19 How to Take the Emotions out of Investment Decision Making with Roman Lutz of Future Value Capital - 1of2

Niels

Welcome to another episode of Top Traders Unplugged. Thanks so much for tuning in today. I know how valuable your time is, so I appreciate you spending some of it here. On today’s show I’m talking to Roman Lutz, Managing Partner of Future Value Capital. His interest in global macro trading and whiskey, led him to meet and team up with his business partner Walter Distaso, and today they are part of a new trend in the hedge fund space. This trend involves establishing their business as part of a bigger hedge fund alliance platform, which allows them to focus on what they love the most: research and trading. Seeded by a pension fund in 2013, they continue to evolve their Risk Premia trading program, which tries to capture many different alternative return streams. For those of you who are new to the show, I just want to let you know that you can find all of the show notes including a full transcript of today’s episode on the TOPTRADERSUNPLUGGED.COM web site. Now let’s get on with part 1 of my conversation. I hope you will enjoy it.

Niels

Roman, thank you so much for being with us today. I really appreciate it.

Roman

Thank you Niels, thank you for giving me this opportunity.

Niels

You’re very welcome. Now today is a little bit new for me as so far that I have mainly been speaking with managers that often would have had 10, 20, or even 30 years of track record, and predominantly been in the directional trading space, but Future Value Capital does not really fit into this description. Firstly you are relatively young when it comes to your live trading of the strategy, and secondly you have a number of different ways of extracting the returns that you are looking for, Although I sense that there may be some trend following aspects in a couple of the sub-strategies, you also do a lot of other non-directional trading inside your portfolio, so I’m really looking forward to learning much more about this area as it is new to me in some respects. Another theme that I think is really interesting is the way that you combined fundamental research with systematic implementation, so I guess the best description of what you do might be systematic global macro. I hope I’m correct in these observations, Roman.

Roman

No, that’s absolutely correct. I think we are a classic systematic global macro manager. Basically, if I have to summarize in one or two sentences what we do, we implement very well established hedge fund strategies in a systematic way. A good example is merger arbitrage. There are a lot of very successful merger arbitrage managers in the market. They have track records of sometimes more than 10 years. But the typical merger arbitrage manager is an alpha proposition. So often these managers invest only in the best 10 mergers they can find in the market. So they have a big research team, and they basically try to select the best mergers they can find.

We are a bit different. We believe there is a risk premia, which can be earned in a systematic way, and we basically invest in every announced merger we can find, provided there’s some very basic criteria which have to be fulfilled, and they’re typically market cap, deal size, liquidity, but provided these very, very basic conditions or met, we invest in every announced merger. It means that we buy the target share and we either short the acquirer or we just hedge out the market risk by selling some index futures. We do this across different asset classes. We do this for example in volatility – we do systematic volatility arbitrage. So we try to capture the spread between implied and realized volatility on different asset classes: let’s say on equities, or interest rates, on commodities and also currencies. We do carry trades. A lot of people are familiar with carry trades in the currency world, so we obviously do this too.

We also are very diversified. We don’t only trade G10 currencies, we actually also trade emerging market currencies, so we are going long, high yielding currencies like the Brazilian Real, for example, and we go short low yielding currencies like the Japanese yen, or the Swiss franc. But again, we don’t take any directional bets. It’s basically a systematic way how we capture these carry risk premia. We also do a carry trade, for example, that’s a bit unusual in the credit space. So we are going long, high yield credit, and we’re going short investment grade credit – not a lot of people do this, but we think this is also a very interesting risk premia which can be captured. So in total we have about 15 broad strategies, and then it depends a bit on the market. These 15 strategies have sometimes 4 or 5 (sub-strategies) but in other cases 20 to 30 sub-strategies. So…

Niels

That’s diversification inside.

Roman

Yeah, a lot of diversification, but typically very simple model. So nothing very complex.

Niels

Sure. That’s a great way to start and a great introduction to the program which we will, of course, go into in much more detail on this pod. What I wanted to do first, and maybe even before we talk about where you’re company is today. I’d like you to take us back all the way to the beginning of your career, or maybe even before you go into the financial world, and just tell us your story and what led you to take this path and really feel free to go back as far as you want, and also share with us how you met your business partner Walter Distaso, because that’s obviously very relevant to where you are today.

Roman

Yeah. I think the idea for the strategy kind of developed when I was working in the investment banking industry. I spent 15 years working in the financial industry. I spent most of my time working for Morgan Stanley, and I basically have a derivative background. When you work in derivatives, often the way you build your business is you try to develop solutions for your investors or for your clients. So that’s, I think, a typical way of how to build a derivative business: you try to find a regulatory or an investment problem and you then develop a solution. Typically that works quite well. In 2008, in the financial crisis, I just realized that the hedge fund industry has actually quite a big problem, and I think that the problem was, and to a certain extent that the problem is still here, is that a lot of the hedge funds don’t really deliver what a client expects them to deliver.

I think that the biggest problems are that the high correlations of hedge fund returns, with the returns of assets clients already hold in their portfolio (like equities, or credit, or commodities) and this is really the starting point. I felt that there is an opportunity, and why don’t I use the knowledge that I acquired in the equity derivative space, and try to develop an investment strategy which really delivers uncorrelated returns, because that is what clients want to see, which is liquid, which can basically be put into a regulated fund with daily liquidity because that’s really what clients want to see. That’s basically the whole starting point.

I started to do my own research. I first dug in to the CTA world, because I think that whole CTA space embraces the concept of uncorrelated returns and liquid investments quite well. But then I thought it’s probably interesting to develop other alternative investment strategies, besides the trend following in a systematic way, and then I basically started to discover this whole world of alternative risk premias, and I basically, over many, many months – I think the whole learning process took probably about nearly 3 years, I think, where I basically  started to understand that a lot of these strategies, like merger arbitrage, or volatility arbitrage, or the carry trade – they basically can be implemented in a systematic way.

Niels

If I can just interrupt you here. Because I think that’s very interesting. Now you said you realized what investors were looking for – they weren’t really getting from the hedge funds due to the high correlation. I think that’s an interesting observation. It was one of my questions later on, but I think you’ve already gotten there, because one of my previous guests, Marty Bergin from Dunn Capital, who has been around for a very long time as well, he certainly mentioned on that episode that he had seen higher correlation now between traditional alternative investments i.e. the hedge funds space (maybe excluding the CTAs), and the traditional assets, exactly as you are pointing out in the beginning here, but was it only from your own observations that meant you went down this path, or were investors telling you this? Where they actually saying to you, “listen, we’re investing in these hedge fund strategies, but here comes 2008, and suddenly we find ourselves being down, losing money at a time where these strategies should be helping us”, how did that come about? If you can remember back in 2008?

Roman

Yeah, it was a bit of a combination of both. I knew a lot of investors, and I was speaking about it with them and they clearly indicated that there is definitely an opportunity in this space because most hedge funds have far too high a correlation, and it also can be seen in the data, so if you measure the rolling correlation of one of the big hedge fund indices, let’s say the Dow Jones Creditors Fund index, with the S&P or the MSCI World, you can see how these correlations have increased over the last 10 years. So I think in the 1990s, the average correlation of a hedge fund with equities was about 0.6, and today the average correlation of a hedge fund with equities is about 0.9.

Niels

Why is that do you think, Roman, if I may ask you?

Roman

Hmmm, Yeah. There are different theories around that. We believe, and there is also quite a lot of research that has been published about this, that the alpha capacity is very, very limited, so what I want to say is that there is far less alpha in the market available than people who want to capture it. I think Lars Jaeger, for example, he is the owner of a company called Alternative Beta, he wrote extensively about that, and he estimates that about 4 times more assets are looking for alpha then alpha is actually available in the market. So what it means, basically, for a hedge fund manager or also for a traditional investment manager: if I can capture only a quarter of my returns with alpha, how do I get the rest of my returns? The correlations are basically a chest. Most investors basically build exposure to traditional market risk like equity or commodity or credit, and this basically explains these high correlations of the returns of hedge funds with these other traditional asset classes.

Niels

So, maybe another way of say it is that (if this is what you are suggesting) a lot of these hedge fund managers are secretly becoming trend followers in traditional markets, either by design or inadvertently, but that’s what they need to become in order to put all the assets they manage to work, and get some meaningful return.

Roman

Yeah, I think if they will be a trend follower, I think the correlations will be lower. I think the industry over all is just very, very much long biased.

Niels

Yeah, that’s what I mean, because we know that if you were a hedge fund and you were focusing on stocks and bonds. For example, in the last five years a long only strategy or a very long term trend following strategy, would have kept you long, would have given you good results, but of course would have also increased your correlation significantly…and risk, if I might add.

Roman

Exactly, yeah. So, I think to be fair, the trend followings…it was a very difficult time for a lot of the CTAs over the last 3 years because there weren’t many trends out there, but typically they react very quickly and they generate positive returns when traditional risky assets are falling, so I think they deliver when they have to deliver. I think it’s just very difficult when we are in a mean reverting environment.

Niels

Now I interrupted you in the middle of talking about your background, so please go back and continue where you left off.

Roman

Yeah, maybe I can move over to how I met Walter. During this process of doing research we had a common friend, and it was actually a social event. He organized a Scottish whiskey tasting (laugh). But, he obviously knew that Walter was doing academic research in this area, and I basically did research more from a practical angle, and he just felt it might be a good idea for these two guys to meet and to have a discussion because they are interested in the same fields, they are interested in alternative risk premias but they have completely different backgrounds. One comes from the academic world, and one has industry experience, and this could be a very good combination. It turned out that he was right.

So we started to meet, we had a couple of lunches and dinners, and very quickly we realized that we can learn a lot from each other. I have no academic background, but I know a lot how these rates are implemented. I am very much familiar with transaction costs and how these transactions are implemented in practice, and Walter with his background as a professor in Economics, he has an extremely deep knowledge in statistics. He knows a lot about how to build models and also to build stable models…stable and robust models, because it’s very, very easy to fool yourself if you have a lot of data and build up a system which looks great in the back testing, but I think the key point is that you build a robust model which also works going forward, not only in the past.

So I think it is a very good combination from a skill set point of view. We have completely different histories, but we have a common passion, and I think it’s not only to produce a product in this alternative risk premia space. Our passion is more broad. We really want to be a client focused alternative investment firm, and we just want to deliver to clients what they expect from alternative investment. That’s what our passion is, and we think with alternative Risk premias we have a very powerful tool to do that.

Niels

Now, where did the systematic side to your business come in? Was it the amount of data that you need to analyze that forced you in that direction, or is there, in fact, maybe another reason for also going purely systematic in term of implementation, and so on, and so forth?

Roman

I think there are two sides of that. To invest systematically has two advantages. One thing that is very powerful about systematic investments is it takes the emotions out of the investment process. I think this is very important that you keep emotions away, and you react or invest rationally, even if markets are completely irrational and investors are behaving irrationally. I think it’s very important that you continue to follow that path and to trade systematically gives you this opportunity. The second point is, I think, it really allows you to be very diversified and trade a lot of asset classes and a lot of models alongside. I mentioned in the introduction that we have 15 broad models and sometimes only five, and in other cases 20 or 30 sub-models. So, we have probably over 100 sub-models. If we would have to make rational decisions without having very good technology and the systematic investment process, this would be an impossible task to do, or we would have to hire 20 or 30 people to do that. I think this is probably the other big advantage of trading systematically, you can trade, even if you trade very simple models as we do (we don’t do anything complex) you can be invested across many models, across many asset classes, and at the end you end up with a very well diversified portfolio which gives the investors a lot of protection.

Niels

I think these are great points, Roman. To those two I would add one more in that being systematic allows you to test your models back in time, and that’s obviously also very important, but a big issue I find, when speaking to investors, is generally that as soon as you mention the word systematic they think black box, and that causes a bit of a negative emotion with many people. I also hear a lot about investors looking at managers that they sometimes at least, have a preference for discretionary managers, almost shying away from people as soon as they mention that they are systematic. I think that’s a bit of a shame, and to quote one of my previous guests, Karsten Schroeder, from Amplitude, he once said in an interview, which I thought was a great explanation, is that it’s almost like going on an airplane: you really wouldn’t expect to go on an airplane and the pilot would be sitting there manually flying the plane for 12 hours. You actually prefer that he uses technology and uses his autopilot to get from A to B. That’s essentially the same that the systematic trading managers do, they just help on the implementation. It doesn’t mean that the airplane or the computers are making the decisions, that they’re just implementing your decisions or the manager’s decisions. Anyway, those are some great points that you mentioned there.

Before I jump to the next area of our conversation, I wanted to ask something like an overriding question, and that is, strategies today are often designed to perform well in a specific environment. So we know if you are a trend follower, you want trends, that’s very clear. Therefore there will be periods or environments where a strategy doesn’t work, and so in many respects, what investors should be looking for when putting together their portfolios of external managers, is to design a portfolio that has strategies that work in very different environments, because that increases the overall robustness of their portfolio. So, how would you describe the environment that your program is designed to work best in?

Roman

I think that’s actually a very good question, because the way we construct our portfolio is probably similar to maybe a broad hedge fund investor, or a big fund the fund. So a big fund the fund tries to pick the best long/short equity manager, maybe the best CTA, maybe the best credit manager, and they obviously make sure that, overall, the portfolio is balanced and delivers stable returns in different market environments. So that’s what a good fund the fund, or a good hedge fund investors should do.

Now we do exactly the same, the only difference is that we don’t invest into hedge fund managers, but we build systematic trading strategies which basically do what these managers often do in a discretionary way. We look less at market environments, but we look a lot, we assess a lot how the returns of these strategies are distributed. Typically they’re not normally distributed. Either they have negatively skewed returns – so they perform poorly during distressed markets. For example, merger arbitrage, you have long buyers, you have long target shares, you try to hedge out the market risk by shorting the acquire or by selling index futures. But still, a typical systematic merger arbitrage strategy has a negatively skewed return. Similar to volatility arbitrage, where you capture the spread between implied and realized volatilities. It’s like an insurance premium, you earn every day, or every week, or every month, this small premia, until volatility starts to spike and then you lose. So these strategies which have negatively skewed returns. We try to combine them with strategies which, obviously, have positively skewed returns. Trend following for example has these characteristics. Another good example would be tail hedge strategies being long forward stopping variants, or being long on the spread between high yield and investment grade credit. So when credit spreads are widening, the strategy performs well. Basically what we try to do is to come up with a very balanced portfolio which should perform in most market environments.

Niels

So kind of an “all weather” type strategy (laugh). To quote a very famous large hedge fund product that we all know.

Roman

(laugh) Yeah, exactly.

Niels

Now, I want to go to our first area which is a little bit about how you’ve organized your business, but before we do that, maybe you could just summarize where the program is today, when it started trading, and what your current AUM is in the strategy.

Roman

Yeah, so the whole research process started about 3 years ago, so we did a lot of research, we traded the strategies during these three years with our own money. Initially, obviously, it was a very small portfolio, only a few strategies, and basically it then grew into the full program. But to trade really with client money, we started last year, in September, we launched a UCITS fund. We got seeded by one of the largest European pension funds. They put in a bit more than 30 million. We basically manage this money now for about 8 months.

Niels

And that’s where your AUM is at present as well.

Roman

Exactly.

Niels

In terms of your organization, I’d love to find out more about how you’ve structured your firm, partly in terms of what you decided to do in-house, what you decided to do without outsourced providers, but I also noticed that you joined this alliance with Trium Capital and I’d really like for you to tell me about that, as much as you can, because I think it’s so modern the way you’ve done things, the traditional way of setting up as a hedge fund strategy or firm has really been starting from scratch and building everything in-house. That’s how I’ve done it a couple of times. But what you’ve done is you’ve kind of slotted yourself into a structure, a platform, as far as I can tell, and I think so many people can benefit from learning what the advantages of this is, what if any, disadvantages you’ve come across, how it works in practice, and so on, and so forth, so perhaps you could spend some time really telling about the way that you have organized your business internally, as well as the people that you work with.

Roman

Yeah, I think what has changed since 2008, just to describe a bit the new environment, the new managers are faced with. The regulatory environment has completely changed, so I think before 2008 or 2009 – it really changed in 2010. It was completely reasonable to take a small office, to have a head of research, maybe have a trader, and a junior person who does a bit of compliance and back office, and launch a Cayman fund. Investors accepted that this is a new manager that this is a great opportunity, we are happy to take these operational risks. This has completely changed, first from a regulatory point of view. Regulators just don’t accept such a lean setup anymore. If you are FCA regulated, you have to fulfill not only these obvious regulatory requirements like capital and fit and proper owners, but also the whole infrastructure. You need experienced people in key positions like operations, risk management, and compliance. It’s not enough just to have two guys out of a basement in Mayfair. It’s not working any more.

Also investors have changed. Unfortunately Madoff completely changed the industry, and investors have very high expectations and very high due diligence requirements. So this is the new environment that new managers have to deal with. Obviously, I told you that we were seeded by a European pension fund. They were very clear – they told us look, we can only give you the money if you provide us with institutional infrastructure. We basically decided to team up with a couple of other hedge funds and create a hedge fund platform alliance whereas we keep the key functions within Future Value Capital – so research, portfolio management, and all the distribution of the fund, these are the key functions we keep within ourselves. We share, for example, the CEO, we share the risk manager, and we share legal and compliance with currently two other managers.

The advantage is massive economics of sale, so we are in a position to hire a very experienced CEO. If we, with the assets we currently have, and the fee income we currently have, we probably could hire only a very young operational person, now we are suddenly in a position to hire a CEO who has 25 years experience in the hedge fund industry, who has been a CEO of a very large multi billion, multi strategy hedge fund. So somebody who knows exactly what the investors want to see when they come and do due diligence with it. The same of the risk side. Obviously you can hire a very junior risk person, but typically investors are not comfortable with that because the partners or the portfolio manager can easily overrule such a junior person. We have a risk manager also with 15 years experience. Somebody within my age, so if I would breach some investment guidelines he would have the necessary procedures in place that he basically can force me to correct it. It is the same on the legal and compliance side. We have, basically, very, very senior people in these key functions and this gives investors a lot of confidence. At the same time the costs for providing this infrastructure, because we can share the costs, are manageable.

Niels

How did it actually come about, because it sounds to me like you actually found your own investor to begin with, but this alliance, was that already in existence, or did you actually have to go out and find a couple of other hedge funds to say, “why don’t we do that, and let’s go together, let’s hire a CEO”, or how was Trium Capital actually functioning at the time when you started.

Roman

We were basically the first manager. So shortly after us a long/short manager joined and now we have a pipeline of other managers, but we basically were the first ones who joined the platform.

Niels

I think that’s a great, great strategy for, as you say, emerging managers today. It’s really, really hard for them to get going now-a-days.

Roman

I think it’s good also for investors because investors like new strategies, they like new managers, they are keen, they are interested to explore new avenues, but what they cannot accept are weak operational infrastructures, and I think this is a very good opportunity to give investors access to a new innovative strategy, and investing to a fund which maybe doesn’t have 100 or 200 million under management, maybe only 35 or 50 million. At the same time they have the confidence and the peace of mind that this is a very, very stable infrastructure. If you think about it, it’s actually very similar as if you would invest into a very large multi-strategy fund.

If you look at big hedge funds. They’re often organized in this same way. They have maybe a long/short equity manager. They have maybe a systematic manager. They have maybe a credit managers. Then within the group they have the risk manager. They have the back office. They have the legal and compliance team. The difference is that all of this is under one roof, and it’s all under one brand, and these portfolio managers are basically employed by this big hedge fund group, whereas in such an alliance like we do is we are independent, we are still the owner of our company (I think this is also important), but at the same time we have similar economic scale as if we would be a part of a big hedge fund group.

Niels

Sure. And in fact, Roman, these kinds of setups, they seem new, but in fact they’re not. I was part of a similar structure back in the early 1990s called G&I Fund Management, and they did exactly the same. It works, and it probably is more important today for other reasons, but I completely agree with you that it’s a good idea.

I have a couple of questions before we jump to the next area and that is, now I can see all the advantages, but in trying to get to as much detail and openness about these conversations that we’re having on our podcast, what’s the disadvantage? Have you come across anyone or anything where you said, OK there’s a bit of pushback from maybe investors or from other people, and I see their point, I can’t change it, but I see their point, is there anyone who has been voicing any pushback to being part of an alliance like that?

Roman

I think the key point, or the critical point is whether you get the necessary resources. The risk is that such an alliance, they take too many managers on board and then you don’t get the necessary support from the risk manager, or from the compliance officer, or from the CEO. This is the risk. It is an alliance, so at the end of the day the managers in this alliance, they are in a quite strong position because we pay a fee to this infrastructure and at the end of the day we have a service level agreement, and this service level agreement can be terminated, so if the service is not good, you have two options: you resign and you hire the people yourself, or if you don’t get the resources from the platform you build it yourself internally, but typically we all sit in the same boat.

These platforms have a very strong interest in these managers, which are their clients, that they get the right level of service. So basically what needs to happen is that, if there are more managers coming, they just have to provide more headcounts and more resources and hire more people. But if it doesn’t happen, let’s say, if this platform would say we don’t want to do that, or we cannot do that then there are many options to do that. The worse thing is that you break out and you do it yourself, or if you say OK I need an additional back office person, you just can hire this person directly into your company and not into the platform. So there are different ways to do that.

Niels

Does Trium operate independently from the managers, or do you have a say in terms of who they add to the platform?

Roman

We don’t have a veto right, so we couldn’t influence that, but obviously they wouldn’t do anything we would oppose, because they would lose us as a client. You know how these things are, it’s like if you have an investor in your fund and it’s your biggest investor, or the most important investor, you always make sure he’s happy. I think in theory there could be possible problems and conflicts and they’re obviously getting raised in due diligence meetings, but in practice we all have a common interest, and it is an alliance, so we want to work together, and these problems can all be solved.

Niels

It’s like any marriage, isn’t it, it’s a give and take. (laugh)

Roman

Exactly (laugh)!  You have conflicts, obviously there’s always a bit of conflict, but there is in every business relationship but they can be solved.

Niels

I had one more question about this before we move on. I don’t mean to ask for a specific number relating to your business, so I’ll ask the question a little bit differently, if a company or a group of people came to Trium today, and wanted to be part of the alliance, what do you think they should expect to pay for being part of an alliance and get the services required to be able to operate as a regulated and well run operational firm?

Roman

It is a bit difficult for me to answer because I have to keep this confidential, but typically it is a certain percentage of the fee income. It depends on how these things are negotiated. I think it’s like every deal, it depends a bit on negotiation positions of the two parties. Sometimes, let’s say if you are a high profile manager, you come from a top hedge fund firm, you bring already 100 million, and the platform thinks that you’re in three years at 500 million, then you probably can negotiate a very fantastic deal. Whereas, if you come with 5 million, with your own money, you have no hedge fund experience, you have no sales, you don’t bring a sales team with you, and the platform thinks OK they’ll probably need 10 years until this guy is on the reasonable level, then the deal will look very differently.

Niels

I think the answer is the people who are interested need to reach out and find out, but it’s interesting and it’s nice to hear that there are these opportunities and clearly it’s working well for you and for the other managers in the alliance and that’s great. I want to jump on to track record, and I know I said initially, and you obviously mentioned that as well, that since you started trading the portfolio in 2013, so in a sense maybe it’s not quite so relevant as a question, but let me ask it anyway, and that’s about whether or not we should look at your track record in stages? Meaning, often what happens with a strategy, as it evolves, more models, more strategies etcetera, you could argue that it’s difficult to look at a 10 year track record because the system is simply not the same 10 years ago as it is today. In the period that you have been trading live, have you already made significant additions to your model, or has the model itself, (I call it the model, but maybe it’s the program as a whole) been reasonably stable in term of the number of models and top models that you run?

Roman

Yeah. I think we haven’t changed anything on the models. We added a few new strategies, just because we continue to do research and it’s our intention to launch every year a couple of new strategies, so we have done that. Generally, I think we try to be very forward looking, even though we work with back testing. That was why I think systematic global macro or global macro is a very good description of what we do because what we basically establish semi-annually is a global macro view. We sit together and we try to assess where the economy is going and what kind of risk premias or what kind of strategies are going to perform well in the next 6, 12, 18, or 24 months. So it’s a very forward looking way to do it even though we work with back testing.

So a good example, and I always come back to merger arbitrage. You know merger arbitrage has been a terrible strategy over the last 2, 3 years because for the simple reason that we came out of a recession and there weren’t many mergers. So all these merger arbitrage managers had a very, very difficult time and the performance was actually very flattish, I would say. It was not terrible but it was clearly not a strong performance in this sector. Never the less, we decided to develop a systematic merger arbitrage strategy and have actually an overweighting exposure in this strategy at the moment because we believe that we are in a very good environment for these strategies for the simple reason that the number of mergers has increased dramatically over the last couple of months.

The corporate balance sheets are very healthy. They have a lot of cash which they want to employ, and if you read economic research, or strategy research a lot of people believe that the merger activity is going to continue to improve over the next couple of months. More of these are getting announced and more activity will come into this sector. So even though the back testing looks terrible over the last 3 years, we actually have a significant portion of our portfolio invested in this strategy.

Niels

That’s a good segway, maybe, to the next part because this is really where I want to talk about your program as a whole, and the design, and so on, and so forth. Clearly when you talk about it like this, you can say that there is this fundamental, and I might even add discretionary element of the strategy, not in terms of implementation, but clearly in terms of how you allocate risk. As you mentioned you decided to allocate more risk to merger arbitrage at present. Now that’s a decision that the computer didn’t make, that’s a decision that you made and so on, and so forth, so maybe from a top down view, let’s talk about the program and really feel free to go into some of these different types of risk premia. You used both short term, long term, you had the equity, and the FX volatility, and many other, so that people can get a feel for how it’s constructed and how it works together, which is obviously quite important.

Roman

Yeah, I think there are probably three sub-categories: one big category like this traditional alternative risk premias and basically merger arbitrage is clearly there, volatility arbitrage is there. So volatility arbitrage, it’s basically captured in a spread between implied and realized volatility.

Niels

And how do you do that? Because we have to assume that a lot of the people listening to us today may not be hedge fund managers themselves, so how do you capture that spread?

Roman

So technically it’s done with variance swaps, but what the strategy is actually doing is it captures the spread between implied volatilities, so these are volatilities extracted from option prices, and the realized volatility. Now this spread historically has been most of the time positive.

Niels

You mean that people are expecting more volatility than is actually being realized?

Roman

Exactly, and has to do with risk aversion with investors. So that means more put buyers are basically in the market than put sellers. So more people are basically looking to buy protection than people are waiting to sell protection. This basically explains this spread, which can be captured. So you’re selling implied and you’re buying realized volatility.

Niels

How do you buy realized volatility?

Roman

You just dealt the hedge, this option portfolio. So a variant swap is basically nothing else than a portfolio of listed options, let’s say on the S&P. You basically replicate the whole options que. So if you have calls and put options, you sell all put options and you sell all call options, and you just have to get the ratio right. In general terms you are selling more put options than you are selling call options, just to replicate this options que. In a technical term, you build a US dollar constant variants portfolio, that’s basically what you do. Then every day you delta hedge this portfolio, so you calculate the next delta of all these option positions, and if the delta is positive, you sell some index futures. If the delta is negative, you buy some index futures. It depends on the market movement.

Niels

Sure. So just for me to understand is that, if for example, buy selling more put options obviously you have a certain risk that if the market really gets in a big correction out of nowhere, clearly you have a risk there. Therefore you sell futures to offset that open risk so to speak.

Roman

Yeah. Exactly, that’s what you do. There are other things you can basically do to manage this risk. Often you cap the variance. So you basically sell capped variance swaps. So the elastic space is limited. It’s like a stop loss. Then often you can manage the duration of these variance swaps, so typically you spread the trades over, every week you trade monthly variance swaps instead of trading one variance swap and roll it like every month. So you half the duration of the trades. Then that’s probably the most important part of the trade. This trade works well when volatilities are mean reverting. It becomes very dangerous, or it can create losses if volatility starts to trend. You need a good model, which basically tells you when these volatilities move out of mean reverting regime, into trending regime. There are different ways to do that.

Niels

Now a strategy like that, is that something that is employed all the time, or would there be something in the market, something in the data that suggests, no you shouldn’t be doing this right now? For example, if volatility starts trending against you…I’m trying to convey this back to sort of what could be a trigger for a new signal, if we look at it from a traditional CTA point of view, but in your case, it’s a little bit different, so yeah, it would be interesting to find out whether there is anything that basically tells you when to deploy these strategies and when not to deploy these strategies.

Roman

Yeah. So generally you would try to unwind the trade, or leave the trade, or not to roll these variance swaps any more when volatilities start to trend. And the different indicators: in the past investors looked often at implied volatilities, so they for example, looked at the VIX, and they for example used SAT scores where you measure basically how many standard deviations are currently implied volatilities away from the mean. We think it’s not a very well suited indicator because implied volatility is actually a very bad predictor for future realized volatilities. You also see these, very often, you might have observed that yourself. You see, especially over the last couple of months… or in January, for example, you see massive spikes in implied volatilities. So implied volatilities go from 15 to 30, but the realized volatility, the S&P is not doing much. So the volatility of volatility is very, very high, and especially the VIX reacts very, very quickly, and tends to over react.

So we think implied volatilities are actually a very bad indicator for future realized volatilities, but what is a much better predictor is basically realized intra-day volatilities. If you calculate realized volatilities using high frequency data, but I don’t mean say every tick, but a frequency of every 5 minutes for example, and you compare that to maybe the weekly or the monthly realized volatilities and you calculate certain ratios. There’s also a lot of academic research written about that so what I say here this is not a secret. This is a much, much better predictor of future volatility than for example the VIX. So we work with the later. We look a lot at what is the distribution of the returns intra-day. That’s where we basically take our signals to assess whether the regime on the volatility side is actually changing a lot.

Niels

What other main categories do you have in your portfolio from a strategy point of view?

Roman

So the other one is obviously trend following because they have these traditional risk premias, then have negatively skewed return. The nice thing about this momentum risk premias, they have positively skewed returns, so typically they perform well when the market is in distress, often a little bit with a time lag. It depends a bit how quick your model is, if you have a very fast model you might capture a downside move very, very quickly. If you have a bit slower model it takes a bit more time, but I think one of your CTA guests is much more competent to talk about that then myself.

Niels

That’s fine. I’d actually be interested in hearing from you how you do trend following, what, in just broad speak, how do you implement it?

Roman

We use very simple models…

Ending

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