Finding Anomalies to Fuel Short-Term Strategies

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This summary is written by Rich based on a conversation in our CTA series between Michael Pomada, the CEO of Crabel Capital Management, and the podcast hosts, Niels and Alan.

About Crabel Capital Management

Crabel Capital Management, founded by Toby Crabel, is known for its short-term diversified quantitative strategies in the futures and FX space, with $8.2 billion in assets under management. The company's strategies are based on market observations and behavioral analysis, aiming to exploit market anomalies. 

Michael mentioned that they have strategies across the spectrum, from minutes and hours to months and years, including trend following. While trend following might be a part of their overall approach, the primary focus of Crabel Capital Management is on market observations, behavioral analysis, and exploiting market anomalies.

In particular, Crabel Capital Management focuses on short-term quantitative strategies in futures and FX, with assets under management growing over the years due to increased interest in uncorrelated strategies.

The company's investment philosophy is based on market observations and behavioral analysis to understand market situations and how participants might react, then taking advantage of market anomalies.

Michael Pomada highlighted the importance of risk management, emphasizing Toby Crabel's motto, "Live to fight another day," which stresses the importance of keeping drawdowns small and letting the upside take care of itself.

Crabel Capital Management draws inspiration from the work of Victor Niederhoffer, with several team members having worked at his firm. However, Crabel's approach is more focused on actual market movements and risk management, compared to Niederhoffer's eclectic thinking.

Crabel’s Approach to Trading and Portfolio Management

Michael Pomada discussed Crabel Capital Management's approach to trading and portfolio management. The key points included:

• Crabel Capital Management's short-term trading strategies are not intentionally designed to be zero correlated to stocks. However, they do have a program that is negatively correlated to the stock market.
• Managed futures strategies, like those employed by Crabel, often play a role in clients' portfolios by being long volatility most of the time. This is not by design, but it often results in making money when the stock market goes down.
• The importance of a long-term perspective in portfolio management is emphasized. Investors should focus on the next 10 years instead of short-term performance.
• Michael acknowledged that there may be periods of underperformance, but stressed the importance of believing in the chosen manager and the long-term potential of the strategies they employ.

Use of the Sharpe Ratio to Evaluate Portfolios

Niels discussed with Michael a paper by Cliff Asness, raising the question of whether the industry is becoming too concerned with short-term performance and Sharpe ratios, potentially detracting from long-term results.

Niels pointed out that the Sharpe ratio was originally intended for portfolio evaluation, not single strategies. He asked Michael if there is a better metric for evaluating strategies in their industry.

Michael acknowledged that the Sharpe ratio can be misleading. He mentioned the example of the basis trade, which can have a high Sharpe ratio until it faces a significant loss. He emphasized the importance of understanding the potential pitfalls of a strategy.

Rather than focusing on a single metric, Michael suggested that investors should consider how a portfolio or strategy is expected to behave in various market environments. He advised assessing if the strategy can protect against downside risks and recover from small drawdowns.

To evaluate a strategy or portfolio, it is essential to understand the underlying objectives and consider the track record of the manager or program. Investors should ask whether the portfolio manager delivers on their stated goals and expectations.

In summary, the discussion highlighted the limitations of using the Sharpe ratio as the sole metric for evaluating trading strategies. Instead, investors should consider multiple factors, such as the strategy's behavior in different market environments, the track record of the manager, and their ability to deliver on stated objectives.

How Crabel Unearths Anomalies through Research Processes

Michael discussed the process of unearthing anomalies and how it has evolved over time. He explained that while it may have been easier to observe behavioral biases in the past, the availability of data and advanced tools today make isolating core market anomalies more accessible. 

Additionally, he noted that their most productive year in research was in 2022 due to the availability of new data and continuous observation of changing markets.

Michael also talked about the transition from a siloed to a de-siloed approach at Crabel Capital Management. 

In a siloed approach, different teams or departments within a company work independently and focus on their specific tasks or investment ideas without much interaction or collaboration. This can lead to over-allocation of resources to simple or popular ideas while neglecting more unique, uncorrelated investment opportunities that could provide better returns.

A de-siloed approach, on the other hand, encourages collaboration and information sharing across teams and departments. This enables the company to better assess and allocate resources to a diverse range of investment ideas, including those that are orthogonal (uncorrelated) and have the potential to generate alpha, or excess returns above the market benchmark.

The de-siloed approach has been more effective in capturing the most alpha for their clients by avoiding over-allocation to simple ideas and under-allocation to orthogonal, uncorrelated alpha. The firm's culture emphasizes personal accountability and a focus on continuous improvement.

Machine learning has been used by the firm, but with limited success in producing consistent, persistent returns. However, they have found value in applying machine learning techniques to Crabel's existing alpha ideas. This approach has led to the development of new strategies and ways of thinking by combining various concepts from their historical data.

The Importance of Execution in Short Term Trading

The conversation focused on the importance of execution in the short-term trading space, specifically highlighting the need for substantial investment in technology and infrastructure. Michael expressed his enthusiasm for the topic and notes that high-frequency trading (HFT) firms spend hundreds of millions of dollars on execution as it is their primary source of profit.

Michael emphasized that shorter trading durations demand more precise execution to protect one's intentions from being exploited by the market. He compared high-frequency traders to traditional pit traders, suggesting that the main difference is the speed at which transactions occur. To keep up with this fast-paced environment, firms must invest in cutting-edge hardware, co-location, and latency reduction.

Crabel Capital Management, according to Michael, has dedicated tens of millions of dollars to execution, which has given them a competitive advantage in both short-term and trend-following programs. Their execution costs are among the lowest in the industry, which translates to significant increases in Sharpe ratios when compounded over time.

Michael also noted that Crabel's sizable investment in execution infrastructure benefits all their programs. However, he acknowledged the challenges faced by startups in the space, as they may not have the resources to make similar investments in execution. This has led to consolidation in the industry, with established players gaining more market share.

Views of Replication Methods

Niels brought up the SocGen CTA Index and the fact that a firm replicating the index experienced massive inflows. He asked Michael about his thoughts on being replicated and the concept of replication in general. Specifically he asked Michael whether replication strategies can effectively and consistently replicate the returns of more complex investment strategies, such as trend following or short-term trading. 

Replication strategies generally involve using mathematical models to track the performance of an index or a group of assets. These strategies aim to deliver returns that closely mirror the underlying assets' performance, often with lower fees than actively managed funds.

Michael expressed doubts about the effectiveness of replication strategies, referring to them as a "fool's errand." He argued that such strategies often oversimplify the complexities of the market and the active decision-making process involved in generating alpha by experienced managers. Replication strategies rely on data-driven models, such as linear regression, to mimic the returns of more sophisticated investment approaches. While these models may offer lower fees, they may also miss out on the deeper insights and unique perspectives that skilled managers bring to their investment decisions.

The replication approach is compared to a drug-like solution in the sense that it offers a seemingly quick and easy fix to a problem without addressing the underlying causes or complexities. Michael believes that investing in a few well-chosen managers with strong track records and risk management capabilities is a better alternative to replication strategies, despite the higher fees. He emphasized that seasoned managers spend considerable time and effort understanding markets, managing risk, and discovering new alpha-generating ideas, which cannot be easily replicated by a purely data-driven model.

The discussion highlighted that, while replication strategies may appear attractive due to their lower fees and potential for capturing some portion of the returns generated by more complex strategies, they may not fully capture the value that experienced managers bring to the table. As a result, investors seeking consistent performance and more sophisticated portfolio management should carefully consider whether replication strategies can truly deliver the desired results in the long run.

Importance of Diversification

Michael shared his thoughts on the importance of diversification within investment portfolios, particularly in the context of trend following strategies. 

Diversification is the practice of spreading investments across various assets, markets, or sectors to reduce risk and improve the potential for returns. By diversifying, investors can mitigate the impact of poor performance in any single asset or market and reduce the overall portfolio volatility.

Michael emphasized that diversification has been a key component of Crabel Advanced Trend, a program he designed. He believes that it's essential to be exposed to a variety of markets, as one can never predict where alpha, or outperformance, will come from. He pointed out that some markets may underperform for years before suddenly becoming profitable. This unpredictability makes diversification valuable, as it ensures that investors don't miss out on potential opportunities.

However, Michael acknowledged that there is a trade-off between diversification and execution costs which is particularly important for short-term Managers. While he personally chose to prioritize diversification in his program, he admitted that if forced to choose between the two, he might prioritize execution costs. This suggests that, while diversification is important, it shouldn't come at the expense of efficient trading and cost management.

Additionally, Michael mentioned that diversification can lead to exposure to new and interesting markets, further illustrating its potential benefits. However, he also acknowledged that there is significant cross-correlation between markets, which can limit the effectiveness of diversification.

In summary, the discussion on diversification highlights its importance in managing risk and capturing potential alpha across various markets. However, the conversation also suggests that diversification should be balanced with other considerations, such as execution costs, to ensure optimal portfolio management. Investors should carefully weigh the benefits of diversification against potential trade-offs to make informed decisions about their investment strategies.

Relevance of ESG to CTA’s

Niels introduced the topic of ESG (Environmental, Social, and Governance) and whether it applies to CTAs (Commodity Trading Advisors). He mentioned his concerns regarding trading Chinese markets and whether it fits into the ESG thesis.

Michael responded by separating ESG into two categories: product construction and firm practices. He emphasized that their firm is focused on ESG and has a dedicated committee to address related issues. 

Regarding the application of ESG in trading, Michael provided examples of corn and crude oil markets to illustrate the complexities involved when attempting to apply ESG principles in the context of CTAs. He explained that CTAs, which are market neutral, have a role in creating efficient markets that benefit all participants, including those who support ESG objectives.

In the case of corn, Michael argued that if a CTA were to decide that high prices for corn are bad, because it's bad for people, and therefore they should only short corn, this would create a biased approach that neglects the roles and interests of other market participants, such as farmers. Similarly, in the crude oil market, if a CTA were to decide not to trade crude oil because it is perceived as dirty, it would disregard the fact that an efficient market is essential for all participants, including those who want to promote a cleaner environment.

Michael emphasized that the role of CTAs in the marketplace is not to make value judgments about particular markets, but rather to facilitate liquidity and efficiency that benefits all participants. He suggested that classifying a market as "bad" based on ESG criteria without considering the roles and interests of various stakeholders is an oversimplification that overlooks the broader context and the overall benefits of an efficient market.

He argued that CTAs, being market neutral, play a role in creating efficient markets, benefiting all participants, including those with pro-ESG stances. He believes that categorizing a market as "bad" without considering the roles of various participants is an oversimplification.

In conclusion, Michael's perspective highlights the importance of understanding the nuances and complexities of applying ESG principles in trading, particularly for CTAs. It emphasizes the need to consider the roles of different market participants and the broader benefits of efficient markets when discussing ESG-related topics.

Niels agreed with Michael's perspective and shares that a similar viewpoint was expressed by Harold at Transtrend. He appreciated the discussion and acknowledges the importance of understanding how to address ESG in the context of CTAs.

Risk Management, Drawdown Control and Retiring Strategies

Michael explained the approach at Crabel, highlighting the importance of flexibility, risk-adjusted returns, and being adaptive. Key points include:

• Risk management: Crabel uses multiple levels of risk management, including vol targeting and a high-frequency value-at-risk model. They also allow the target volatility to fluctuate based on alpha availability, which has helped them outperform peers.
• Drawdown control: Michael stated that Crabel systematically down-levers during a drawdown to manage risk. For their trend follower, Advanced Trend, they tend not to be as aggressive in drawdown management and let the strategy run its course.
• Retiring strategies: Crabel differentiates between strategies with a strong track record that experience a significant loss and those that steadily deteriorate over time. They tend to down-allocate the latter but do not often retire strategies completely, as they may regain value later.
• Market environment and strategy performance: Michael emphasized the importance of considering the market environment when evaluating strategy performance. He suggested being cautious about retiring strategies that underperform in certain market conditions, as those conditions might not be ideal for the strategy's success. This circumspect approach can prevent missing out on gains when market conditions become favorable again.

Overall, Michael emphasized the need for adaptability, flexibility, and a thorough understanding of market conditions when managing risk, drawdowns, and strategy allocations.

Fund Fees and Flows

Michael believes that fees for simple hedge fund concepts will continue to come down due to competition and ease of implementation. However, he suggested that more innovative and unique strategies will be able to charge a premium for their services. As a result, the best alpha shops may see their fees rise.

Regarding flows, Michael acknowledged that some outflows occurred in 2022 despite good performance, primarily due to portfolio rebalancing by clients. He expects inflows to resume in 2023, with a lag between good performance and new investors coming on board. Pension funds may revisit their allocation to managed futures and CTAs, recognizing the benefits these strategies offer for portfolio diversification.

Michael emphasized the importance of maintaining strong relationships with clients and appreciating the opportunity to generate returns for them, particularly when serving the pension funds for teachers and other public servants. He remains optimistic about the future of the industry and expects 2023 to be an inflow year, even if some pension funds still need to rebalance their portfolios.

Role of Short-Term Trading Strategies and Allocator Perception

In this section, the discussion revolved around the role of short-term trading strategies in a multi-asset portfolio, how they are viewed by allocators, and the liquidity in the market.

Key points:

• Michael's firm considers their major products as absolute return oriented, and many clients view them as a crisis risk offset style bucket. They primarily focus on generating alpha, but their return stream does lend itself well to a balanced portfolio.
• Short-term trading strategies are generally seen as diversifiers, and their return streams can sometimes help during market crises.
• Although short-term futures can be idiosyncratic within the CTA space, they still get lumped with trend followers. This highlights the importance of having a diversified portfolio with multiple zero-correlated trends.
• Michael believes that the popular media and even some financial institutions get the liquidity issue wrong. They often fail to volatility adjust when assessing liquidity. In reality, volatility-adjusted liquidity is still present in the market.
• Crabel Capital Management experienced its lowest slippage year in 2022, indicating that the liquidity was present when adjusted for volatility.
• While Michael acknowledged the unusual wide spreads during the March 2020 market turmoil, he believes that market makers and high-frequency traders have adapted to the modern world and adjusted to volatility accordingly.

In summary, Michael stressed the importance of a diversified portfolio, with short-term trading strategies playing a role as diversifiers. He also challenged the popular belief that liquidity has significantly worsened, arguing that when adjusted for volatility, liquidity is still present in the market.

Misconceptions of Short-Term Trading and Trend Following

Michael addressed misconceptions about short-term trading and trend following. He disagreed with the idea that a "set-it-and-forget-it" approach is more reliable in trend following. Instead, he believes that consistent improvement and adaptation are necessary to stay competitive in the market. He used the example of John Henry's firm, which failed to evolve and eventually fell out of relevance.

As for short-term trading, Michael pointed out that having a long vol bet does not guarantee success on every single down day. The path dependency and intraday market gyrations can lead to losses even with a long vol profile. He emphasized that while their approach may not be perfect, the long-term track record should provide evidence of the efficacy of their strategies.

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.