Allocation to Discretionary CTAs Grow as Market Stalls
Copyright 2000 Barclay Trading Group, LTD.
Terms, Conditions and Trademarks Apply.

It should come as no surprise that the universe of managed futures trading advisors is composed primarily of CTAs who rely on systematic, computerized approaches to generate market-trading decisions. Given the complexity of the world economy, the myriad of inter-relationships affecting supply and demand on the global level and the confounding influences wrought by financial engineering, it is somewhat surprising to me that as many as 20% of CTAs can be classified as utilizing a predominately discretionary or judgmental approach to trading.

There are clear advantages to a systematic approach. Freedom from the necessity of having to be continuously making countless trading decisions under duress is certainly a major advantage. Few people have the mental discipline required to keep the decision making process unfettered by the stresses and potential emotionalism of adverse price movement. Yet, in spite of the inherent difficulties associated with discretionary trading, a significant number of CTAs continue to prefer this approach.

Many investors as well prefer discretionary traders. Europeans, in particular, prefer the CTA who makes his/her trading decisions based on an informed subjective opinion rather than the one utilizing a computerized black box. Japanese investors, on the other hand, prefer a more systematic approach.

In order to try to understand the attraction to and the advantages of discretionary trading, we've invited a panel of distinguished discretionary CTAs to comment on some of the issues. Our panel includes:

Nick Djivanovic, Light Blue Trading (Bahamas) Ltd. Mr. Djivanovic is the founder of Light Blue Trading (Bahamas) Ltd. He has been involved in the derivatives markets since graduating from Cambridge University in 1983. His training included stints at the Morgan Bank, the First National Bank of Chicago and Salomon Brothers. In 1988, he moved to Morgan Grenfell to establish a proprietary trading operation that specialized in fixed income markets. He founded Light Blue Trading in 1991.

Robert Ecke, Marathon Capital Growth Partners, LLC. Mr. Ecke is a managing director at Marathon. He graduated from Amherst College with an A.B. in Mathematics and from Harvard with an M.A. in Mathematics Education. Mr. Ecke's experience includes researching and developing models for trading futures and options. He began managing futures portfolios with his short-term discretionary approach in 1995. He is solely responsible for management decisions with regard to Marathon's Discretionary Program.

Ezra Friedberg, Friedberg Commodity Management Inc. Mr. Friedberg is a broker - analyst with the New York office of Friedberg Mercantile Group, Inc., a subsidiary of the Toronto-based Friedberg Mercantile Group. Friedberg Commodity Management Inc., a Commodity Trading Advisor, is a subsidiary of Friedberg Mercantile Group.

Scott T. Ramsey, Denali Asset Management. Mr. Ramsey has been the president of Denali since its formation in 1994. He developed the Denali Trading System and has the principal responsibilities for directing trading of customer accounts.

Q: Less than 20% of CTAs can be classified as utilizing a predominately discretionary approach. As an experienced trader, I'm sure that you've had the opportunity to evaluate numerous trading approaches. What makes you believe that a discretionary trading approach is superior to a systematic approach?

Djivanovic: I do not believe that a discretionary approach is necessarily better or worse than a systematic approach. A systematic approach relies on pattern recognition, charting or other technical analysis, which is the modern equivalent of "reading the tape". This just means that you are watching the markets very closely and doing a lot of hard work identifying the various forces at play. Whether you do this with a computer or with your brain is immaterial. But this hard work has to be done nonetheless. Only once it has been done, can you begin to add the extra layer of experience or flair or talent or whatever one wants to call it, which is the discretionary approach. But it cannot be a substitute for the original hard work that the systematic approach crunches for you.

What I am trying to say, is that a discretionary approach can only be superior to a systematic approach if it is an extra filter on top of the systematic approach itself. The notion that a discretionary trader wakes up in the morning and is somehow inspired to put on a trade is a complete fallacy. All trades come from the hard work in identifying them; and only then do your experience and talent as a trader pick the best one to run with, under the prevailing market circumstances. Sometimes you will underperform the systematic approach, you are bound to. But if you are truly talented, in the long term you will beat it, as you are bringing something extra to the party.

Ecke: Although I have great confidence in systematic trend following, my short-term discretionary approach addresses some of its weaknesses and has yielded results that have a low correlation. Using discretion, I can adapt my trading style to changing market conditions. I can also keep my risk low in difficult trading markets by limiting position size or staying out of those markets entirely.

Friedberg: Our approach starts with a fundamental analysis of global markets that is heavily influenced by the Austrian School of Economics. Technical indicators and analysis of the psychology of the market assist us. This style, by definition, can only be accomplished through the discretionary trading approach rather than the systematic trading approach.

Ramsey: I would never claim that a systematic or discretionary methodology is superior to the other. I believe they are very different and each approach has its benefits and place in an investor's portfolio. I choose to manage assets as a discretionary CTA because it utilizes the skills I've developed trading on and off the exchange floor for over 20 years.

The majority of the participants in the marketplace are traders who make their decisions based on expectations and emotions. Until such a time that computers can take over trading all together, there will be a place for the discretionary trader that can sift through the emotion, act rationally when others aren't, identify the opportunities and profit from them. Denali's goal is to profit by participating in existing trends, anticipating changes in trends and by capitalizing on panic and emotion during times of turmoil.

Q: Does a discretionary approach work better in certain markets or sectors (currencies, interest rates, grains, energies, etc.) than others? If so, which ones?

Djivanovic: I am not qualified to answer as I only trade interest rates. However I believe that in the long term I have a definite edge with my approach in my market. This is because I have yet to see a systematic model that can cope with the idea of a yield curve or the myriad of option strategies and hedges. Systematic approaches work for simple decisions like "buy" or "sell", but when it comes to doing 2s, 5s, 10s, barbells, or trading option volatilities, they cannot begin to compete.

Ecke: My discretionary approach is best in markets which have trends of short duration or are range-bound due to differences of opinion among market participants. I am constantly looking for signs that a trend has lost its momentum, if only temporarily, and I act on that very quickly. I look for market action that might shake a commonly held market opinion and lead to forced liquidation as stops are hit. In this scenario, the short-term momentum is so strong that I can put on a trade with low risk and with clear indications when the trade has gone wrong. Currency, interest rate, and stock index sectors yield the best results.

Friedberg: Conceptually we do not believe that there is an advantage in using discretionary trading in one sector rather than another. In practice, we have enjoyed better results trading currencies than commodity or financial futures.

Ramsey: I believe a discretionary approach can work equally well in all markets. If you take the time and effort to thoroughly research the fundamentals driving a market and you combine that knowledge with technical analysis, trading experience and effective risk management you will be rewarded over time. Some markets require more work to research than others do because they are smaller and are followed by fewer analysts. Therefore, to the extent that one market sector has a tendency to produce better outcomes than another is to me a function of trader effort in that market or sector, rather than any disposition on behalf of the marketplace.

Q: For the three year period ending December 31, 1997, The Barclay Systematic Traders Index measured a compound annual return of 13.21% versus 2.75% for the Discretionary Traders Index, yet allocations to the discretionary sector remain robust. What is the value-added that is continuing to fuel investor demand?

Djivanovic: For a start, a lot of people claim to be discretionary traders. What they mean is that they do not use a system, and do whatever fancy takes them. That is not my definition of a discretionary trader, rather that of an amateur. I believe that you can be a successful discretionary trader only if you concentrate on particular segments of markets and become totally familiar with them. In other words, a true world-class specialist. A discretionary trader who regularly trades all known markets is on a fast route to the poorhouse. He cannot possibly do all the necessary preparatory work and devote enough attention to his existing positions. For example, at LBTB, we have traders specializing in only a handful of markets within the financial segment only. This ensures one stays focused on one's strengths and that the return and volatility characteristics remain constant.

It is the investor demand for exposure to your particular market segment which fuels demand, and should continue to fuel it. Investors are becoming much more sophisticated. They should not look for absolute return. Volatility of performance and specific market exposure is much more important. I believe the days of investing with a "super star" are ending. Investors are constructing their portfolios in derivatives in the same way as they construct them for other investment classes: first you decide on the market you want exposure to, and then you pick a handful of the best traders in that segment.

Ecke: Discretionary traders are often not correlated with systematic traders. Their risk parameters may be lower. They can capitalize on special profit opportunities afforded by certain areas of the market.

Friedberg: Some discretionary traders have a proven ability to make money. As discretionary traders we are able to provide added value service in that we can justify each trade to our clients, thus providing our clients with confidence in our abilities. With that information, we are able to educate our clients about what we are doing and why. Many of our clients find this information useful in allocating investments dollars in other asset classes.

Furthermore, over long periods of time discretionary traders in general and Friedberg Commodity Management Inc. in particular, exhibit an extremely low correlation to global equities, debt markets and systematic traders, making discretionary managed portfolios a good complement to a well rounded portfolio.

Ramsey: The majority of our clients and prospective clients have portfolios comprised primarily of systematic CTAs who perform similarly during most market cycles. Our clients find value-added in Denali's discretionary approach because it complements their systematic CTAs and potentially smoothes overall portfolio performance during times of market turmoil.

The prime examples of this are last year's Asian crisis and the Fed's intervention versus the Yen a few weeks ago. While most systematic CTAs lost money, Denali profited. The primary reason is that Denali's research and trading focus is on events and scenarios that will present opportunity in the future. Additionally, our 20 years of experience as a trader is value added during turmoil where chaos and emotion create opportunity.

Q: For many investors, it seems to be easier to get a comfort level with risk management within the context of a systematic approach. As a discretionary trader, how do you manage portfolio risk? How much of the risk management process is "carved in stone" and how much is dependent on your judgement?

Djivanovic: I manage portfolio risk in the simplest way. I decide on a stop loss before I do the trade. On top of individual position stops, I have an overall portfolio stop. Both are upper limits and are "written in stone". Then I apply my discretion, but only to lower the maximum loss. This way I enjoy both the dispassion of a systematic approach with my maximum stops, and bring discretion to bear to reduce that maximum loss.

Ecke: I believe even a discretionary approach has to have a "systematic approach" to risk. I look at all the positions I have on and the stop-out level for each. I keep the risk in each position to a small percentage of total equity, and the risk for the sum of my positions under a fixed percentage of total equity. I don't exceed this level, but often maintain lower risk based upon my assessment of the particular markets. I hold to a stop-out level of from one to three percent of capital per trade, depending upon the particular market and my expectation of profit. I watch market action closely to judge if my plan is working. If my expectations are not met quickly or are not reinforced by subsequent action, I will exit the trade.

Friedberg: Generally, our risk management rules, which have been developed (and continue to be fine-tuned) over 30 years of trading, are "carved in stone". Among our risk management rules is a monthly "blowout clause" whereby we will liquidate all positions and cease trading for the reminder of the month, should it experience a large drawdown during a month.

Additionally, when initiating a position, we determine leverage exposure by assessing the "overnight risk" to the portfolio. This is done by using a multiple of the maximum daily volatility over the past six months.

Ramsey: Denali uses a systematized Risk Management Model to complement our discretionary trading approach. The goal of the model is to quantify and minimize the risk exposure of the investment portfolio while simultaneously allowing the maximum opportunity for gain. What is "carved in stone" is the maximum risk we will take on any single trade (<1%); the maximum risk allowed in any market sector (<3%); the maximum risk to the portfolio (<10%); and how much we will allow a profitable trade to retrace.

without violating the boundaries of the risk management model, however, we use considerable discretion. this discretion enables us to add to or subtract from positions as market conditions warrant maximizing our potential gain or minimizing our risk. in fact, over 90% of our trade exits are discretionary as a result of changing market conditions and expectations. in essence, our systematized risk management model acts as a fail-safe exit strategy if a discretionary exit is not otherwise utilized.

Q: Many investors also have difficulty with determining when a discretionary trader has lost his/her edge. If you had capital allocated to a discretionary trader, on what basis would you set the criteria for redemption of assets?

Djivanovic: I do have capital allocated to discretionary traders and I manage it in exactly the same way as my answer to the previous question, i.e.: as if it was a position in my portfolio.

I study the track record and I set a maximum stop-loss outside the parameters of the track record. This will determine the size of my position. The more volatile the trader, the smaller the allocation, to ensure that my maximum dollar loss is equalized.

Then I study the actual weekly volatility of returns and ensure that it is within past experience. If it starts deviating, on the upside or the downside, I will contact the trader and talk to him. If the explanation is plausible I will continue, reduce or increase the allocation. If it is not I will close out, regardless of the stop-loss.

What I will not do is get bored, second-guess, or have unrealistic expectations. I picked him, hopefully, for rational reasons. As long as the performance is within past experience, then these reasons still hold true, and therefore, I should maintain my position.

Ecke: This is probably the toughest question an investor has to wrestle with. Often times a trader can go through a period of just not getting it right. However, unless performance differs drastically from the historical record or if the trader did not profit from market opportunities favorable to the trading style, staying put is advisable.

Friedberg: If and when a discretionary trader deviates from a stated rule or principal, an investor should consider liquidating his/her account. Furthermore, when dealing with experienced CTAs with impressive long term track records (10 years +) we would encourage the investor to buy on drawdowns. In fact, Jack Schwager in his book Schwager on Futures proves empirically that the most opportune time to buy a CTA is after he experiences a drawdown.

Ramsey: I would argue that it's difficult to determine when both systematic and discretionary traders have lost their "edge". The criteria for selecting a discretionary versus systematic CTA differ in that psychological issues can play a larger role. However, over time the numbers tell the story and the bottom line for redemption of assets is performance. I would use the same criteria for redemption that I used for the selection process. If some of the critical parameters are violated and/or the trader was no longer meeting the needs of the portfolio, it would be cause to terminate. Additionally, I would consider a change in the risk management profile of trades or of the trading methodology to be an admission by the trader of a problem and a cause for immediate review and perhaps redemption.

Copyright 2000 Barclay Trading Group, LTD.
Terms, Conditions and Trademarks Apply.



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