Given the recent turbulence in global capital markets and difficulties in certain hedge fund sectors, it is refreshing to see that trading strategies are enjoying strong performance. In particular, the systematic trading style (ie. funds that use quantitative algorithms for trading macroeconomic instruments) has produced spectacular returns during a period of mixed returns for other hedge fund strategies. It would seem that now is a suitable time for a closer look at this segment of the hedge fund universe.

Systematic traders are, essentially, hedge funds that trade any macroeconomic market (FX, commodities, fixed income, equity indices etc) through an algorithmic trading programme. Typically they will use technical signals (ie. price, volume) in an attempt to quickly detect market trends, and then take positions in those markets in an attempt to profit as those trends come to fruition. This excludes other fundamentally-driven quantitative strategies such as statistical arbitrage and global tactical asset allocation (GTAA).

Most systematic traders will have their trading programme running on all potential securities in their universe, which can lead to a diversified book of positions in hundreds of markets. Traders will often have high notional exposure which arises from their use of futures contracts to take positions.

However, managers typically employ no balance sheet leverage as they will keep cash on hand equivalent to the balance remaining from purchasing a futures contract on margin (resulting in average cash on hand usually between 70% and 95%). This combined with the highly liquid nature of the assets held results in minimal financing risk relative to other hedge fund strategies.

Generating alpha

There is sometimes understandable surprise that systematic trading strategies are able to generate alpha from a pre-determined trading process. Managers are not exploiting a fundamental mispricing of a security (as equity long/short, distressed debt and other managers do), nor do they have a quantitative explanation for the expected realisation of profit (as seen by relative value and arbitrage strategies). In addition, the use of technical information to profit from future price movements contradicts the weak form of the efficient market hypothesis, a cornerstone of the Capital Asset Pricing Model (CAPM).

The primary reason why these managers do generate profits is that many macroeconomic markets are often driven by factors that are not focused on an optimal economic approach. For example, central bank policy will be used to control inflation or placate excited markets, rather than to match the current market expectation for fixed income instruments. FX markets are driven by supply and demand factors that can leave prices significantly different to those predicted by economic theory.

Therefore, since many markets do not behave perfectly rationally, there is the scope for similar trends to occur repeatedly. One only has to look at the prevalence of trends (ie. almost monotonic moves up or down) in interest rates, FX markets, commodity markets, etc to see the opportunity set for systematic trading managers.

While the concept is simple, in practice the implementation can be complex, as there is significant skill and effort involved in identifying trend signals and building algorithms to profit from them. Managers often have experienced staff in trading, risk management, research, and technology. Further, managers must continuously study trend signals to identify any changes in them and update their programmes accordingly. This can be a complex process, and the dispersion of returns among CTA managers demonstrates that there are a variety of approaches and skill levels employed in the sector.

The systematic trading strategy should be particularly beneficial to an investor during periods of market stress. Since the process is so logical, straightforward and unemotional, it is insulated from bursts of market fear or panic. The underlying assets are liquid, and the process scaleable, therefore global liquidity contractions are less likely to impact the manager’s ability to manage their book.

Importantly, the algorithm used by a manager will let winning trades run but cut losses quickly, meaning the trading style of a systematic trading strategy is very similar to that of a long option position (ie. either big wins or small losses). In periods of increasing market volatility (ie. turbulence), options inherently gain in value, and the same is true of systematic trading strategies.

All of these factors mean that systematic traders exhibit low or zero correlation to capital markets and other hedge fund strategies over any given market cycle, making them an excellent diversifier in a portfolio of hedge funds.

Mitigating the risks

There are, however, a number of risks associated with investing in the systematic trading sector. Due to the investment style, the returns from these managers can be very volatile. Without adequate risk management abilities, systematic trading hedge funds can quickly amass substantial trading losses. In many cases, weaknesses in the key models used by a failed systematic tradingfund only become clear after the event. In addition, the fact that the strategy thrives on market volatility can lead to periods of very flat performance during the more sanguine market episodes (2004-2006 for example).

The high level of volatility and manager specific business/model risk in individual systematic trading funds can be mitigated by holding a diversified portfolio of such funds. In addition, due to the low levels of free cash required to manage systematic trading strategies, the most efficient use of capital is achieved using a managed account platform. This method reduces volatility (due to diversification) and boosts returns (due to a more efficient use of capital). A managed account approach also mitigates business risk and increases liquidity, as the investment to the managers is made outside of a typical fund structure.

Returns among systematic traders have been very impressive over the past 12 months, and whilst it is easy to give too much credence to recent performance, the opportunity set for these managers is arguably higher than for any other hedge fund strategy in this period of market turmoil.

Financial Risk Management

Financial Risk Management (FRM) is a fund of hedge funds manager investing $14 billion for institutional and other sophisticated investors worldwide. FRM was founded in 1991 and has over 200 employees in offices in London, New York, Tokyo, Sydney and Guernsey.