This summary is written by Rich based on a conversation in our CTA series between Ed Tricker, Chief Investment Officer of Quantitative Strategies of GCM, and the podcast hosts, Niels and Alan.
About Graham Capital Management
Ed shared insights into Graham Capital's investment strategies, which include both discretionary macro and quantitative approaches.
Graham Capital is an alternative investment manager with around $18 billion under management. Founded in 1994, the firm specializes in providing compelling returns in both the quantitative and discretionary macro space, with a focus on low correlation to traditional investments. Ed explained that the systematic side of the business started with a traditional trend following focus but has since evolved to include broader quantitative macro strategies and other asset classes like systematic long-short market neutral equities.
Ed believes that there are advantages to having both discretionary macro and quantitative approaches within the same firm. This diversification provides stability, which in turn allows the firm to invest in its future. Additionally, combining the breadth of information from discretionary traders with the rigor and efficiency of a systematic process can produce effective results. Having domain experts in different markets within the company has proven to be beneficial for constructing systematic models.
As for the evolution of the systematic side, diversification is at the core of Graham Capital's investment philosophy. This includes hiring diverse thinkers, trading a wide range of markets, and using a variety of strategies. Ed emphasizes the importance of diversification in producing a strategy that can work well across various market conditions.
When discussing the use of macro data, Ed acknowledged that it can be challenging but cites supply and demand modelling as a more straightforward example. He also highlights the behavioural aspect of markets, using inflation data as an example of how sentiment can drive market reactions. Although the relationship between macroeconomic data and markets can sometimes dislocate, Ed believes that having a diverse portfolio of models can help capture a wide range of market conditions.
Evolution of Trend Following and the Role of Diversification
Niels and Ed discussed the evolution of trend following strategies in the investment industry and the role of diversification within these strategies. They mentioned how after the global financial crisis, some managers diversified their trend following strategies to improve their Sharpe ratios, which led to the concern that they might not behave like trend followers when trends come back strongly.
Ed emphasized the importance of understanding how a strategy is used and aligning the incentives of the managers with the investors. He believes that one-size-fits-all strategies can be problematic and that it's better to have a suite of strategies or building blocks that can be customized according to the investor's objectives. However, he also acknowledged that customization can sometimes lead to poor outcomes.
Niels raised the question of whether investors are the best at determining what they should have in their portfolios. Ed responded that while a standard fund account is sufficient for many investors, more sophisticated investors like public pensions and sovereign wealth funds can benefit from customized solutions. He emphasized that striking a balance between customization and standardization is crucial in meeting the needs of different investors.
Investment Objectives of Investors w.r.t. Trend Following and Crisis Alpha
Niels, Ed, and Alan discussed the objectives of investors when it comes to trend following and crisis alpha.
Ed emphasized that different investors have different expectations for trend following or CTA strategies based on their investment horizon and tolerance for crisis-type returns. Consistency is often overlooked, and while trend following does well when equities go down, it is not a put option.
Investors need to recognize the necessary compromises they have to make and find themselves at different points along the curve depending on their preferences.
Niels brought up the role of commodities in crisis periods, and Ed shared that while commodities have been friendly to trend followers in past crises, he doesn't believe one can rely on them always being so. He does, however, believe that they are an important feature of portfolios.
When discussing building blocks and diversification, Ed suggested asking investors what matters more to them: long-term return or crisis return.
If an investor wants to make big chunks of money when markets go down, trend following is nearly unbeatable. If they want to make some money when markets go down without the cost of carry, a quantitative macro strategy might be more suitable. Different investors have different needs, and it's essential to have a conversation to understand their objectives.
Alan asked Ed about the most effective ways to generate more crisis alpha in a portfolio. Ed explained that there is a spectrum of options, from buying puts (which work well but are costly and disliked most of the time) to tweaking models to be faster (which can be optimized for a crisis but may perform poorly the rest of the time). A middle ground can be reducing equity exposure to turn around more quickly during inflection points, although it comes with an opportunity cost.
Ed emphasized that there is no one-size-fits-all solution, and these decisions should be based on individual conversations with investors. While many investors might prefer a “tell me what to do” approach, for the majority, the regular version of trend following is sufficient, with customizations available for those who want them.
Research Process and Enhancements
Alan asked Ed about the research process at Graham and how new sources of alpha are discovered.
Ed highlighted two key philosophies: the rigorous application of scientific principles to trading markets and giving risk equal importance to returns. These two philosophies form the foundation of a comprehensive and effective approach to trading, aiming to maximize returns while minimizing risks through a disciplined, systematic, and transparent process.
- Rigorous application of scientific principles to trading markets: This principle refers to the importance of a logical, systematic approach to the analysis and decision-making process in trading. It's not just about creating complex statistical models but instead focusing on the entire process of inquiry and decision-making. This approach involves developing clear hypotheses based on sound theories, testing these hypotheses through research, simulations, and analysis, and employing peer review and transparency throughout the process. Such a rigorous methodology ensures that the trading strategies developed are robust and well-founded.
- Giving risk equal importance to returns: This principle emphasizes the importance of considering both potential gains (returns) and potential losses (risks) when evaluating trading strategies. Balancing risk and return helps to create a more stable and sustainable trading strategy. Ignoring risk in pursuit of high returns can lead to significant losses or even complete failure in the long run. By giving risk equal importance to returns, a trader can develop strategies that provide consistent performance over time and help protect their investments from adverse market conditions.
Ed emphasized the importance of collaboration, peer review, and transparency in the research process. Everyone in the team is responsible for idea generation, which is then tested rigorously and publicly.
Ed explained that ideas can come from various sources, including academic journals, market observations, and conversations with investors. The challenge lies in efficiently sorting through these ideas and finding the valuable ones. Rapid prototyping helps sift through ideas quickly, while being mindful of multiple testing and overfitting issues.
Alan asked Ed about the process of evaluating strategies that may have underperformed or performed poorly. Ed explained that systematic strategies have an advantage because their behaviour is codified, allowing for a clear view of conditional performance. This lens of expectation helps assess the strategies' performance under specific market conditions.
Ed emphasized the importance of not discarding a strategy just because it performed poorly in an unfavorable environment; the strategy may still be valuable in other market conditions. He mentioned that a three-year evaluation period may not capture all possible market outcomes, and having clear objectives for a strategy in a portfolio can help make better decisions about whether to keep or remove it.
Regime Shifts and Need for Adaptive Models
Ed discussed regime shifts in markets with Alan and the importance of adaptability in systematic trading strategies. He emphasized the significance of historical data analysis, but also the need for models that can adapt and adjust their behaviour to changing market conditions.
The discussion then turned to recalibrating parameter selection systematically, using techniques like reinforcement learning to make incremental adjustments to models. Ed explained that doing this in a continuous way, rather than discrete, is more advantageous and robust.
The conversation also covered the importance of measuring volatility and correlations in trading strategies, highlighting that these factors are equally important as market signals. Ed explained that their approach is to provide the most contemporary view of market risk possible and stresses that volatility has a considerable impact on portfolios. The evolution of volatility can be advantageous for trend-following positions when it functions like a take-profit mechanism, as seen in 2022.
Views on Static or Dynamic Position Sizing
Niels and Ed discussed different views on position sizing, with some people believing in sticking to the original sizing and using a stop to manage risk, while others adopt a dynamic approach. Ed's philosophy leans towards dynamic sizing, but he acknowledges that both methods have their merits and long-term track records.
Ed argueed that to run a variable level of risk, one should ideally have a constant level of risk and modify it when necessary. However, he admited that timing systematic strategies is difficult, and trend following has its challenges as well. Since trend following can't be applied to autocorrelated returns, it's hard to time these strategies.
He also noted that trend following has an asymmetry in returns, which can make timing difficult. Missing a good quarter could mean losing the entire year, while missing a bad quarter might not matter as much. This is different from equities, which have the opposite asymmetry.
Ed's firm elects to run portfolios at a constant level of risk for two reasons: they haven't found a reliable way to time the strategies, and their investors prefer a consistent volatility of returns for protective purposes. In summary, while dynamic position sizing might be more ideal, the challenges of timing systematic strategies and catering to investors' preferences has lead Ed to maintain a constant level of risk in his portfolios.
Alan asked Ed about liquidity in markets and whether he believes markets are as liquid and easy to trade as they used to be.
Ed stated that liquidity is good but not great, and that they have had to modify their trading approach. He explained that they opted for more aggressive trading during less liquid market conditions in the past year because the opportunity cost was significant. Ed also mentioned that they only trade the most liquid assets, avoiding venturing into crowded markets.
Regarding market selection, Ed explained that expanding the market universe should either offer diversification benefits or generate higher returns. However, he argueed that the diversification argument does not hold up mathematically. He is also sceptical about making more money in new markets due to low barriers to entry. Ed revealed that they trade 55 markets in their trend strategy and quant macro strategy.
The conversation also touched upon the LME issue. Although they only trade copper, aluminium, and zinc on the LME and were not directly affected, Ed acknowledges that the incident raised concerns about the LME's viability as a trading entity.
Discretionary Decision Making with Systematic Portfolios
Alan asked Ed about the possibility of making discretionary decisions in systematic portfolios and what kind of events would lead them to stop trading or significantly reduce risk.
Ed explained that discretionary intervention is very rare, and they consider it only when there is something the systems can't comprehend, such as counterparty risk or a hard asymmetry introduced into a market. He also mentioned scenarios where volatility increases more quickly than their models can comprehend or when there is a well-telegraphed macro event on the horizon.
One unique feature at Graham is their daily risk committee meeting, where senior people review positions and changes across their entire business. This process helps inform decision-making on the systematic side and allows them to run stress tests and scenario analyses. Ed believes this daily process, combined with the domain expertise within the firm, is a valuable part of their strategy.
Misconceptions of Trend Following
Niels asked Ed about the one thing he has heard about trend following that he disagrees with the most.
Ed responded that, aside from people claiming trend following is dead, he disagrees with the notion that people can time it. He observed that investor flows often serve as a contrarian indicator for trend following performance. The most successful users of trend following are those who make a strategic allocation and stick with it, rather than attempting to time the market.
Ed emphasized that timing trend following is very challenging, and neither he nor his team can do it.
Outlook for 2023
Niels asked Ed about his thoughts heading into 2023. Ed highlighted that 2022 was a good year for their industry, as they fulfilled an important role in people's portfolios. However, he emphasized the importance of not becoming complacent, as the industry constantly changes, requiring continuous innovation and creativity.
Ed pointed out the need for adaptable portfolios and the wealth of data available, which has evolved dramatically compared to earlier years. This data presents both opportunities and challenges. Additionally, he noted an increase in talent in the industry, which is a positive development.
Lastly, Ed mentioned that investors are now more aware of the importance of active diversification in their portfolios, as traditional options, like bonds, are no longer as effective. Systematic strategies can create their own reality, offering attractive solutions for investors. Ed believes the outlook is positive from both a research perspective and the ability to raise assets and play a crucial role in people's portfolios.
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.