Choosing a fund manager isn't easy. You can look at their track record, but few managers have been managing money for several decades; the length of time you'd usually need to determine if they are adding any alpha in a statistically significant way. You can try and ascertain whether they seem to be clever, and appear to be doing something sensible. But even a brilliant fund manager might not be able to explain how they make decisions. It is also difficult to know if their strategy will continue to work, or if they will stick to it.
It should be easier to select a fund manager who uses a system to make their investing or trading decisions. You can see a back test which can go back much further than their actual track record. They can explain their system to you, even if they won't give away the finer details. Then you can judge for yourself it makes sense, and will continue to be successful. However there are plenty of poor systematic managers out there. As we will discuss below, backtests can be misleading, or unrealistic. You need more than a good back test to see if an investment is worthwhile. So here are seven questions to ask your potential systematic manager.
1) What market and academic experience do your researchers and portfolio managers have?
Designing trading systems requires two kinds of quite different skills and knowledge. Firstly it is very useful to come from a scientific background such as physics, mathematics or engineering. If you're academically trained in one of these disciplines then you are more likely to design robust automated trading systems. Also if you have been trained in statistical methods such as econometrics then you should, in theory, do a better job of fitting your trading system.
However those who are scientific black belts but neophytes at trading are prone to making serious errors. Some of the biggest blow ups in trading history have been caused by extremely clever and well qualified people making silly mistakes. The meltdown of Long Term Capital Management in 1998 happened despite the fund having two Nobel Prize winners on their staff. Derivatives backed by subprime mortgages were radically overpriced before they crashed in value in 2008, thanks to traders using a clever model created by a very smart guy with a PhD. Other examples include the quant quake of summer 2007, and the losses suffered in the Swiss France devaluation of January 2015.
In all these cases the rocket scientists had created a model which was a good approximation to reality most of the time, but ignored the very different dynamics of a market crisis.
This is why it's also important to have people with real market experience. Experienced traders, bloodied by the market crashes of the past, are more likely to design trading systems that can cope with these extreme situations. Other common errors made by academically inclined portfolio managers include underestimating the costs of executing an order, and ignoring critical elements of market structure in back tests, such as short selling constraints.
A successful systematic fund will include people with strong relevant academic backgrounds, and those with real life trading experience. Ideally the senior managers of the fund should combine both those attributes. Also beware of investing in funds which have the relevant experience, but where it is split between different teams who do not communicate with each other.
2) Explain your strategy in terms my grandmother would understand.
A systematic fund manager should be able to explain their strategy to you. It does not need to be revealed in its entirety, every line of code exposed, but you need to have some idea. What's more they should be able to explain the strategy in terms which are transparent and understandable. Do not accept bland platitudes like “We employ high probability indicators and robust risk management”. Why does a strategy need to be explained and understood? We can think of several reasons:
- Being able to explain something in simple terms is an indicator that you have a deep understanding of it.
- Not being able to explain something properly is an indicator that your manager doesn't understand it, or worse still is the next Bernie Madoff (As Mr Madoff himself said: “We run a split strike conversion strategy and opportunistically time our purchases, buying put options to protect our downside”) .
- If you know what the manager is doing then you can judge if they are likely to be any good at it, based on their experience and skills.
- If you understand the managers strategy you can make a judgement as to whether it would have really worked in the past, have an opinion on whether it will still work, and use an appropriate benchmark to compare with its future performance.
- Ultimately, wouldn't you like to know what your manager is doing with your money?
The statement in terms my grandmother would understand' applies equally to the rest of the questions below. Do not be fobbed off with gobbledegook.
3) On average how many instruments do you have in your portfolio? How did you choose them? How did you choose the portfolio weights they have?
Diversification really is the only free lunch in finance. It is much better to add diversifying assets to your portfolio, than to come up with new ways of predicting the instruments you already have.
Beware of a manager who has a relatively small number of assets, or a highly concentrated portfolio. Ask them what evidence they have that this makes sense, and how they came up with the selection they have. What information did they use? Did they use a statistically robust process? If they have a strong belief that some of their instruments will outperform others in the future, then you should probably express scepticism – there is rarely enough evidence for this assertion.
For very large managers liquidity constraints will prevent them from giving the same allocation to small emerging markets as they would to highly liquid US counterparts. But a large manager does have the benefit of accessing a wider variety of instruments, particularly OTC markets which require an up-front investment in back office staff and technology.
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I hope you enjoyed/learned a lot from the points above. There are, in fact, 4 more things you Must know when dealing with your Systematic Fund Manager, and they can be found in our FREE Ebook, which you can download right now.