ESMA Consultations from 2007 onwards. ESMA follows a so called “Lamfalussy process” where they basically question market participants like stock exchanges, associations, and fund managers, to provide supporting views to the regulator.

Once they receive all the answers from market participants, so after the public consultation, ESMA then evaluates all statements and adjusts the final view for the common denominator. But then in Europe, they killed it completely and reversed the liberalization in UCITS. And lately ESMA in the last consultations followed more a contrarian procedure where market participants provide the market’s intelligence, but ESMA disagrees with the participants’ own views. This is how bad the environment currently is. So maybe we could call the process now Contra-Lamfalussy.

Matthias Knab: And that was on the same subject as the consultation in which you participated?

Oliver Prock: Basically yes, market practitioners share their intelligence, but then the regulator tells you “oh, what you are saying is very interesting, but we think it is the opposite…” However, this Lamfalussy process was designed to listen to market practitioners so that the regulator has the opportunity to deliver smart regulation.

Stuart MacDonald: Right, consultations do not necessarily mean that anyone is actually listening…

Oliver Prock: Well, all parties including the regulator should really be committed to such a process. Since the regulator bound itself to the Lamfalussy process, so they should use the market intelligence to develop smart regulation. But the current regulatory environment is so bad that the regulator acts more based on the assumption that they do not understand it anyway, so the best they can do is to ban it. This is really bad for the market and for innovation.

Stuart MacDonald: Very likely, industry’s or financial markets’ efficiency is not uppermost in their considerations. We recently we did a survey of institutional investors and one of the big things that came up was the number who felt that their mangers – and this is across the board, not just hedge funds – have style drifted, often substantially. Perhaps there could be protections against this phenomenon of not doing more or less what it says on the tin. So I wouldn’t dismiss all notions of investor protection.

Oliver Prock: I don’t quite follow, why are you now bringing up the issue of style drift in this context?

Stuart MacDonald: I was just giving an example of where regulation can have a positive and protective role.

Oliver Prock: Well, I have a different view to provide. Actually regulation can also force a fund manager to style drift. If you lookat what has been going on in the last three years in the UCITS sector, some managers needed to style drift due to reversing of changes in UCITS law. So regulations forced them to, and continue to force them to style drift.

Akshay Krishnan: We have heard of opportunities, for example, where an investment bank has been tapped on its shoulder and told they can’t hold any credit risk that’s worse than triple B, and then a structured credit hedge fund comes along and says, “Hey, I will provide liquidity to you and take this risk off your book”, and they are actually making money, for example, doing that. That is happening not just in credit but even in FX where we have heard stories, for example, when a large sovereign needed to execute a certain trade in a really big size; the dealers are not able to warehouse any inventory risk, so they call on the hedge funds who are then stepping in and making more money from market making, if you will. We have heard a number of stories like this where as liquidity providers some hedge funds have managed to find unique opportunities.

Ewan Kirk: But that should remind us of the liquidity crises, where we saw hedge funds suffer some serious liquidity issues.

Akshay Krishnan: Well, maybe not necessarily. I am referring to firms here who survived 2008 OK, although each crisis is different, some of these funds have navigated 2008 and other markets, more volatile environments.

Renaud Huck: I have a question for Ewan and Antoine; Ewan, earlier you touched on the difficulty of diversifying asset classes you trade. We discussed the fact that some new products in fixed income may not necessarily diversify the return stream, while some of the smaller or newer asset classes will have liquidity restrictions, and because of size considerations, won’t make a noticeable difference. So I was wondering, going forward, how are you going about avoiding the trap of concentration of risk?

Ewan Kirk: It is a tough question and there is no ‘right’ answer. Like everyone, we define a universe within which we have to work, and whilst we might wish that Chicago heating degree days was more liquid than it was, it isn’t. For example, we have the CSI feed which lists 1500 commodity contracts, including Dalian Commodity Exchange PET (polyethylene terephthalate) contract, so you work with what you have.

Then you need to generate a cost model on a per asset basis. How much is it going to cost me to trade 10 lots of this contract at 9 o’clock in the morning? How much is it going to cost to trade 100 lots of this at 10:30 and so on? This cost model is then inserted into an optimization routine, and tells you what you can trade. It gives you an answer, which isn’t perfect, but I would question how else are you going to do this?

You will have some idea of what your ex ante gross Sharpe is, or your gross return or, depending on how you want to do it, your gross risk-adjusted return. You calculate what your net risk-adjusted return is, how you put it all together, how you can reduce the trading cost. For some definitions of the word, this is optimal. There will be things that are clearly sub-optimal, like putting all of your assets in natural gas. But there are more optimal solutions than this, and if you look at the world on a cost basis rather than a gross basis, you can find something which should be stable and generate the highest after costs return. So when new contracts appear, then we have to produce a cost model. It doesn’t help just to have some data: we have to look at the order book, collect data on the order book, look at the impact of different size trades on the order book, and build up this complex, non-linear model of cost. Then, maybe we can trade it.

Antoine Haddad: The concentration risk problem at hand is quite simply re-stated as follows: as a manager, you want to get your hands on as many “non-correlated” or “lightly correlated” assets as you can, and you want to weigh them in a portfolio in a way that will maximize, after cost and slippage assumptions, the efficiency of the return stream. The curve-ball in this statement is that “slippage assumptions” are a function of the percentage of one’s participation in each market. For markets where liquidity and volume are not ideal, the slippage assumption will rise, and the output of the optimization will hardly leave any meaningful position in that market.

When you reach the point where the marginal improvement in return efficiency is so slight after the inclusion of a new market with a high trading cost assumption, you have to weigh the benefit of including that new market, versus the potentially unnecessary increase of complexity to your portfolio.
Renaud Huck: So theoretically, when an asset class is brought into a listed format, it should help you in the longer term, right?

Ewan Kirk: Longer-term yes, but I think this is in terms of years, rather than months.

Antoine Haddad: Yes longer term, and subject to the condition that it’s not duplicating something that already exists, as Ewan mentioned earlier in the example of interest rate swaps versus 10-year bonds. If the new asset has a low correlation to the existing mix of securities in your existing portfolio, it goes without saying that your portfolio optimization process with this new asset will yield a more efficient portfolio.

Ewan Kirk: One of the best opportunities that you could look at from an exchange perspective is cement. It’s the world’s biggest commodity – it’s even bigger than oil – and there are no futures contracts on it. Or steel is another good example! Steel is used around the world and the LME doesn’t do a steel contract for actually quite good reasons, because it’s quite complicated. But, nonetheless, things like that will make a difference. We trade billions of dollars a day of OTC foreign exchange, and while having a listed cable contract could be nice, it doesn’t add extra alpha.

But, a steel or uranium contract – something that is really different – would be great. Of course, the problem is that there is a history of failed contracts, such as the propane and European gasoline contracts. Just in commodities there were lots of ideas of contracts that should have taken off, but they never quite made it. But some of the things I mentioned could be game-changers, for CTAs in particular.

Oliver Prock: I really like that Eurex is working on new products, and that you are optimistic. Eurex already provides a lot of relevant contracts to the market. But, I believe the one thing exchanges miss is designing all contracts cash-settled. The new regulation already forces everybody to favour cash-settled contracts. If you look at UCITS fund regulation, physical delivery is at a disadvantage, so in my personal opinion, all the products should be cash-settled.

Matthias Knab: So it seems to be a major challenge coming up with a real innovation.

Ewan Kirk: The last big innovation was the VIX contract. The VIX was a great idea, and it was really well done.

Oliver Prock: Sure, but volatility trading never took off in Germany. For example Deutsche Börse launched the VDAX and then needed to re-launch as VDAX-New, because the first one had a flaw, right?

Renaud Huck: We have volatility futures and options. We are using STOXX as an index provider, and it’s trading actively. It’s trading quite satisfactorily, considering the fact that we are currently in a low-volatility environment. So I think that is where we take confidence from. We have had products that have been active when the environment was reallyagainst them, and also we have seen their maturity reaching decent levels of liquidity outside the quarterly cycles of the rollover period. This shows us that the contract volumes are developing in the right direction.

Mathhias Knab: Well these things need to reach a tipping point from where on the volume the acceptance is there. I believe a number of products Eurex recently introduced have reached this tipping point, like derivatives on Italian and French government bonds, right?

Stuart MacDonald: They came at the right time.

Renaud Huck: Yes, it was good timing. In fact, this is a question that we traditionally ask industry participants like yourselves at roundtables such as this one: what is the ideal level of liquidity of a product that must be reached for you to step in? We understand this is difficult to answer because not all products are the same. You cannot necessarily compare the liquidity of one equity index with bond futures or a medium-term interest rate future. These are very different products.

Ewan Kirk: If you wanted us to use your contracts more, then you should give us the French government bond futures contract and 20 years’ worth of data of French government bonds.

Oliver Prock: Exactly!

Ewan Kirk: Daily close data would be great. When, in a previous life, we came up with the VIX, one of the things we did was to recreate the VIX index going back through time from options prices. It made it much more accessible because there was a history.

Oliver Prock: I agree with it, I fully agree.

Stuart MacDonald: That has been so far an extremely rich discussion about quant or systematic trading, managed futures/CTAs and exchange-listed products, and so before we end, I wanted to add a few words about one of Aquila’s offerings. On the one hand, we have our long-established and broadly based multi-asset risk parity funds and an innovative risk parity bond fund that we launched last year – which was an industry first – and which has performed very well. These are systematic strategies. On the other, one of the main events for Aquila this year was, however, the launch of Aremus, a fundamentally driven European equities-focused strategy with a substantial event driven component.

Ewan Kirk: Is that one systematic?

Stuart MacDonald: No, it’s discretionary, with a team that uses its natural judgment to take decisions. I don’t think any of us would deny that there is at least a tail of human beings who can for a reasonable period of time identify opportunities and trade them successfully whether they are based on broad observations such as the ones which are the basis of risk parity approaches or are based on stock picking.

If I have a hope for the industry going forward – because I’m sure that we can get over the regulatory impediments that have been placed in our way – it is that the pendulum will swing at least partly away from the intense institutionalization and polarization to which it’s been subject over the last few years.

For example, there is some evidence that high-net-worth money is coming back into the industry as opposed to the preponderance of institutional flows we’ve had before the crisis. But I think there has to be a concern about the barriers to entry to newer free-standing managers. Yes, one can understand the considerations of business risk on the part of allocators. When backing the managers, one can understand even the regulator’s concerns not to have two men and a sheep on a stoop managing money, but if the industry is going to remain distinct from the mainstream with which it’s already partly integrated, then the innovation has to be there.

As an aside, the greatest excitement that I’ve seen over the last year or 18 months has not been at hedge fund conferences, although they are hardly dull, and there is some evidence that sentiment has picked up even on this side of the Atlantic, although Europe isn’t exactly booming compared to the States. The buzz has actually been agricultural investment conferences, where about one-tenth of the people seem to be people I recognize from the hedge fund circuit. And people are getting terribly excited about what is evidently enormous and growing demand on the part of institutional investors for what’s belatedly being recognized as almost the CTA or risk parity equivalent within the infrastructure space: agriculture or farmland is uncorrelated with the others and still offers the same general benefits as many other forms of real asset investment, such as inflation hedging and the capacity to generate an income stream. I wonder, in any case, what anyone has to say about the issues of innovation and emerging managers.

Nacho Morais: You mentioned how the conversation has shifted to the more systematic side of the business, and I wanted to contribute that maybe we should have a more blended approach to the investment strategies rather than strictly separating and compartmentalizing the fundamental versus the systematic guys. For example, I think the fundamental guys should make more use of systematic tools in their work. If you are doing primary research on the products of a company, you can build a web-scraping tool and get real-time information on the pricing of the products of that company. Or, in other instances, you see managers who make ultra-thorough research on the companies, but then allocate to positions basically through a rule of thumb. There is a lot they would benefit from using the techniques the systematic side has mastered.

On the other hand, when we look at systematic managers, we tend to mainly analyse the stream of returns and try to figure out what the numbers are saying about the strategy and its drivers. The other side of the equation, the human factor, is extremely important. At the end of the day, a systematic manager will have to manage a group of individuals that develop models, to design how they are organizing their engineering process, their corporate culture, etc. These are things related to human organization, which goes beyond the pure quant aspects.

You can compare it to, for example, the building of an infrastructure. One may have a model for a bridge, but then going into the specifics of developing and building a certain bridge is a whole different story. You need to assemble the right people, give them procedures, sequences, manage them to work together, talk in a common work language, optimize your resources and care for everyone’s safety.

Antoine Haddad: I agree with you that compartmentalizing the industry into systematic and fundamental strategies is not really the right distinction. A strategy can be both systematic and fundamental. Systematic is not a strategy, but a risk framework. At the end of the day, when you are a systematic trader, you are trading models that have an economic or behavioural rationale behind them. Take concepts like value, momentum, carry, or just trend: all these concepts can be traded by either discretionary or systematic managers.

Most strategies are fundamentally based, and then the systematic part simply acts as an overlay that helps a manager with the sizing and the timing of the trades. The systematic model also helps the manager to mix the trades appropriately in order to achieve an optimal portfolio of “views”.

Ewan Kirk: Let me also add my thoughts about the quant distinction. In my view, everyone is a quant. Nobody wakes up in the morning and just decides to go long gold. In a risk parity framework, I have no ex-ante view of whether or not discretionary trading or systematic trading is going to be better in the future. I just don’t know. In that case, you are probably going to allocate equally between the two, according to the risk parity framework.

There are certain things that systematic managers are really good at. For example, we can handle a hundred different views or a thousand different views at the same time, producing something that broadly has a constant volatility and generally doesn’t have fat tails. But as Nacho correctly pointed out, the key here is about getting the team together and having a positive research culture. I also point this out to investors who spend a lot of time looking at my numbers. Of course, I also spend a lot of time looking at my numbers, and I have a really smart team who are looking at our numbers as well. But there is a limited amount of information you can get out of that.

I have said to investors, “Let’s just imagine that I give you the total source code for everything that we do. Complete transparency. Does that help you?”, and they say “well, it might.” But suppose my biggest competitor is sitting on the other side of the table and I gave her my source code and she gives me her source code, and I look at it. The thing is that I can’t tell whether it is better, because you just can’t know what’s going to happen in the future.

So the things to look at for systematic managers are actually the same things you will look at with discretionary managers: people, organization, controls around decision-making processes and so on. How do you go from the idea you have when you are out for a run, all the way to risking billions of dollars of investors’ money on it? If you are looking at all those processes when judging systematic managers, it will also be how you judge discretionary managers.

Oliver Prock: Diversification to quantitative managers definitely makes sense for allocators. I also understand the challenges allocators have to analyse and rate quants. We try to give a hand to allocators by providing information on the team we built, the infrastructure, our track record, also explaining to them our models and that they mimic in many aspects discretionary traders but are more disciplined etc. I understand that analysing idea generation and risk management on a fundamental manager might feel easier than on a quantitative manager. But maybe it actually isn’t.

Here it is worth noting that active investment management success is most dependent on how much insight investment managers successfully apply, rather than simply on the decision to invest on the basis of qualitative or quantitative techniques. As more investment strategies become well known, uncovering and exploiting new opportunities can become difficult for any manager. The best managers, either quantitative or fundamental, will continually invest in research in order to develop both innovative ways to analyse alpha and techniques for exploiting this alpha. We are investing millions of dollars into research and into enhancing the “box”. At the end of the day I think the track record counts. For example, we are annualizing 16% p.a. with Sharpe of 1.2 since 2003.

Stuart MacDonald: Looking into the future, I wonder about the extent to which algo, quant or systematic trading will actually take over our little universe. Will our business go beyond being in effect a cyborg? Will there be a time where the whole construct becomes machine-driven? I can imagine that there will then also be human beings who will find ways to cut across all of this, like cybernetic guerrillas. It also occurs to me that we may at some point in the future start referring to managers, not as “he or she”, but as “it or they”.

How far down the track are we towards one’s true competition being an inanimate, inorganic “thing”, or do you think we will never actually reach such a millennial end-point?

Ewan Kirk: Essentially, no. We make a decision every time we comeup with a model or a risk tool. Some people believe that if we just had a complex enough formula with enough inputs, it would tell you what the S&P price is tomorrow. That’s not going to happen.

Matthias Knab: Three years ago, IBM’s Watson beat Jeopardy experts in real time. Three years from now, something like Watson may beat Warren Buffett. If you look at the combination of ever-increasing data and accessibility of data, Moore’s law continuing to make computing power ubiquitous and ultra-cheap, together with advances in artificial intelligence and robotics, it may not be unrealistic to foresee a time when machines may outmanoeuvre humans in many fields of our current finance industry – like the drones, self-driving cars and cloud-hosted medicine have started to do in other sectors. These revolutions are happening right now.