109 Risk Mitigation Whilst Trading Exotic Markets with Doug Greenig of Florin Court Capital - 2of2

Niels

I read an article the other day, actually, about the AUM and funds that focus on exotic markets and your firm was definitely mentioned in that article. It talked about the total assets in those kinds of strategies having gone up from about a billion dollars, five years ago, to (they’re estimating) seven billion today, I think was the number. Of course, I know that your firm has grown a lot as well. How do you view that development, and how big, as a space (not necessarily as a firm but as a space) can this become without too many people chasing the same exotic markets?

Doug

I think that the space has a fair bit of room to grow. The CTA space has, I think, about three hundred to three hundred and fifty billion in AUM. We’re talking about a number in the neighborhood of ten for the exotic markets. Some of the exotic markets are very big and deep markets. The Chinese commodity markets are huge, for example. Some of the interest rate markets are quite large as well. Some of the foreign exchange markets are pretty large.

Now, one piece of evidence that it’s not getting that crowded, just empirical evidence, is when we went to a one hundred percent exotics focus in April of 2017, before that we were about fifty percent exotic and fifty percent not. But, we said we’re going to be a pure play exotic CTA – that was in April of 2017. From then to the end of September or even to now… I believe from April to the end of September we were up twenty-one percent when the CTA index was down one. So, the exotic space has continued, and it’s not just us. Other people in the space have done well also. The exotic space has continued to perform well. In addition, we’re not seeing the kind of weird kurtotic behavior, weird fat-tailed behavior, that we’ve seen in the regular CTA space.

October, for example, was a difficult month. There were some other difficult months for the CTA space this year. It’s not been a good year for CTAs. We’ve seen some shocking numbers, just shocking numbers among regular CTAs indicating that there’s a fair bit of kurtosis in what they’re doing. But you really haven’t seen that in the exotic space. Yeah, you have your good months, you have your bad months, but things seem better behaved.

Niels

Right, absolutely. Being focused, as you refer back to the CTA industry, and of course, that’s been known over a number of decades for being one, predominantly futures-oriented, very liquid strategy, kind of the ATM during the financial crisis, and trading on exchanges where there are very limited counterparty risk, etc., etc. Making the decision that you made last year to go fully in on the exotic, how much more education do you feel you have to provide when it comes to explaining what you do and explaining how you execute them successfully? How difficult is it to attract investor’s attention?

Doug

It hasn’t been that difficult. The diversification argument everybody gets: eggs in China, Columbian interest rates and Spanish electricity – people get that, they get that right away. The better performance of exotic markets over the past eight years, since the financial crisis, that’s also pretty straightforward, although explanations differ. Perhaps regular CTAs would have performed spectacularly had Central Banks not rescued the world from the brink. Again you can consider the counterfactual.

So, diversification, better trends, I think people buy that. The point where some education is required is on liquidity. The number one way to protect yourself from idiosyncratic risk, liquidity risk, is to make sure that your positions aren’t too large. Part of that is volatility floors, part of that is other position limits you can put in place. You don’t want all of your eggs, even Chinese eggs, in one basket. That’s step one.

Another point that is very important is to rely overwhelmingly on momentum as your key signal as opposed to carry or any other kind of signal. I think the Turkish episode will illustrate my point. When we talk about illiquidity, actually there’s a kind of asymmetry to it. It’s usually a lot more illiquid in one direction than another.

So, think about the case of Turkey. The situation in Turkey where inflation has been increasing, the questions have been raised about the governance of the country, and the independence of the Central Bank. The situation there has been deteriorating for months and months. If you’re a trend follower, you’re going to be short risk in Turkey, let’s put it that way. You may be betting on higher interest rates or lower asset prices, but you’re going to be short risk.

There was a very typical crisis where things deteriorated, deteriorated, deteriorated. Then there’s a catalyst, and it goes down really hard. That is typical. Ninety percent of the financial crisis’, and I’ve seen so many of them over the years, have this characteristic of bleeding, denial, concern, then there’s a catalyst and things really break.

But when things break and start moving quickly, if you’re trading momentum as opposed to other kinds of signals, you’re very likely to be going in the right direction. Then, it’s when that peak of the crisis occurs, when things are really hairy, that’s when liquidity “dries up.”

At that point, by the way, what we do is we recognize that liquidity is not so good and we reduce or eliminate the position. But, notice that when we do that we’re going the right way, by which I mean, if you were short risk in Turkey, as the August crisis hit, it was not very hard to buy risk, to cover your short. It was pretty easy to do so. The problem is much greater if you’re going the wrong way and you need to get out.

People can learn a lot, actually, from the housing market. So, in housing markets, when you start to get into a bear market in housing, bid-offer widens for residential housing, sellers are reluctant to lower their asking price, the bid starts to disappear, transaction volumes drop, and then, gradually, some of them will force sellers to come in and will hit lowball bids. But, the reality is, if you’re looking to buy, it’s not hard to buy. The illiquidity is much worse from the standpoint of the seller, with their expectations about what they might get.

Mort

So, interesting point there, one question, do you have an exit as a function of liquidity as opposed to price turning around?

Doug

Well, under normal circumstances, where there isn’t a huge change in liquidity, the exit occurs through the price in volatility changing. Remember that the day to day changes in CTA type systems, which are the types of system that we use in trading exotic markets, the day to day changes are driven more by changes in volatility than by changes in momentum.

So, for example, in a case where a market starts falling very had with very high volatility, volatility may double or triple in a short period of time. So, volatility scaling will cause you to get out of half of your position, or two-thirds of your position, just from the jump involved. Then, if it starts to turn the other way, then over a period of time the momentum signal can pick up that you bottomed and are now turning, but it’s the jump in volatility that causes the fastest, and most reliable position reductions in a crisis.

To your question, we manage our liquidity risk so that we can confidently liquidate our portfolio in a matter of a week or so, under most liquidity conditions. So, when liquidity drops then we have to, as a matter of principle, as a matter of policy, cut our risk accordingly. If it’s bad enough, we just take a decision that we’re not going to trade until liquidity returns to more normal conditions. The good news, as I said, is that when you take that decision, the odds are really good you’re going the right way.

Niels

I was just curious because I don’t really have much experience with over-the-counter markets. How do you measure liquidity in over-the-counter markets on a day to day basis?

Doug

Well, the first thing is that you are interacting with dealers. As you interact with dealers, you see the bids and the offers that are available. You see the dispersion on the bid side and the offer side, and you also see the quantities that they’re willing to do. So, having a human trader, an experienced human trader – we have an excellent execution team, and they’re very important for our business. Having them saying, “Doug, here is what the situation is, the sizes that the dealers are willing to give prices on are half as large as before, and the bid side is very small, and the offer side is better.” That will tell you the information that you need to take a decision.

Niels

Sure, sure.

Mort

Right, earlier in our conversation you mentioned cash equities, so cash equities they’re not an exotic market, so what role do they play?

Doug

Well, in some ways you can think of what we’re doing is like synthetic assets because what we’re trading is momentum on factors. So, for example, what’s the standard equity factor? The standard equity factor will be the value factor. Now, is value trending lower, is it trending higher? So, basically, the equity factors you can think of as a synthetic asset expressing a theme within the equity market such as value, such as growth, and there are many others. I say that they’re like synthetic assets because the value factor consists of a portfolio of long and short positions at a point in time. You can use CTA like methods to trade these derived synthetic markets, if you will, that you get from equity factors.

Mort

Got it. Staying with the equities, one very popular instrument there, in that space, is the VIX index, so volatilities, is that a market that you trade?

Doug

It is, but we don’t have much of an allocation to it, and that is one market that we trade a little bit differently because a naive CTA approach on the VIX is dangerous given the skewed and kurtotic distribution. So, it’s a little more complicated how we trade the VIX. But, we keep both the leverage and the position size small. It’s really pretty simple.

I don’t want to spend a lot of my time having to worry about or explain our position in volatility because the VIX can positively explode. I have a lot of experience, over the years, with market crisis’ and you need to be really, really careful. Because if you simply trade momentum on the VIX, the roll down on the curve and the carry look appealing, but the distribution is really quite different from other assets. So, that’s one case where special methods are needed.

Niels

Absolutely, absolutely, I think a lot of managers will say exactly that answer that, yes, we’ll trade it but we do trade it a little bit differently, which is absolutely true. I was just going to go back to one question, because you’ve got such an edge, so to speak, in implementing trades and trading these markets, and a lot of it is off-exchange, I was just curious, from a purely operational point of view, I imagine that a lot of what you do is governed by ISDA agreements. I only really recall the early days of those types of setups. How has that evolved, over time, and how sophisticated are these arrangements nowadays in terms of having multiple brokers, clearing brokers, etc., etc., for these types of markets?

Doug

Well, actually, the swaps market, for example, is very mature. Many things are standardized, and some things are actually exchange cleared I might add. Anything that we can clear on an exchange we do, as a general statement. So the market is very mature it’s just that, from the standpoint of a CTA, it’s a hell of a lot of work. It’s not something that they’re used to.

For me, interest rate swaps are pretty basic animals. I think interest swaps are, for me, less difficult than getting my hands around lumber futures, or something. That was because, for a while, I ran the swaps desk at Greenwich Capital, so I’ve been dealing with interest rate swaps, actually, going back to the 1990s. So, they are something that I’m used to.

By the way, a lot of the instruments, over-the-counter instruments that we trade are things that I’m familiar with over the course of my career. I’m very used to operating in the OTC derivatives area. Things have matured quite a lot from the old days.

Niels

Sure, I can imagine. You were the Chief Risk Office at AHL, and so I was a little bit curious in terms of how do you define risk? How do you think about risk and what keeps you up at night, if anything, when it comes to these things?

Doug

Well, there are a lot of ways to define risk. You want to start with the simplest and most basic things. There are various kinds of operational risk. You want to make sure that you’re operation is tight, that you don’t have trading errors, you don’t have the possibility of an order going in at the wrong size and being undetected.

We pride ourselves on just an extraordinary level of precision, care, and many, many layers of checking to make sure that basic mistakes don’t occur. So, that’s one level.

Then the next level to look at things is at a market risk level. What are the bets of the portfolio? How concentrated are they? You really don’t want to look at the portfolio and see that after you take correlations, and correlations in the tail into account, that you have one big bet on. That’s something that you don’t want to see. Now, if you see that, that’s a sign that the whole process wasn’t constructed correctly.

We have chosen sectors, whether we’re talking about credit, power, interest rates, exotic commodities, crypto, emerging market FX, and on and on, synthetic assets. We’ve designed this thing so that if you simulate it in the past, or look at it in the present, you are never going to look at this and say, “Oh my God! I have one big bet on!”

You end up, as I was saying, with about a dozen independent bets, some more important than others, but if you even get to seventy percent of the variance of the system. You can do this with the exotics better than the standard CTA space.

You want to build your portfolio from the ground up with these blocks that are pretty independent. Then, you want to be able to weight the individual assets within the block in a way where you get a lot of that diversification.

It’s no good to say, “OK, power is a great thing.” And end up having almost all your risk in Phelix or something – German power. Instead, you really want to make sure that you’re pushing that diversification down, not only from the sectors but across many individual assets.

So, it’s not been the case that when I scrutinize… We have lovely risk reports. They are works of art. When I look at this thing, I’ll look through it, and I’ll say, “This looks pretty balanced. You’re not betting the ranch on any one thing.” I can spot a number of different themes in there. That’s a very important part. A critical component, of course, is the volatility scaling which is common among CTAs, but I think it’s very important in what we do, very, very important in what we do.

Then there’s another level, and that’s the level of model risk. There are a number of different things to talk about there. The first thing is that you want to make sure that you have a broad spectrum of momentum frequencies everywhere. It makes it more robust. You don’t want a system where… Some of these people will talk about a performance heat map. You want it to be robust so that at slightly different frequencies, different shuffles of the data, that performance is reasonable.

You want to avoid binary things as well. Trading at excessive speeds, that can get you into a great deal of trouble. Model risk, again I talked about volatility floors, which most CTAs are involved with.

Then we get to something that I think is important. How big should the momentum allocation be? From a risk management standpoint, generally, more is better. By which I mean that the major alternative signals are carry, and carry has the unfortunate property, in most circumstances, of causing you to want more of it when it goes against you. That can get you in trouble.

Think about the case of emerging market FX. You have some country in trouble; it’s putting up interest rates, the currency is deteriorating, you’re liking the currency better and better the higher the interest rate goes, that can be a problem. So, we favor a relatively light weight on carry.

Then, there are other kinds of signals that don’t raise the same issues as carry does. Of course, the carry issues vary from sector to sector. But, we’re a big believer in focusing on the markets and using tried and true momentum systems and putting our energy into getting the next great market, or next great sector in. That’s our philosophy and our approach.

Niels

Moritz, do you have some topics you want to raise as we start slowly to wind it down?

Mort

Yes, I have one final one that I want to touch on. You mentioned the Columbian interest rate swaps, and I’m sure you can find a number of dealers that trade them, but just going back to the eggs in China, because you’ve mentioned them quite a few times. My understanding is that access to the Chinese markets is restricted, so how do you get access? Is there a special cost for trading those markets? How does it work?

Doug

Well, I’m not going to get into all of the details on how we access the Chinese market, but the point is that there are people who are legally entitled to trade the markets, and by working with them we are able to get derivative exposure to the Chinese markets. It requires a lot of work, and it requires strong relationships. That’s the key, and it does cost a little more to do this.

Niels

All right, I wanted to end on some more fun and general stuff that is, maybe, not so much related to markets and models and so on and so forth, but just for people to get a chance to get to know you a little bit better as well, Doug. So, I wanted to ask you, first of all, do you have children, if I may ask?

Doug

I have three.

Niels

OK, good, all right, so my question here is if you could pass on just one of your skills to your children, which one do you think that would be, and why?

Doug

Hmmm, you use the word skill.

Niels

Well, I use it casually.

Doug

OK, I’m thinking about it. I think a couple of things that come to mind immediately is hard work. There is absolutely no substitute for applying yourself consistently. It’s really important in this business. The systematic business is all about having a superb process and working at it and refining it. You have to put the work in.

The second thing that’s very important is focusing on building good teams and taking advice well – taking good advice. Typically, when a problem comes up at work, I’ll call some of my guys into the room. I’ll lay out the problem, and I will listen to what they have to say about it before even expressing my own opinion.

Coming into situations with very strong preconceptions about how things should be, and not listening, is a real barrier to learning and working effectively. Then, related to that, you want to pick people around you who are really good. You don’t want a situation where you can’t learn a lot from the guys you’re working with. I’m learning stuff from Dave Denison all the time. He’s learning things from me, from Matt Stevenson, from Tony, from everybody here.

Sometimes managers won’t always choose people who will challenge them, who are on a similar level. I love that. I just want the best, but I want them to have good people skills and not be too difficult either.

But the point is, one of the things that I’m so proud of, for example, with my kids, is my daughters are extraordinarily hard working. They’re doing their University applications now. In some ways, I don’t care what the outcome is because I know that they’ve done their best and I know that they have worked so hard and I’m incredibly proud of them. They’re just extraordinarily conscientious. I like to see that on my team as well, and I do.

You know the other thing, taking the example of my son, who’s reading biology at Imperial, I gave him some advice a year ago about how to get a great summer job. I told him just to find out what the hot biotech firms are in this area and just write to the CEO, say, “I’m a student at Imperial. I’m interested in your business. I’d like to learn more. Can we have a conversation?” He took the advice, he listened, he did it, and he ended up with a great, great internship this summer as well as contacts with a bunch of people.

So, I was thinking about the things that I actually am very proud of. Of course, I’m proud that my kids are smart, but I’m particularly proud that they are conscientious, and diligent, and take advice well, and act on it. In answering the question, I actually started with the things that I’m pretty proud of.

Niels

That’s great, I love that, that’s fine. Speaking about best, so to speak, what’s the best question that investors should be asking right now, both of themselves, but also of the managers? I’m sure you have been in countless due diligence meetings and many of them, I’m sure, it is these standard questions that people come up with, but what are some of the great questions that you think investors should be asking when it comes to alternative investments in general – it doesn’t have to be specifically just about exotics, but, in general when they look at our space, if we call it that?

Doug

Well, that’s a great question itself. The first critically important question is, “What is your edge? Why do you think you have it? Why do you think it will persist?” Those are very important questions.

The next thing and I’m not sure this is just something that should be asked but can be observed as well, is to try to understand the firm’s culture. I certainly have a preference for a certain kind of culture and promote it here. I’m very happy with the fact that the folks on my team actually try to help each other. The goodwill trust and helpfulness is just so high. There are very, very few cases I see of someone trying to undermine somebody else or upstage them. We really feel like we are in it together. So, understanding a firm’s culture, looking at their turnover, the stability of the management team.

Another important thing is the issue of specialization. You can’t do everything well. You need to choose something and focus on it. Again, it gets back to what is your edge? I think that it helps us a little bit that this is the only thing that we do. We’re not doing anything else except sitting here thinking about new exotic markets we can trade and how we can improve our trading of the existing ones.

There are some really interesting questions that investors can ask similar to the questions that you’ve asked about why do you think momentum will work in the future, apart from saying that it’s worked in the past? But those are almost ontological and philosophical questions that are very difficult. By the way, probably the answer is something like anchor and bias. But, the question is always, why do you have an edge? Because you shouldn’t be paying high fees to anybody, who doesn’t have an edge or isn’t bringing something special to the table.

Niels

Sure, that’s very true, that’s very true. As the last point before we wrap up our conversation, we’ve been around a few topics. Of course, we can’t cover everything. So I wanted to give you the opportunity to bring up anything that you want, really, that you think maybe we missed, or we didn’t think about, just anything you want to talk about. Or, if there is nothing, that is fine as well, but I just wanted to make sure that you feel that we’ve been covering the areas that you feel are important when it comes to you and your firm.

Doug

Well, you’ve certainly covered things pretty comprehensively. I think one point that I would want to clarify is I think that I do have a measure of optimism about momentum performance even in the developed markets, in the future. This period of massive government intervention is slowly ending. It hasn’t ended, but it’s slowly ending.

I believe that momentum has been a very persistent phenomenon in financial markets going back as far as history will take us, as far as we have data. So, I wouldn’t want to come across as being relentlessly negative on regular CTAs; I’m not. My view, however, is that the better diversification and, probably, the better trends available in alternative markets make them really, really interesting and allow you to make better pizza with these better ingredients, to use that analogy.

Niels

Sure, sure, I think that’s a great point, and it’s a great place to end our conversation, Doug, because I completely agree with you. I think that it’s been the industry as a whole, momentum or trend following, etc. etc., has been beaten down a lot. People need to look at these things in a much longer term, and maybe we’ve just gone through a short, difficult time when we look back at this in ten years time.

So, on that note, let’s wrap up this fascinating conversation where I think we all learned a lot of new things. Doug, thank you so much for being on the podcast and for sharing your thoughts and experiences with Moritz and me. It is so important to have practitioners, like you, to share these ideas because when ideas become conversations that lead to action, that’s when real change happens.

To all our listeners around the world, let me finish by saying I hope you got a lot of value from today’s conversation and if you enjoyed it as much as Moritz and I did in making it for you, please share these episodes with your friends and colleagues so that the conversation can continue.

From me, Niels Kaastrup-Larsen and Moritz Siebert, thanks for listening and we look forward to being back with you on the next episode of Top Traders Unplugged. In the meantime, go check out all of the amazing free resources that you can find on the website.

Ending

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