45 How To Overcome Cognitive Bias in Investing and Trading with Roy Niederhoffer of R. G. Niederhoffer Capital Management - 1of2

Niels

Welcome to Top Traders Unplugged, where my goal is to give you the clarity, confidence and courage you need to invest like, or invest with one of the top traders in the world. It is the stories that you never get to hear, set out as the most honest and transparent account that I can make of what goes on inside the minds of some of the best investors in the world delivered to you via a one-on-one conversation. Today you’re listening to episode 45. If this is the first episode you’ve head, you might want to go back and listen to all the earlier conversations. Before we go any further, let’s find out who’s on today’s show.

Roy

I’m Roy Niederhoffer. I’m the founder and President of R. G. Niederhoffer Capital Management, and I’m here today on Top Traders Unplugged.

Niels

Thanks for doing that, Roy, and by the way, if you want to read a full transcript of today’s episode, just visit the Top Traders Unplugged website where you can find great details from today’s conversation. Now let’s get started with part 1 of my conversation. I hope you will enjoy it.

Niels

Roy, thank you so much for being with us today. I really appreciate your time.

Roy

Thank you Niels. I’m really happy to be part of this.

Niels

Great stuff. Roy, as you know people who stand out tend to get noticed, and I think that many people who are involved in the hedge fund or CTA industry are familiar with you and your firm, but perhaps not all the unique size and talents that you have, so I think today will be great for the audience. There’s some unique stories that we can share, but before we go to your story, I wanted to ask you a slightly different question, a question that I sometimes struggle with answering myself, and it goes something along this way. Imagine that you meet someone that you haven’t met before, and you start talking, and suddenly they ask you, “so Roy, tell me what you do?” How do you respond? How do you explain what you do?

Roy

Niels the strategy that we employ has a very specific intent which may distinguish it from many other things out there. We are trying to combine both interesting standalone returns with very, very consistent downside protection for people’s portfolios in equities, traditional investments overall and also alternatives. What we try to do is maintain a consistent negative correlation to equities. In other words, we do better than average when equities are having trouble, and there’s a lot of volatility. Typically when portfolios that most people have are having their toughest times and our strategy’s actually tuned not to maximize our own sharp ratio; not to maximize our own risk-adjusted return, but actually to maximize the risk-adjusted return of our clients.

Niels

Absolutely. Now before we jump to the bigger question, I want to stay with you as a person for a while. I want to allow you to tell your story. Perhaps not just how you got into the business, but really sort of going back as far as you feel comfortable and share with us what were you like as a kid, and what drove you to the path that you took in life, so to speak?

Roy

Sure, I guess my path that led me to where I am today began with a very early interest in computers and programming. When I was thirteen, after a year of begging, I got a computer – an old Radio Shack TRS80 – one of the first microcomputers for a present and I immediately set out to teach myself to program, and I did, and I decided that because I didn’t want to feed quarters into an arcade machine, I wanted to make my own version of the old arcade game Space Invaders, which you may remember, which is what I did. I realized that that might be something that other people wanted to have as well, so I started a little company and that company eventually took me to the point, by the end of high school, where we had about 30 employees and I and my three other partners – I added a few partners along the way, we all paid our way through school and had cars and lived a rather… it was small-change compared to now, but for a bunch of 16, and 17 year olds we were surprisingly successful, I guess you could say.

Along the way we… my own experience was that I taught myself to program in a very efficient way, because you’re dealing with memory limitations that… you literally had 2,000 bites in some cases to write a program, and 16,000 was a luxury – bites. So it forced me to become a very efficient programmer. That skill then served me very well over the summers. I was also doing so work for my brother Victor, who was a very early entrant into the hedge fund space. Victor was there the first day that equity futures began and actually was a participant in the first equity futures trade. He was on the floor and very quickly realized that there were patterns in the intra-day price data that were observable and quantifiable. So I began working there when I was in high school and then all the way through college as an intern, and I was exposed to futures trading in my early teens and all the way through.

While I was in college, I had a bit of a deviation from that path. I decided that a very interesting problem was the question of how the human brain works, and I spent my undergraduate years studying neuroscience and particularly, since I’m a bit of a musician, as we may get into a bit later, I was very interested in the difference between musician’s brains and non-musician’s brains to see whether there were any observable patterns that made one’s appreciation for music different if you’ve had a lot of training. Of course, the great finding of neurosciences is that the structure of the human brain has a tremendous influence on human behavior – that we are essentially products of our hardware. That actually is an insight I’ve taken with me into the trading side.

When I graduated from Harvard in 1987, I really had this choice whether I was going to go into the field of neuroscience and continue, and I was all set to go to Cambridge. They had admitted me, but I didn’t have enough money to go, so I went to work for my brother, back in New York and it was 1987 and just before the market crashed and it was really easy to be long equities and make money, because that’s what everyone had done for five years. I started trading in the summer, and fortunately not equities, but fixed income, some short term strategies that I had already developed even in the first few months, and I was off to the races in 1987.

So while I was at my brother’s… first of all he had an incredible team there. Already I had met Monroe Trout, who was there for a couple of years before I was, and many of the people that have successful short term trading firms, were also there at the same time – Steve Wisdom, and Paul Buethe, who are now part of Crabel’s operation; and then Toby, himself was there for awhile, and many others along the way who have gone on to great success, so it was a tremendous mentoring experience for all of us and I really had the idea, early on, that there was an institutional version of this that we could develop. So we tried to do it in-house, but it turned out that the vision that I had didn’t seem to be exactly the way that my brother wanted to go, so in 1992 I left and I formed R. G. Niederhoffer Capital Management. That was the beginnings.

We began trading in 1993, in July, and since then, if you look at our pitch book from early part of 1993, it’s very much the same thing that we do right now. We’ve continued to try to distinguish the firm in a very particular niche of providing not just diversifying but truly protective returns that really benefit a portfolio and to do that by avoiding trend following, being in the short term space, capturing realized volatility – the very same things that I’ll tell an investor today.

Niels

Sure, absolutely. I wanted just to ask about how the brain works. I think we could all learn from that. What are the things that you took away from that? Maybe you can somehow come up with some examples that you find fascinating or interesting from our day to day life in terms of the cognitive biases and then, perhaps, draw the distinction as to how the brain works, and I hope I’m right here, when it comes to trading which I have a feeling it’s not quite the same. I have a feeling that we react slightly differently when it comes to trading decisions relative to day to day decisions. Am I on the right track here?

Roy

Yes, you are exactly. I think the key to the human brain and how it influences behavior, is that the human brain, for the most part, has evolved to solve the problems that existed during the time and in the place where the human brain evolved, which is of course the last many hundreds of thousands of years, almost exclusively on the African savannah. So the behaviors that we have in the brain, the tendencies, the way our visual system works, everything is there to keep us alive and keep our genes reproducing, however, those behavior patterns are not going to be optimal for investing and that’s why so many investors, especially those who trade discretionarily run into trouble. If you follow your instincts, you’re following instincts that are not optimized for investing and keeping you profitable. They’re not there to keep you profitable trading dollar/Swiss; they’re there to keep you alive and free of predators and able to reproduce and find food. Those are what your instincts are there to do.

Niels

Sure.

Roy

There are a number of ways that one can first avoid falling prey to these emotions, and then capture the tendencies that other people have. Some of the ideas that we find very interesting are things like risk aversion: people hate to lose more than they love to win. So certain strategies appear to be more appealing than they otherwise would because it’s very smart and will tend to increase the probability that you’re genes will propagate if you are risk averse in Africa, when you’re surviving predators. It’s good to run more than… being a contrarian, when the lion is stalking the herd is not a particularly good strategy.

The same thing goes for some of the economic cognitive biases people have. Something you have is typically worth more in the state of nature, but it turns out that that’s not true, and it is in fact a well-known cognitive bias, they always say that people hate to lose about twice as much as they love to win and as a result there’s a certain appeal that strategies have the incorporate that notion that may or may not be optimal in a full-fledged investment strategy. So that’s one. The endowment bias, you might call it. Another bias that we all have, we all fall prey to is the consensus bias. We love to stampede with the herd, and it’s very, very hard to be a contrarian, emotionally. Another bias we have which is very well known is that we remember recent information more than past information, so a market move that occurred today or yesterday is seared into our memory, but the same market move that occurred three Tuesdays ago, might not be so important to us in decision making today, again, very much based on the idea that in the state of nature, the current environment is actually a pretty good predictor of what’s going to happen next. That is not true in financial markets. Finally, another bias that is very important I think to try to avoid when one trades and is something that we really try to capture is a tendency for people to see visual patterns in data. One thing my brother really taught us all was to avoid using charts. He was a tremendous opponent of any sort of charting what so ever.

My view on why charts are not so helpful is that your brain wants to see patterns that aren’t there. Again, very helpful to find patterns in… maybe you’ll spot a predator if you brain is in the grass, if it’s camouflaged, if your brain is good at seeing patterns, but if you see too many patterns in the data, you almost see too many and you make decisions that are not statistically based. So we want to make decisions based on probability rather than on our belief in visual patterns that may or may not actually be predictive, so one thing that we’ve tried to do is avoid the traditional methods of visual pattern recognition that people have used in technical analysis. So there are some examples of cognitive biases and how…

Niels

In a sense what you’re saying is actually human beings, as just normal human beings are actually terrible investors.

Roy

That’s right. Unless you take tremendous pain to avoid falling prey to these cognitive biases. Now a lot of people will ask me, well what about systematic strategies? Isn’t the point of a systematic strategy to avoid cognitive biases and doesn’t it by definition avoid the emotional response that might be suboptimal like selling at the worst possible time so your stomach doesn’t hurt, obviously. One would think that a systematic strategy would be immune to that, but it turns out that it’s not. People tend to have the same cognitive biases when the create and then actually use systematic strategies – quantitative strategies, that they do when they trade discretionarily.

For example, they tend to overuse recent performance in deciding whether to use systematic strategies. Obviously investors tend to do that when they invest in systematic strategies. There have been some great research pieces that have been published showing that the most common evaluative tool, which is the last two years of sharp ratio, is completely un-predictive in CTAs of the next few years of performance, but that’s probably the most common thing that people use. So when you’re using a quant strategy, if your strategy has a lousy sharp for two years, well it’s very tempting to get rid of that strategy. But it turns out that that generally will not be helpful in actually boosting your achieved sharp ratio. You can also have things like the tendency of people to hate to lose more than you love to win will create incentives to use certain kinds of strategies and not others.

For example, when people get jobs as prop traders, using quant or discretionary strategies, typically they have a very tight loss limit. Well, what this means is that when you join a prop shop, you’re typically not going to be able to use a strategy that’s going to make money one month in six, but make a huge amount of money and lose money five months out of six, because you’ll hit your stop, so it sort of… it induces a short vol approach, where you’re more likely to have a profit. Then, of course, all together, again, the idea is that people, firm owners, traders, hate to lose more than they love to win. They’re afraid to take losses and as a result, everyone gets short volatility, and the firm itself can have a very big short vol vulnerability. I believe that one of the reasons why many multi-strat funds have the tendency to lose significantly during big periods of illiquidity and volatility is this very factor. If people are truly diversified, a year like 2008 shouldn’t have been as bad as it was for a lot of diversified strategy. I think we’re going to see that again after the last five years.

Niels

Yeah, sure, no I don’t disagree with that at all. Now in a sense, I know you’re not a trend follower in the classical sense at all, but I mean, in a sense, what you just said there, is this the reason why trend following, despite having been around for more than 40 years, at least with track records… and actually for most of these people, having done pretty well compared with so many other things, but it’s never really been accepted, is it really down to that bias that people have against the fact that trend following is a bit volatile and probably will lose money 8 months out of 12 and so on and so forth?

Roy

I think that has something to do with it. I think there’s been a difficulty in explaining trend following, why it should work. Everyone knows (or I should put “knows” in big quotation marks) that stocks rally and that companies get better over time at producing earnings and therefore there should be this upward bias in equities. It’s not quite so obvious why there should be a tendency of a market move once it’s established itself to continue in that same direction. I think in fairness, we all, in the CTA world have been a little bit lax in providing the fundamental explanations for why this strategy should work. In my case, we really have gone in a different direction from most CTAs, and I always say that our correlation to CTAs which has been about .1 historically, makes us more different from CTAs than CTAs are from hedge funds and equities and pretty much everything else out there. We certainly trade the same things that most CTAs trade.

We also face the difficulty of explaining what it is that we’re actually doing if we’re not just capturing the idea that risk is on: that stocks go up over time, that people overestimate the chance of loss and therefore it’s good to be short volatility, and that there’s a carry because of the positive shape of the yield curve.  I think one of the simplifying assumptions of the hedge fund world is that hedge funds are long equity, short volatility and long the height of the yield curve. In other words, an interest rate carry trade, and without those three trades you don’t have much hedge fund performance. Well, it’s easy to simplify CTAs into markets trend, and if there’s a big trend in big markets then, CTAs make money. Of course there are strategies such as the short-term world that we’re in and I believe us, in particular, when compared to the short-term world, that are quite different in that respect from the existing  particular strategy.

Niels

No, I agree. Now before we go too far away from your story, I just wanted to go back and ask you, you mentioned yourself that quite a lot of famous traders have come from your brother’s firm originally. What do you think it was that Victor taught you, or what was so special about the environment that you were in at the time that actually has produced so many people who became successful in their own right?

Roy

I think one of the things he really emphasized was taking a very scientific approach to what one was doing. To not just believe things because everyone else believed them, and that was the traditional way that one had done it and learned to do it. There was a lot of things, especially back then, that were just accepted as conventional wisdom, but I think in retrospect it turns out to be almost like articles of faith that Elliot Wave, for example, to me it’s almost like numerology, it doesn’t really have a predictive value that I can identify. I don’t think anyone’s ever shown it scientifically. If you then have to prove that something has statistical significance, you immediately have to have a testable hypothesis and a falsifiable hypothesis.

So beginning… number one I would say a scientific approach to the data, rather than an almost religious approach to the data. Number two, I think there was a tremendous emphasis on not following the status quo, on not doing the same and knowing everybody else did it. So immediately, you avoid the popular trades and having to deal with 10 other or 1,000 other people doing exactly the same thing you’re doing at exactly the same time. Because typically providing liquidity to the majority is a very good thing to be doing, you immediately start with a strategy that has a positive expected return. I think, looking at intra-day data was something that was unusual at the time. It’s certainly a lot easier right now. I think there was a certain encouragement of diversity and of innovation that a lot of firms, I think, they have a very clear philosophy and if you deviate from that philosophy you’re gone. He really did encourage a lot of people to explore and just create, almost in the way that some of the tech firms say you’re suppose to spend 30% of your time doing your own stuff and your own creative work, well he really let us do that too.

Niels

Interesting, very interesting. Now you mentioned that you started your own firm back in 1993 and I did a little bit of research on you, Roy, and I understand that that was sort of done back in your own apartment, but I’ve been told by reliable sources that you had to employ a cook and a maid in the beginning. Do you know what I’m referring to here?

Roy

(laugh) I do. Yes, we started the business. My head trader Paul Shen, who’s still with me, and we had one other person do marketing very early and then my wife was also part of it back then, and it was a very fancy co-op that we were subletting for a very inexpensive amount of money, but when we started to get a lot of messengers and FedEx and people coming in, eventually they said, well either you go – we’re evicting you if the business doesn’t go, so this all occurred on my honeymoon, so I tried to convince them that my head trader, Paul was my cook and that Jill, the marketing person was my maid and how could they not let them in, but that did not fly, unfortunately. We ended up going across the street to 888 7th Avenue, which is the building that Soros and Ackman are in right now, but we were there. About six months in we had a pretty good sized office there. We got a great deal. It was $3 a square foot for an office, which is about, just to calibrate, about 1/50th of what it costs now.

Niels

Wow amazing. That’s a great story, thanks for sharing. Now, of course, running your firm today is a big part of your life, but when you’re not working, and I think we might get into this a little bit later in a different way, but when you’re not working, what do you like spending your time doing?

Roy

Running a quant strategy and having a fairly robust operation with a couple of dozen people it does allow me a little bit of liberty to explore some other interests, and to be more of a top-down manager rather than to have to put in every trade. So it does give me some time to do that. I really tried to, over the years, continue some of my outside interests which are things like being a musician. I play in an orchestra called the Park Avenue Chamber Symphony, which I’m in the violin section and we have gone from… it literally started in my apartment as me and the conductor playing duo piano things and eventually we played in Carnegie Hall four times, and Avery Fisher, and we have won the prize for the best non-professional orchestra in America four times in a row, so we’ve done reasonably well. I do a lot of other instruments too. I play piano and guitar, and took up steel drum recently, saxophone, so there’s a lot of music in my life. I’m scheduling a big chamber music reading in my house for this Sunday to give you an example of that too.

I’ve tried to make a difference in the world as well. I chair a philanthropy called The Harmony Program, which gives intensive music education – 10 hours a week of instrumental music education to New York City public school kids, and really changes their lives. It’s four years, from second to fifth grade, and these kids are really just doing incredible things. There are a couple of hundred of them now, and we’re expanding rapidly. I’m also very involved in the project to bring back the New York City Opera after it went bankrupt last October. So I have a lot going on, but I guess the biggest thing that I do, my biggest responsibility is my family. I have four beautiful kids, 17, 14, 3, and 1, and I spend a lot of time with them and they’re really my pride and joy.

Niels

Yeah, absolutely, fantastic, thank you very much for sharing that. Now, I want to go to the next topic, but before I do so I want to ask you a much broader question, because we’ve been in the low interest rate environment for a long time now, and we’ve even been in the declining interest rate environment for decades, so I think everyone agrees at some point they’re going to start to rise, maybe we don’t know quite yet when that’s going to happen, but it will happen, and some of the guests that I’ve had on who come more from the trend following side, there’s been a bit of a debate about how will CTAs do in general when interest rates start to rise again? Of course many of the conclusions that I’ve seen says they should be doing OK, but in true spirit to your sort of contrarian approach I also think you have a slightly different conclusion to this, so maybe you can talk about, without being too technical, we have a wide audience here, without being too technical, maybe you can talk a little bit about why you might have a different opinion about how CTAs might perform in a rising interest rate environment?

Roy

Sure, I think there’s really two facets of my view on this topic. The first is what will happen to performance, and the second is what will happen to the traditional protective role that CTAs have played… or at least trend followers have played. I should be very clear, I’m referring to the industry as an asset class, when people are talking about the new age CTA Index, the 200 billion, most of that is in longer term trend following. Here, when I say CTAs I’m using it as the term for the industry, not any particular CTA. The view that I have is that, first of all the greatest contributor to CTA success over the last 25 years has been fixed income and the more specifically long fixed income. The tremendous decline in interest rates has been a big factor in that. I always left it at that until I actually tried to dissect out the price change in the futures contract that came from being long something in a declining rate environment that would rise because of declining interest rate, say the 10 year or the 30 year futures. Then being long something with a positive role yield. Of course for the last 25 years, just about all of the time the yield curve has been positively slipping averaging about 3% per year. So it turns out that when you actually run the numbers, 2/3rds of the profits of being long the 10 year, the 30 year, have actually come from the role yield, not the actually decline in interest rates.

So the question that I tried to answer is, OK, well what would happen if interest rates start to rise? We happen to do our study which was that we literally ran time in reverse and said, what would happen if rates over the next 25 years would just tick right back up to where they were in 1990? So we reversed the futures contract you could say. What we found is that while it would seem as though, you’d just be short the futures contract and you’d make the same amount of money; because of this role yield problem it doesn’t work that way. The role yield is negative if you’re short fixed income, not positive; as long as that yield curve continues to be positively slipping. So that 2/3rds of your profits that you made on the way down in interest rates, for the last 25 years are now negative, not positive. So the amazing thing and this is really kind of a shocker for me, is that the price of the 10-year futures goes up not down if interest rates rise to where they were in 1990. Now, of course, most people they want… well interest rates rise, futures contracts go down because of the role yield.

So this is a real problem because instead of having this beautiful smooth uptrend where you have the decline in interest rates and the role yield all going in the same direction. If you’re short you’ve got the direction of interest rates correct, so the contract wants to go down, but the problem is the role yield forces the contract to actually go up. This destroys the trend. You can’t trend follow in fixed income on the short side. It just doesn’t work. So now you have the question, well OK, if 2/3rds, or 1/2 or whatever the number is of profits of fixed income for CTAs came from being long fixed income, and now this is going to not work, well what is going to work? So that is my argument in a nutshell. We have a big whitepaper on this, and it takes 26 pages or something to go through this argument, so if I seem to have skipped a few steps, I apologize. That’s really the gist of it. What do you do?

So there are a few answers. The first is you’ve got to look elsewhere. A lot of people say well, OK if interest rates are rising there should be some inflation somewhere, commodities will go up. In the 1970s, you could make a lot of money in commodities if you were a big trader because that’s what the markets were. They were mostly commodities markets. Of course being a big trader meant that you had 20 million under management. Now if you have 20 billion or 100 billion or the summation of all of the trend following CTAs out there, which is probably 1/4 of a trillion plus all the people that are doing it internally or macro and multi-strats. it’s probably… it could be 3/4 of a trillion dollars that’s trend following when all is said and done among all of the different strategies. Well, compare that to the size of the commodity market. The commodity markets are 1%, 5%, 3% of the size of the financial futures markets. They’re really small. So I just don’t think commodities are going to be big enough to support profits even if there are trends in commodities. So that’s one question: If not commodities, then where else?

What about the equity market? Well, equities go up over time, so I think this is an explanation for why we’ve seen a lot of morphing of CTAs into multi-strat, into whatever they call themselves – Quant Global Macro. Well, what’s happened is the correlation of the CTA index has increased to equities. People are getting long equities. They’re not, I don’t think, bi-directional. They’re just saying, well stocks go up over time. There’s a great place to be. To support the growth of the industry in any sort of environment you’ve got to be long equities. So the larger managers, I think, are going to be pushed in that direction, and we’ve already heard of some that are doing it already.

Then the final piece is FX. If anything is going to provide the driver of returns for CTAs in a rising rate environment, it’s going to be the FX markets. They’re liquid enough. They are volatile enough. They are diverse enough, at least in the Euro time zone and Asia, and even in emerging in some cases, for some of the managers who are smaller and are able to do those emerging markets. So the burden is going to come on the FX markets. So as an industry we have to make money in the FX markets.

Niels

Sure, you point out some really, really interesting observations and I would encourage… there are some of the people that have already been on the podcast and who have different views, I encourage them to put in some comments into the show notes for this episode where they can challenge some of these things because I think that’s a good debate, but I think what it highlights, to me, from what you’re saying is some disturbing trends really, because what’s happening, in my opinion, in the industry and in particular in the last four or five years is of course that investors tend to prefer the large managers. So we have a massive concentration of capital with the large managers, but what you’re really saying is that if this comes through, what you really need to do is to find smaller managers who can actually get a meaningful allocation to some of the markets that are not fixed income related such as commodities and so on, and so forth, but we’re seeing so many small managers not being able to survive this environment because investors prefer large managers, so for me that’s a slightly disturbing trend. I also wanted to pick up on something else you said, and it’s a little bit about the correlation to the S&P and how more and more CTAs look like they’re more correlated towards equities. That is a true statement. You can certainly prove that in the numbers, but I’m just wondering here, Roy, isn’t it normal that CTAs would become more correlated to equities in a period where we’ve had a bull market for five years and where by definition, long-term trend followers have to be long?

Roy

Right, I think there’s no question that that’s what’s worked. The managers that have made money have been ones that have put in that high correlation to equities for the most part. As part of my discussion of interest rates, the correlation actually is an important piece of it too. I alluded to it earlier with the question of will CTAs be as protective as they have been. My view on this is something that I’ve been talking about for pretty much my whole career. I believe that the protective quality of CTAs that people have seen in events like long term capital’s demise, or 9/11, or even more recently in some of the equity sell-offs in say November 2008 – the last big example, a lot of that came from being long fixed income. The reason that people were able to be long fixed income in the CTA world was that we’re in this tremendous secular uptrend in fixed income, and of course the big secular decline in interest rates. The question then is what happens if we don’t get as much of that big uptrend and rates start going up? Clearly, as I mentioned before, the futures contracts aren’t going to rally as often… as much, so it will be harder for CTAs to be as consistently long fixed income as they have been in the past.

Now if you start off a equity shock short fixed income, that’s not going to go well, because obviously in a flight to quality you’re now short what everybody wants, which is the safety of fixed income. I think October 15th was a perfect example of that where, in the midst of a fairly small equity decline we just had the largest rally in the 30-year bond contracts since the market crash of 1987. It went up six points intra-day. It only went up 7 in the crash of 1987, so this is a real problem if you’re going to start that day short, and have a tendency to be more short fixed income. So my point is, I believe that correlation of CTAs will secularly shift, in the absence of any other change in strategy, just because you’re spending more time short fixed income than you were long fixed income in the big decline in interest rates. So that’s a question.

I also believe that what we are seeing is not just that stocks are going up, and CTAs are following the trend. I believe that there are a few managers who are actually moving into pure long strategies. Just like long/short equity is really long equity – we see that in the hedge fund indices, that long/short equity has .86 daily correlation to the equity markets, I think, this year. That’s also true of CTAs. When you get into the equities unless you are a short-term trader, you’ve got to be on the long side. You just can’t sell and hold. So if you’re using a longer term strategy, you’re going to end up with a rising correlation to equities, and I think what happened in October; what happened in January of this year – these little equity selloffs, demonstrates that even today, there’s already not as much protection as people are going to expect from CTAs having gotten in 2000 to 2002 and even at the very end of 2008.

Niels

Yeah, absolutely. Now Roy, when I look at CTAs and hedge fund strategies in general, I kind of see them positioning themselves to a large degree as a standalone investment, but you’ve already alluded to it, but when I look at your program and when I look at your marketing message, it’s really about a story about how you shouldn’t really look at your program in terms of a standalone investment. You should look at it how it works and how it helps in combination with an existing portfolio of stocks and bonds, for example. Tell me why you chose this specific approach which is different to how most firms position themselves.

Roy

For better or for worse, we have chosen to tune our strategy to maximize our benefit to our clients rather than to ourselves. That I guess boils down to my belief that people should be paid on the basis of alpha, not on beta. It’s rare to hear me agreeing with Calpers, but I think their absolutely right that a lot of the hedge fund community gets paid on beta. You just see what happens in 2008. To have… even this year, to have what happened in October occur where you had a… the hedge fund industry was over .86, I think it was .87 weekly correlated to the stock market this year, and just about that last year. How much beta can you possibly produce? You have to produce incredible performance with that kind of correlation and very, very, few people do.

So what we’ve tried to do is maximize the alpha that we provide and the strategy from the top down is designed to have this negative correlation to equities and to hedge funds and essentially to any type of portfolio that we see from a client to maximize the amount of alpha that we provide. It’s been a bit of a quixotic quest, I know, because when everybody else is making money, very often we’ll stand out at the bottom, but at the same time that’s why our best years, if you look at our track record, our best years are 2008, 2000 to 2002, 1998, 1994, some of the selloffs in 1997, 2011, we had huge performance in January of this year and the first two couple of weeks of October when there was this big sell off. That’s what we are specializing in and to me that’s what a hedge fund is supposed to do. That’s what a manager is supposed to do, to really provide not just we don’t lose money when the rest of your portfolio is losing, but we help you make money.

Now why is that important? The reason it’s important is that if you can reduce the size of your portfolio’s drawdown, when you get back on a positive environment you start the next positive cycle on a much higher level. So the amazing thing is if you take our strategy and the equity markets at a 50/50 mix, just exactly equal concentration the combined return of us plus the equity is actually higher than the return of either us or equities. It’s a complete mathematical paradox and the reason is that negatively correlated assets tend to meld together and work in harmony in a way that people are generally not used to seeing because it’s so rare to have positive expectation negatively correlated assets. You get about a 20% boost in performance out of nowhere from… let’s say two assets averaging 8%, suddenly your combined portfolio averages is 10%. How can that be? But, in fact, that’s what the negative correlation does, and that’s why it’s so important to have people focusing on portfolio improvement rather than on their own standalone sharp ratio. To focus on your standalone sharp ratio all you’ve got to do is add beta, and it improves your sharp ratio until the equity market sells off.

Niels

I completely take that point aboard, and I know, you’ve certainly, you mentioned here specifically that you distinguish yourself from the hedge fund industry and that I fully understand with the beta argument. What about the managed futures industry? Do you see yourself being an outlier or outsider there because it’s a little bit confusing I think for some investors because they think of managed futures, and certainly think of trend following as also being a protective element in their portfolio. Now we know that, OK it’s not going to happen maybe the first week or the second week of a big turnaround in the market, because these strategies will take a little bit of time to turn, but clearly, as 2008 came along and the moves were significant then CTAs in general and trend followers and so on and so forth, did deliver some negatively correlated returns, but how do you see yourself within that category?

Roy

I think there’re two questions there. First is how we distinguish ourselves from other CTAs let’s say, and even in the short term space, how are we different from other short-term managers? Then the other question is how much protection do CTAs provide and when? I’ll try to answer both of those in turn.

I think what makes us unusual (I don’t want to say unique because I don’t really know)… the last person that anybody tells what they’re doing to is Roy Niederhoffer, I don’t have too much intimate knowledge of what other managers do. My impression is that what we talk about maintaining negative correlation year in,  year out, and at least on a quantitative basis, our weekly correlation to the stock market really has been negative every single year for the last 15 years to the equity markets, and that’s not true of pretty much of every manager that I’ve seen. So I’d say our continual focus on maximizing the sharp ratio of our client by providing both positive expectation and negative correlation at the same time, makes us unique.

The short term strategies, to begin with, will have a much greater relationship to realized volatility than they do to trend. The ideal environment for trend followers, of course, a very quiet market that goes straight in one direction for years. For a short term manager, the ideal market could be completely flat over the course of the year but moving up and down 4% every other day. So that’s a very different “ideal” environment, and I think just being a short term manager and, for us, there’s a lot… I think maybe much more contrarians ideas in our approach then in most of the short term managers, again from what I understand. We’ve always described ourselves as majority contrarian rather than majority momentum, or primarily, or exclusively momentum of various time periods. So I think that’s a difference as well.

Now I hope that gives some sort of sense of the first side of your question. The second part your question was more about, eventually CTAs do manage to provide protection. That is definitely true. My view on it is that you have to look very closely at the numbers and what they mean. CTAs were not very productive portfolios during the first part of the decline all through the highs of 2007 and through say September of 2008. At the very end of the year, the trend started to happen in fixed income in a big way. A lot of managers caught up and actually the same thing happened in 2000. There was a lot of profits at the very end of the big decline, but as of August, September, October, it was only some of the short-term managers who were up significantly after the stock market had really corrected.

Why is it important there? It turns out that a lot of the damage in equity market corrections occurs very, very rapidly and on a very small number of days. We have an interesting study that we just did that we took the biggest equity declines over the last ten years, and we said, “how much of those declines occurred in the ten largest days of each downdraft? Those include a good chunk of 2008 and big corrections along the way. Actually, sorry, it was more than ten years, about fifteen or twenty years of equity decline. What we found is that in general more than 100% of the decline occurs in the ten worst days of the decline. Going back as far as you want. So what that means is if you can protect your portfolio on those big days, you actually have a huge benefit to your overall portfolio because the next upward cycle, whatever… whether it’s a big decline in equities, or a small one, the next cycle begins at a much higher NAV. So it’s my view that different types of protection, some long term protection, so eventually you’ll get long fixed income and great, you’ll make money on the long side there in a huge equity decline, but there are also the 10% declines, the 5% declines, that occur much, much more frequently and if you have a strategy that’s able to make money let’s say the first two week of October of this year, when stocks dropped 7% or 8%, if you have a strategy that’s up 5% or 10% in those two weeks, well your whole portfolio begins the next leg up at a much higher level. So long as that protective strategy is actually earning you money itself and providing a positive return, the combination has an incredibly positive impact on the return. I don’t think too many people look at their portfolios in that way. A lot of allocation decisions are made in an all-star team, you just want the best manager on a standalone basis, and I think in sports we often see that the best teams are not the best combination of the best individual players.

Niels

Right. I completely buy into that, and I think the truth is that investors in these strategies really need to understand the role of each manager in the portfolio and clearly someone like yourself, you’re not only just diversifying against equities and bonds, you’re also diversifying against other CTAs if we can call it that. Likewise, they will diversify against your approach, and it all has to work together, so I agree with that.

Roy

Exactly, I think one of the interesting characteristics of the short term space is that the inter-manager correlation of the short term space is maybe .1 or .2 on a monthly basis. I don’t think there’s an asset class in the world where you will find an inter-manager correlation of anywhere near zero except short term traders in managed futures. Long term traders in managed futures are all .5, .7 correlation to each other or more. Certainly in event driven, we just saw a big deal break in October, and 90% of the worlds event driven managers appeared to have had that one deal and it all got crushed down 5% because of that one deal. It doesn’t mean that these are bad managers at all. That was a great deal, and they all should have had it because it was very likely to close, but you do have the same risk factor. That is not really as true for short term traders. If there’s one factor that seems to drive short term trader returns, it’s realized volatility, however, because that’s really your opportunity set. What’s very interesting, and you alluded to this earlier, is the fact that the secular decline in interest rates may be ending as QE ends in the US.

Quantitative easing has had a tremendous suppressing effect on realized volatility across every market. If you look this summer, you’ll find all four sectors pretty much at all-time lows of volatility and combined I would say at all-time lows of combined volatility. Suddenly with the end of QE in the US everything exploded in volatility and we’ve noticed that over the last few months there’s been a complete sea change that our whole strategy is started to work pretty much better than it’s ever worked before in our whole history and I believe that we are going to face, over the next few years, an environment where volatility is going to rise rather than fall and that’s going to throw a lot of portfolios that have been created based on the last five years of returns, which is typically what people use, out of wack because they’re tuned to short volatility and declining volatility. It is very, very important for people to be proactive in looking at portfolios and saying holy cow, what happens if volatility rises and I have all these managers chosen because they’ve made money in a long volatility environment?

Niels

Very important, absolutely Roy, and I would actually add to that, that I had a guest on a couple of weeks ago, Kathryn Kaminski who just wrote this book, Trend Following With Managed Futures, but more important we did speak quite a lot about also the difference between long/short volatility and compressed volatility and expanded volatility. But actually just convergent and divergent strategies that people don’t necessarily… trend following is not necessarily just long volatility, it’s just long divergent strategies and people need to understand and appreciate the difference between convergent and divergent strategies because it will of course change after such a long period of time with massive controls and interventions. Now Roy, we could speak about these things forever, but I do want to try to move one. I want you just to paint a brief overview of the strategies that you run today, just very briefly. I think obviously we’re going to be spending most of our time talking about your largest program, but I do want to offer you just the opportunity just to say this is what we do today, and then we’ll jump on to the next topic.

Roy

Sure, we are employing a core strategy that has a number of different timeframes ranging from a few minutes at its shortest to a few weeks at its longest. Both momentum and counter trend contrarian signals all of which is done systematically and we have about 60 or 70 individual strategies that we put into, you might call them style buckets, we call them families, and the whole thing runs essentially automatically, I like to say, in a way that an aircraft flies, that’s the way our strategy works where most of the time the aircraft is on autopilot and does a great job of flying itself. Every once in awhile it’s necessary for the pilot to step in, in the most difficult moments, like landing the plane, that’s a very, very important time for the pilot to be at the controls, but 99% of your flight is automated. That’s what we do for all of our different programs and it’s the same set of models. Now, as you’ve heard, we have tuned our core strategy to have this negative correlation to equities, to hedge funds, to portfolios in general. That is our diversified program and that is the same program that I would have been talking to you about 22 years ago if you were thinking about being one of my first investors, and it has remained our flagship product. We haven’t changed it. Obviously you can improve your results retrospectively by changing your flagship. We have not done that. That strategy is supposed to have about a -.3 to -.4 correlation to the equity markets.

We decided a few years ago to say well, “what would happen if we just brought that up to zero?” Part of the intent of it was that I needed, being so negatively correlated in my business, I needed some risk-on. So we brought it up to zero, and we created something called the Optimal Alpha Program. This is a program that has in the last couple of years as you can imagine, outperformed.. Diversified has had two good years the last couple of years, but Optimal Alpha is about +25 last years, and actually it’s just over +25 this year too, right now. The reason is that it doesn’t try to be negatively correlated. In a portfolio, however, both of them produce about the same amount of alpha. So it’s pretty interesting that our alpha is consistent… the performance can be very different, but in terms of alpha, yeah there is a little bit more long equity risk in the Optimal Alpha program. To me it seems like it’s massively risk on, but it’s actually zero correlated to the equity markets. To me that’s risk on.

Then we have another program called iHedge, iHedge is a program that is again reflecting one of my own portfolio needs was I decided I was very concerned about inflation a few years ago, and that we’d have rising interest rates and rising commodity prices. Now obviously, I was completely wrong about that macro call, but I wanted to have some of my own money invested in it so I created this fund called iHedge which shifts the emphasis of our program so we have more buying of commodities and more selling of fixed income. Now getting back to what we said before about not wanting to be secularly short fixed income in a negative carry environment, I want to emphasize that short term managers are much less susceptible to this carry trade on the short side. So short term managers can get short fixed income and not have to worry too much about paying the cost of being short. So while this fund does spend much more time on the short side, because that’s its mandate, it’s not secularly short, but it will spend a few days more short than Diversified would be, when Diversified is short.

We also let our clients switch back and forth among these funds once they’re in our fund complex, they don’t have to redeem and then go in a different fund and lose the high water mark, they can actually switch on just 24 to 48 hours notice. What this means is that people get to express individual portfolio views. With that in mind we’ve now extended this and we actually have an SMA where a client has actually requested a custom correlation: particularly essentially hedged to the rest of their strategy and we can provide a targeted correlation even lower than our normal -.3, -.4 we can go to -.6 or -.7, or we can even get to say plus .3 which is that 50/50 mix of us and equities, which has had a tremendous performance, and we may even offer that as a product too.

Niels

Now, as I said, I want to shift gears on you and go into more of the different overall topics that I try to cover with all of my guests. The first one is really about organization and clearly you run, as a short term manager, you have other needs and constraints to longer term managers, so tell me about how your business is set up today, and what the infrastructure looks like in order to handle that. Also, of some interest to me at least, is in the short term space, are you able to take advantage of any of the outsourcing opportunities that has been developed, or are you really reliant on having to do everything in house because you’re obviously trading with a very high volume?

Roy

The infrastructure that we’ve developed has had 22 years to coalesce, so everything we do here is our own code that we’ve written. Our platform is generally in C++ and everything from our top down allocation tools to decide how much we’re going to do of each piece of our strategy and when we’re going to do it, down to the algos that we do to execute our code, everything is developed here and is run out of this one office. I do run three shifts. I have to have people flying the plane essentially 24/7 while the markets are open. So we have about two dozen people here, almost all of them are on the investment side. There’s probably 13 or 14 these days – people who are quants – they’re all programmers, very, very good programmers. They’ve all worked the overnight shifts. They’ve all run the strategy essentially flown the plane – I keep getting back to that.

Niels

No that’s fine. I think it’s a very good analogy.

Roy

I think it’s very important if you’re going to design and autopilot system or design and component for an aircraft that you actually know how to fly, and some of the questions and issues you have flying a plane are therefore built into the autopilot and that same thing analogously is true with our strategy that they issues that one has in trading are built into the platform, the tools that we use, and the algorithms that we use. The firm is really not so much… we don’t have to do very much to actually trade. Signals come up, they’re sent directly to the markets and everything really pretty much operates by itself, so what most of my people are doing are working on how to make the strategy better; working on risk management; working on the new ideas; making old ideas improved, or perhaps deciding we’re not going to do certain things that we have done for awhile. So a lot of it is offline and very, very creative almost… I like to think of it very much the way say a scientific research lab would work in a university, where you have a professor who has a lot of suggestions and tools at his disposal, but in reality it’s the grad students who are providing the creative experiments and actually doing the coding and actually running the testing of hypotheses. It works very much in the way that I had some experience back in University doing research on neuroscience.

Niels

Sure, I noticed on your organization chart that you refer to your research team as Research and Trading which obviously is somewhat explained by what you just aid, but I wanted to ask you a slightly different question and that is what do you look for if you want to add another person to that team? What are the things that you look for in the people that you look to add to this very important part of your business?

Roy

I’ve had a lot of experience now over the course of time in how to hire: what kinds of people have been successful, what kinds of people have been not successful and I guess the first admission is that it’s very difficult. It’s very, very hard to find truly profitable successful traders, both on the discretionary side… in other organizations I’ve seen other people have this issue, and in our side it’s a very challenging problem. To try to solve that problem we really want creative out of the box thinkers. We don’t want people that are just going to produce the same kind of ideas that we already have produced that are constantly going to try to make incremental improvements that are merely adding complexity and extra variable and fitting the data better than anyone else has ever fit the data before. That’s not particularly helpful because it doesn’t generalize. It’s not a robust way to operate.

We’re looking for people that are able to produce negatively correlated strategies; zero correlated strategies, to say, “you know what, the way you guys are doing it… why don’t you try it this way?”: to really have world-changing insights if we can or at least game-changing insights to help us really make course corrections and improvements that are significant and valuable. To do that a lot of our interview process is creativity. We’re looking for people who are willing to think differently and who are not, let’s call it, status quo thinkers; that don’t just quote the conventional wisdom on everything; that walk in here with really interesting new ideas.

Niels

Do you think people like that… I mean do they need to by heart be contrarian. You describe yourself as a contrarian in probably all… not just in trading but in many respects. Do these people also need to have that personality, or is it more the creative side rather than the wanting to be contrarian?

Roy

Contrarian is a funny word. I think people who are not afraid to challenge the status quo is very important to me. I do not want a lot of people who are just sitting around in a  research meeting nodding their head and saying, “Wow, what a great idea, Roy.” That’s the last thing that I want. Very often, it’s not quite so obvious at the beginning who’s going to have the strength to  really challenge the existing paradigms that we have. Sometimes I’ve been very surprised. It’s not necessarily who has the most advanced computing skills, or who has the largest number of statistical graduate level courses on their resume, or who interviewed well and was able to solve our puzzles the best. There’s a certain personality strain that we’ve found has been particularly helpful in really improving things over time.

One of the things that I’ve always treasured about my head trader, Paul, is that he has been a tremendous foil for me over the years, and we really have a very successful interaction in that it’s not that we disagree on everything, but Paul has a certain intellectual purity where in our modeling and our discussions of our strategy, he is a very… almost a theoretical view that is a great foil to my own. I think when we’re looking for new people, we’re looking for people who also are able to think about the theory of model creation and the questions one should and could ask, and the value of adding variables and some of these more methodological issues, rather than just having the latest intricacy of say support vector machine kernels at their disposal. People can learn that, but it’s much harder for them to do is actually to learn to have useful and game changing ideas in an operation like ours.

Niels

Sure, part of what you’re saying there, to me, is also about building a culture that allows people to constructively criticize. We’ve heard stories from some of the very large hedge funds about cultures where brutal honesty and what have you, everything gets recorded so nothing can be changed, and all of these things, but sitting in a research meeting and saying to you, the owner of the firm, “Roy, I think you’re wrong.” It takes courage. So how do you build a culture that allows people to have that courage?

Roy

We have to trust people. That’s one thing. I have to trust what we do and letting people know about it. For example, in our trading room, everybody sees the P&L in real time. Everybody sees the positions in real time. Everybody can drill down and say this model and this particular person is responsible for it and here’s what it’s doing, and so it’s a very open culture. Our researchers, our IT team, our people that are running the strategy, executing it, are all in the same big trading floor, and there’s no distinction. We don’t have people in a backroom doing secret research that no-one can know about. There are firms that operate very successfully that way. I don’t want to minimize that there are a lot of potential answers to solving this particular question, but our answer has been if everybody is helping each other and really educating each other, people feel like they do have the confidence to ask the dumb questions and say, “Hey, maybe we should do it this way, have you ever thought about that?” If you’re in an environment where you’re not going to get shot down for showing somebody up, then maybe there is a better way to do it. I think you would get more of those interesting improvements over time.

Niels

Absolutely. Let’s jump to the next topic I want to talk about. The topic is about track record, and the question I have is it’s a general question about track records where I think investors struggle and for good reason. I think it can be very difficult to look at a track record and make a meaningful assessment of how will this manager perform going forward, because what I’m looking at here is an evolution of models, of trading strategies, and how do I know what it will look like in the future. With that in mind, how should people look at your track record when they look at such a long track record, how should they read that to begin with?

Roy

I think one of the qualities of having a longer track record is that it indicates that you survived. There are people that survive because they’re lucky and people that survive because they’re skillful. I freely admit it’s often hard to judge between the two. I would like to think that we’ve survived because of some sort of persistence and clarity in what we’re trying to accomplish and some sort of… something interesting in the strategy that has allowed it to, over the course of time, do a pretty good job of what we set out to do at the very beginning. We really did say to our initial investors, “we are going to be negatively correlated to everything else that you have. We are not going to trend follow. We are probably not going to have the highest sharp ratio, but we probably will be very, very beneficial to your portfolio over big market cycles, not every year, but when you really need us you are very likely to see us be there.” That has been the case all the way through, so I think maybe one way to evaluate it is consistency to message and consistency to the mission of the company.

I think obviously firms improve over time, so I believe, for example in our own track record. We had a very, very tough time from 2009 to 2012. We did not… we completely underestimated the impact of QE and the change in investor psychology from bad news is bad, to bad news is actually great because it indicates more QE is coming and that’s fantastic. It took us a long time to balance and frankly to figure out how to balance the negative correlation that people had bought us for and we were here to provide with the fact that we had a market that rallied: that’s probably up 300% or something, almost since the low tick. We had to find a better way of doing it that wasn’t as costly so over the course of time I think our strategy really has improved.

We certainly feel like we have a lot more sophistication in our algos, let’s say, and executing our strategy for low cost. We have a lot more sophistication in diversity of models that we employ and most importantly, I think, when you look at us quantitatively it’s very, very clear that we’re providing at least as much downside protection as we’d every provided before. But over the last two years we had a plus 30% equity last years. We’re up pretty strongly this year too and our models are doing, I think, a very, very good job of making money: last year of 9 or so and this year 14, I guess on the year, or 13 for Diversified and more for Optimal, but we’re doing that with the same negative correlation that we’ve always had. So a combination of: is the manager continuing to do what they said they are going to do both on a mission and more top level basis, and also quantitatively can you identify quantitatively that the manager really is doing it to? That’s one way to look at it.

I think performance, however, for better or for worse, it’s completely non-predicative, I always tell people where it says at the bottom past performance is not necessarily indicative, you should just cross that out and say completely un-indicative of future performance. If you then begin your allocation process at that point, the question is, well what do you have left? If you can’t use performance what can you use? But actually there are a few things you can use. You can use correlation; you can use performance in certain shock events; does the manager tend to capture trend? OK then the manager is a trend follower. Does the manager tend to capture rises in realized volatility? Well, they’re probably doing that kind of strategy. You can look more carefully and say well these are the factors that are driving the program, do I want these factors in my portfolio? Do I need these factors?

Maybe then you have to look at longevity and the process itself and costs and things like that, but you might as well just throw out the mean in the sharp ratio. The standard deviation, volatility, probably has some consistency and correlation I think is very, very predictable, but mean – forget it. I think what most people finally realize is picking managers is just like picking individual trading strategies, it is a really, really, hard job and it’s almost impossible to be a low-cost diversified mix. Galen Burghardt of Newedge, now COEX actually, show this beautifully quantitatively in a paper that I love to give people called Superstars vs. Teamwork and I alluded to it before, but I think it captures the fundamental difficulty of allocating to managers. The last two years of sharp ratio are actually worse than chance at helping you predict the future.

Niels

Very interesting. Now I picked up somewhere, that kind of your general philosophy that…

Ending

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