Allocations to Short-Term CTAs Increasing at Rapid Rate
Four Experts Discuss Investor Preferences, Risk Adjusted Returns and Capacity Issues
Copyright 2000 Barclay Trading Group, LTD.
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1997 was a banner year for asset gatherers in the managed futures industry. Money under management grew by approximately $9.1 billion, a 37.9% increase to $33.1 billion. This increase is the largest single year increase in dollar terms to date, surpassing the previous record increase of $7.5 billion in 1993.
For the most part, it seemed that money went to money, with the large, established CTAs being the main beneficiaries of the record inflow. However if we examine CTA rankings based on recent increases in money under management, we find a surprisingly rapid increase in assets managed by CTAs with short-term approaches to trading.
Some of the more successful short-term traders have seen their asset base increase by three or four-fold during the past year. Certainly, this recognition of their abilities by investors is entirely justified and well deserved. But increases of this magnitude over a relatively short time period are sometimes an indication that other forces are at work besides investor appreciation. Several reasons are given by industry observers for this recent trend.
The Barclay CTA Index, which is comprised largely of long-term trendfollowers, measures a gain of only 3.93% for the 12-month period ending March 31, 1998. Short-term traders have provided returns markedly higher during this same period, all the while keeping volatility levels lower than those usually found among the long-termers. Add to this outperformance a growing recognition among asset allocators that short-term approaches usually have fairly low correlations with the longer-term approaches and the picture becomes very clear.
However, there are other factors that should be considered before jumping onto the short-term bandwagon. Are their superior risk-adjusted returns sustainable in different market conditions? Investors typically turn toward CTAs with shorter time horizons during periods characterized by market trendlessness. In the past, when trends re-emerged, the longer term approaches once again provided investors with superior returns and their popularity consequently re-bounded.
Are capacity limitations becoming an issue? Short-term approaches necessitate much greater trading frequency. An average turnover rate for a long-term approach may be about 1000 - 1500 round turns per year per $1 million of equity versus 3000 or more for the short-term approach. As a result, short-term traders approach their capacity limitations at much lower equity levels than their longer-term counterparts. In fact several of the more popular short-term CTAs have already announced their plans to close shortly for precisely this reason.
In order to clarify these and other issues, we've assembled a panel of distinguished CTAs representing both ends of the time horizon. Our panel includes:
Scott A. Foster, Dominion Capital Management. Mr. Foster is president and Chief Executive Officer of Dominion, a global money management firm specializing in exploiting short-term inefficiencies in global financial markets. Dominion, organized in May 1994, currently manages approximately $250 million in assets for both institutional and private investors.
Alexander Hyman, Hyman Beck & Company, Inc. Mr. Hyman is co-founder and president of Hyman Beck & Co., a money management firm based in Florham Park, NJ that specializes in the global futures and forward markets. Hyman Beck & Co. was founded in 1991 and originally utilized only long-term trend following trading strategies. Beginning in 1995, short-term trading strategies, which are not trend dependent, were added. The firm currently manages approximately $340 million for institutional and private clients worldwide.
Roy G. Niederhoffer, R.G Niederhoffer Capital Management, Inc. Mr. Niederhoffer, the founder and president of R.G Niederhoffer Capital Management, Inc., graduated from Harvard University, magna cum laude, with a degree in Computational Neuroscience. RGNCM uses a primarily contrarian strategy to take advantage of major world fixed income, equity, foreign exchange and commodity markets.
Clark Smith, Trendview Management, Inc. Mr. Smith is the President of Trendview Management, Inc., a CTA firm that he founded in 1979. Trendview specializes in the systematic approach to trading foreign exchange and futures markets.
Q: Recently, CTAs utilizing short-term trading approaches have been very much in demand. What do you see as the primary factors within the investor marketplace that are driving this increased demand?
Foster: Cash. Global economic expansion, record breaking bull markets (Asia notwithstanding), and greater investor sophistication have conspired to pump trillions into financial markets. Putting this cash to work, along with a much greater emphasis on risk adjusted rate of return, has lead investors to seek out non-correlated markets and managers. The one billion (approximately) cash influx into short-term systematic futures managers during 1997 is just one example of cash seeking non-correlated returns via futures and hedge fund strategies.
Hyman: There seems to be an overabundance in the marketplace of similar trading strategies. Most of the technical approaches utilized by sophisticated clients are of the long-term variety. It is clear that long-term strategies may experience high degrees of short-term volatility. Customers seem to be eager to diversify these trading strategies in an attempt to achieve a smoother overall rate of return. Short-term trading approaches, especially in the non-trend following category, have captured investor attention because they blend efficiently with longer-term trend following strategies.
Niederhoffer: Short-term trading offers a clear alternative to the more traditional managed futures approaches, not just in name, but in diversification value. Markets trend less than 30% of the time, and traders employing this methodology have clearly demonstrated an ability to profit during the periods when markets are not trending. Short-term trading approaches have correlations that are near or below zero against not only managed futures, but against equities and fixed income too. Now that managed futures is a more mature asset class, investors are seeking diversification within the asset class, rather than just to the class.
Smith: We believe this increase in demand has been driven by three short, I doubt that investors will be as fickle as last time unless there are few short-term advisors with decent performance.
Q: There are those who would argue that increasingly rapid dissemination of information coupled with easy access to high speed computational technology and a global economy linked by derivatives has resulted in a fundamental shift in the duration of price trends towards the short-term end of the time spectrum. Do you believe that this is true? What are the implications for trend following CTAs?
Foster: Yes. There is no doubt that markets are more efficient than they were 10 or 20 years ago. It used to be the public vs. the professional traders. Now professional traders who are all well capitalized, educated, and armed with superior technology represent the public. Short-term moves used to be considered meaningless aberrations in the long-term trend. Now they are considered to represent the current pulse of the market and a gauge of money flows-and consequently are considered by many to be as important as the long-term trend (especially considering risk management). There have always been short, intermediate, and long term trends in the marketplace (and there always will be ). Trend following is philosophically sound and will continue to work, but it will be survival of the smartest.
Hyman: I would argue that long-term price trends continue to be based on underlying macro economic conditions and take months to develop. Outside influences, whether it be intervention or fast, efficient dissemination of information, have short-term implications. I believe that trends in price will continue to exist as they have for hundreds of years. However, I do think that the case of instantaneous communication today has contributed to increased short-term trading opportunities that may not have existed years ago. At Hyman Beck & Co., Inc. we were so convinced by this argument that we chose a different path in our research and have created a short-term trading style that is designed to exploit these trading opportunities and to have very little or no correlation to our trend following strategies.
Niederhoffer: The increase in assets employing trend following strategies has clearly had an impact. But instead of a fundamental shortening, I think what we tend to see is a more cyclical market, where long term trends, short term trends, high volatility and very quiet periods occur, instead of the more consistent movements we once saw, with somewhat more rapid beginnings and ends of trends as increased assets trade the same markets.
Second, as assets increase, I have noticed that the industry no longer profits as significantly from trends in commodities, probably due to liquidity concerns. Looking at the trader performance indices, trends in foreign exchange markets account for the bulk of the indices profits, followed by fixed income. A trend in grains or metals tends not to show up very much at all.
What I have found over the years is that many simple strategies which were successful for years have been absorbed into the market, most likely as a result of the factors you cite plus general "learning" in the market, and it takes a more subtle approach to be successful. Trend following is certainly going to be a successful strategy, but I would say the most successful traders will be those whose money management and diversification abilities get them out of trouble quickly during the difficult periods, and who can deploy strategies which can profit from whatever the market throws at them.
Smith: While we believe that the same level of profit opportunities exist now as earlier, we have noticed a subtle shift in the duration of some of the price trends from what they were in the 1970s and for most of the 1980s, particularly in some of the physical commodities, which is a large portion of our trading. Whether this has resulted from random factors or from the factors mentioned is hard to say.
The implications of this for most long-term trend followers are not too significant. The most important thing for a long-term trend following CTA is to trade in accord with correct principles. If the principles are correct, then the specific implementation of the timing of entry and exit signals can be adjusted as necessary.
Q: On the other hand, there are those who argue that because long-term trend following approaches are willing to tolerate a higher level of volatility than other approaches, they are most likely to deliver above average returns over time. Is this a valid argument?
Foster: No. Toleration of volatility is purely a function of leverage. Superior returns are only superior if they are still above average when adjusted for risk. Historically, longer-term approaches have not had superior risk adjusted rates of return relative to other futures or hedge fund strategies.
Hyman: At times short-term volatility is a necessary evil in pursuit of long-term profits. To some extent the higher the volatility you are willing to tolerate over time, the higher the expected returns. Trend following by its premise needs to ignore shorter-term fluctuations in price. At times the trading philosophy has resulted in increased volatility, but I would argue that most technical models would experience a similar degree of volatility if they existed long enough. I think that trend following has over a long period of time, relatively speaking, demonstrated an ability to deliver returns that are competitive.
Niederhoffer: I think you have to be able to tolerate a reasonable level of volatility in order to profit. I think the long-term trend followers who have been successful are the ones who really take advantage of the big trends. But this goes for short-term traders too. There's no free lunch, and the tighter your stops are, the smaller your positions are, the more diversified you are, the more returns tend to approach zero as assets increase.
Smith: We believe the argument is probably valid based both on academic theory and on historical empirical evidence. Academic theory strongly suggests that in various markets risk and return tend to be closely related with greater risk (or volatility) implying greater return. On an empirical basis, if you look at a list of CTAs who have achieved above average returns over a significant period, that list will invariably be dominated by long-term trend followers. This is true whether you look at the 1970s, the 1980s, or the 1990s.
Q: Both long and short-term strategies can have scalability issues What works at $5 million might not work at $50 million and what works at $50 million might not work at $500 million. With reference to slippage and execution techniques, how have you responded to increased assets over time and has your strategy changed as you've grown?
Foster: Dominion is currently managing $250 million. We have had very few "growing pains". We built our systems, portfolio, execution techniques, back office, and technology infrastructure to handle several hundred million dollars while we had less than $10 million. We have had to make only minor adjustments to accommodate the new assets. Capacity constraints will become an issue at some point, probably somewhere between $350 and $400 million, but we will not know for sure until we get there. We believe our current execution techniques (we can't discuss them because they are proprietary) are superior. Last month we traded over 100,000 contracts and averaged less than 1 tick in slippage.
Hyman: It is certainly true that trading approaches need to change to accept additional assets. The questions are: At what point? And to what extent? Trading strategies that are of a longer-term nature in my opinion need to change less and only after a significant amount of assets have been added. Shorter-term systems need to change more and are also forced to change earlier in their history. The reason for this is obvious in that shorter-term systems need to access the markets for execution on a much more frequent basis. The frequency of trades creates consistency issues and obviously increased slippage. So new strategies need to be employed in order to limit the degradation of returns caused by the increased assets traded. It is clear and proven out in history that shorter-term approaches typically have more limited capacity constraints, while longer-term approaches can afford to remain more constant and suffer capacity constraints only after a much larger amount of assets have been added to those approaches.
We pay very close attention to implementation of our trading approaches. Execution techniques vary among different markets and slippage is monitored closely. Dilution of performance can be a serious issue. We have closed our Short-Term Original Portfolio at $50 million in assets. On the other hand, our Global Portfolio has in excess of $200 million and we anticipate $500 million in capacity. I believe our integration of short-term trading strategies has improved our ability to reduce slippage and enhance our longer-term strategies. Don't be greedy - you'll live longer and make more money for your clients and for yourself.
Niederhoffer: From the beginning, we focused our attention on the largest, most liquid markets, particularly fixed income and currencies in the U.S. and major European markets. This has meant that increased assets have not forced us to redesign our approach. In fact, we have found that historically we have been most successful in trading the most liquid markets.
In terms of execution, having a group of brokers whom we trust, and having the experience to execute trades effectively can have a positive impact on slippage. Finally, we use some discretion in the execution of our trading signals, rather than doing market orders. This also tends to reduce slippage and minimize our impact on the markets.
Smith: Capacity usually becomes an issue much sooner for short-term trading approaches. Short-term approaches have smaller average gains per each contract traded. Even relatively small slippage can become critical to their performance. Position limits can also impact the short-term traders sooner because they tend to utilize larger position sizes to compensate for the smaller trends from which they seek to capitalize.
When we developed our programs, part of our design criteria was to have programs that would be relatively insensitive to execution costs and capable of handling large amounts of money. With this in mind, we designed multiple entry and exit systems which would be highly selective in trading, resulting in very few trades. These trading strategies tend to generate higher profits per contract and minimize execution slippage, which should allow us to grow to several times our present size without execution issues affecting the performance.
Copyright 2000 Barclay Trading Group, LTD.