Roy
... worse than chance at helping you predict the future.
Niels
Very interesting. Now I picked up somewhere that kind of your general philosophy that you talk about is that when people trade using their instincts that behavior becomes predictable, and that's what you can then exploit. My question is, in the last five or ten years more and more computers get involved in trading and I just wonder whether these instincts and behavior and the predictability of trading and markets, are they impacted with less and less decisions possibly being made by humans, and more and more being made by computers who obviously behave differently?
Roy
That's a very good question. Part of the answer is we already discussed with regard to the cognitive biases that people fall prey to when they use quantitative strategies which can be just as significant: things like trying to allocate to the strategy that's doing the best recently - that's a consensus bias, you might say. Of course, when it's spread over a lot of managers you get a very, very big tendency to do what was working recently just as you would discretionarily. Things like the types of strategies you employ quantitatively that too is subject to cognitive biases. We have certainly observed changes in the market. Any close reading of the entry day data will show that. However, we're still finding tremendously interesting, systematic strategies. Is it as simple as it used to be? No, but the effects are still there and for better or for worse there are still plenty of opportunities and frankly I think it's not so much the change in markets that has occurred by the increase in computers, as it's actually been the change in markets by the increase in government intervention that I feel has really influenced the data. Because when we look very closely, it looks like QE has been the determining factor of the performance of certain kinds of models, rather than a slow degradation.
When markets are volatile, like what we just saw in September, October, November; or January of last year, and you can just go back at each burst of volatility, it really does appear that particularly during those periods that same sort of instinctive behavior is still there. I think some of it may have to do with the fact that there's still a very, very, large fraction of participants who are subject to the same issues that they always have. They have to get out of losing positions because they don't want to show it on their balance sheet, or they have a firm rule that when you lose X%, all these things subject to cognitive biases of both them and clients tend to make markets still susceptible to them.
Finally, there is the tendency of clients to invest and pull money from strategies, even quant strategies that are performing and not performing. So the whole short term trading space has contracted tremendously over the last five years. In 2007, 2008 short term trading had about twice the sharp of trend following, and everybody piled into it. Well, certainly it's been the most out of favor strategy let's say through the end of 2013. It's much smaller. So I think there are still a lot of opportunities out there. Again, because of the diversity of different things to do in the short term, you don't all have to be on the same trend - the one big fixed income trend, or dollar/Yen trend. There are a lot of different ways to do it. Every manager has unique solutions, so the niches are more refined. Like in an ecological system there are a lot of different animals filling lots of different niches versus one very common animal that eats up all of the easy to get food.
Niels
True. In your world, the short-term world, is model decay a big issue? Do these models stop working and then you have to constantly find new ones to replace them in order to keep up?
Roy
There definitely is some model decay. One problem that I think is a problem that one has in making a decision, do you pull a strategy, very much like the problem that we have, do you pull a manager from your portfolio? That decision itself is subject to cognitive biases. So we have tried, actually, to quantify that decision-making process, and that's a difficult question to quantify, because some of it is much more complicated than is it performing or is it not performing. We do believe that there are ways to do it and ways to let the computers figure out how to allocate as well as... how to pull strategies as well as how to allocate the strategies. So I guess I could say we try to quantify even that piece of the strategy.
Niels
Yeah, absolutely. Let's move on to the heart of what you do, namely the trading program itself. I know you've already talked a little bit about it, but the Diversified Program, tell me a little bit more about, from a top down point of view why you've designed it the way you do? You talked about some family; you talked about different time frames; 60 plus different trading rules, talk to me about why it's been structured this way. What's the rationale behind that?
Roy
Given that we have focused the mission of the business on providing diversification and protection, I guess it's not surprising that we apply that same idea to the strategies that we employ. We're trying to do a lot of different things: to have them be as different as possible and to allow them to operate effectively in harmony with each other. So in the design of the program we have tried to think about some issues... some interaction effects regarding risk management. We've looked at offsetting of trades and how that is important in reducing costs. We've looked at the tendency of models to perform or not perform at certain times, the tendency of types of models to perform and not perform at certain times, and also to make sure that when we do this we don't believe our backtests quite as much as one might if you had a pure quant approach. I think having some experience in... and again I like to talk in analogies in managers selection: you realize that you can create 4 and 5 sharp portfolios of hedge fund managers every day of the year, but when you actually allocate to those managers you are not going to get that 4 and 5 sharp, and you're probably lucky if you get a 1 sharp out of a 5 sharp portfolio. The same thing is true in the models that we use and how we've structured the strategy. We've tried to use models that contain interesting ideas at their core that we believe in, that we're going to stick with, that we think should be robust, that are as elegant and I don't want to say simple, but they're not over-parameterized, and to not force our own tinkering and biases onto the approach. So what I believe we have right now is a group of nine different styles, as I mentioned in the time frame ranging from minutes to weeks, that complement each other and each of them representing a different way to think about the markets.
Niels
Can you give me an example. What's a way to think about the markets?
Roy
What I mean by that is... one of the theories that we believe in is that the recent path that a price has taken is highly influential of what happens next: in the mean that one achieves, in the shape of the distribution, in the direction of the path and the tendencies that that path has. So when we think about what makes our styles of trading different, we're thinking of how different types of paths, be they strength of momentum, or mean reversion after a market becomes oversold, the paths that get us to those conditions have a certain consistency and that's what makes a style of model for us. So it's a type of effect that we're capturing in each one of our models that defines each style.
Niels
Is the parameter set for each of these models, are they fixed, or do they somehow go in, because you're saying the reason history is very important about what is going to happen next... do they go in and kind of recalculate, recalibrate parameters in order to best fit in with the current environment even though the objective and the role it plays won't change but maybe it needs to gradually adjust itself, or is it just completely fixed parameters until you decide to change them?
Roy
I think the best way to answer that is there are elements of both. We have pieces of our strategy that are adaptive. We have pieces of our strategy that are really meant to be relatively static, and effects that we believe in, even if they're not working, we still want to apply them with the idea that there's a mean reversion and even when something hasn't done particularly well, it's still important to have them in the strategy. Very much analogously to why it would be important to have things that are risk-on in 2008 even though it's had its worst year ever, or why it's important to have things that are not risk-on after the last five or six years of risk on in a more diversified portfolio. So we think about things that way too, but at the same time you do want to react to what the market is giving you and what changes have occurred.
Niels
Sure. You have three categories: you have this very short term trades, you have the within a week kind of trades, and you have the longer term trades, and you have a certain allocation I'm sure in terms of risk to these different categories. Do these allocations of exposure, do they change automatically or is that something again that you set and say, "right, we want to be 40% of this or 20% of that?"
Roy
It's again a combination of both. There's a fixed initial allocation, and then it varies beyond that quantitatively.
Niels
Alright. How many markets do you actually trade across?
Roy
I think it's 54 right now, is the current number. The markets that we trade are the most liquid markets in the world. There're no emerging markets; there's nothing that... as a short term trader you're very focused on your opportunity set divided by your trading cost as kind of your magic number. The opportunities that are how much you can trade and how much of the market move and the cost is your commission costs, and even more importantly your market entry and exit costs.
Niels
Yeah. You have, you mentioned, you have a certain sector allocation. My understanding is you use a pretty evenly distributed sector allocation between the four main asset classes: FX, interest rates, stocks, and commodities. I almost know the answer to my question here, but why do you choose that completely 25% to each?
Roy
I'm kind of curious, based on what I've said so far, let's see if I'm getting my message across, what is my answer?
Niels
Well I guess the answer is that we just don't know where it's going to be and therefore we need to not try to be too clever about these things.
Roy
Exactly, having a certain humility as to what is going to work versus what has worked in the past is very, very good portfolio wisdom I think. Again, always analogously to the problems that we all face in constructing multi-manager multi-asset portfolios; that I have in managing my own assets; that any investor in CTAs and hedge funds and traditional has in creating portfolios, it's very, very important to say not what has worked the best in the past, but be humble about one's ability to predict the opportunity set and what will happen in the future, and most of all to avoid the common and instinctive reaction that your brain puts you in, which is that the current conditions are the best representation of the future and the best predictor of the future. That is really not the case in markets. Believing that can get you into a lot of trouble.
It's my view that the last five or six years are probably the worst predictor of the next five years because there's been an external force. Although liquidity and lack of volatility associated with it are being pumped into the market. So when we look at markets we are not trying to predict what is going to make money in the future over the next two years based on what has made money in the last two years. I think one of the most interesting conversations I had with a manager... with another manager was back in the mid 1990s, I was sitting with some folks at AHL at their offices in London and we were both lamenting the fact that it's been very, very difficult to trend follow in equities. I remember very distinctly they said... I forget who it was, it might have been David or Adam, but someone said, "we trade it even though it hasn't made money ever," and that's exactly what we do as well. We both agreed that it was important to trade things that have not been particularly successful.
If you look at the last couple of years, what had the best trend? Dollar/yen, when was the last trend in dollar/yen - probably 20 years ago. So it's been really a stretch to keep that market in your program if you believe that what has made money will continue and what has not will continue not to. British pound has been fantastic. I don't think anybody has made money in British pound since Soros did in 1992, but that's been great lately and you have to be humble and it's very, very hard to predict. In our sector allocation, we have tried to focus on that.
Niels
Well I'm glad I passed the test, but more importantly I think you stress an important point and that's also in the sense, how do you convince someone to look at it this way and say, even if it hasn't made money for ten years we're still going to trade it. Again for the people sitting outside looking at these strategies, wanting to make a decision it's hard work sometimes for them to really understand why we do what we do. This is why I think the stories behind these are much more important because you don't really understand the numbers that people see or that they present unless you understand the story and their thinking. Now tell me a little bit about your system in the sense that you have this kind of 10 step process from idea generation to actually implementing something in the system, just talk to me a little bit about that and what's the thinking about going from the initial stages to hopefully end up with something that you can trade.
Roy
I think the goals of our research process which is designed to create viable, robust strategies that succeed over the long term is very much the same as the way one would approach any sort of good scientific process. The beginning of a good scientific process is, having a good hypothesis, and what's a good hypothesis? A good hypothesis is one that is extremely falsifiable, so the classic example is all swans are white. Well, that's easy to falsify if you come up with a black swan, and that's what the original black swan idea was, that it's an easily falsifiable hypothesis. So we prefer highly statistically significant, very frequent observations - things that occur a lot, rather than things that occur very rarely because we can easily tell when something has stopped working. So to falsify one of our trading strategies, it has to be statistically significant in say actual use or in actual use for a certain time period versus what it previously had done. So rather than favoring strategies that you might have to wait 20 or 30 years for the trend of the century to make all of your money, we'd like to have strategies that give you enough observation that you can really start to see when they're working, when they're not working and ask why and see good statistically significant answers. So falsifiability is very, very important in our research process.
The second idea is parsimony. We want to have as simple an idea as we can possibly get away with before it becomes trivial. This is something we've really learned over time. The simpler, the better. It is so easy to fit the data. The data is just waiting to have the models just squeezed out of it with enough variables. I remember I spent a year or two working with neural networks back in the 1980s right when they were popular, and the neural networks are the world's greatest data fitting tool. By definition, they can fit any data that's their whole point. You give it enough nodes and enough freedom and bang you've got a beautiful matching of the historical data. Of course, it never generalizes. So we have really tried to focus on parsimonious ideas - very, very simple. The kind of thing you can just take a couple of sentences and explain, not complicated parameter sets.
The third one is robustness. We are looking for things that are as consistent as possible across markets. Now this is something that not everybody does. We believe that if what we are finding are things that are true about the way people approach markets, then it should be true in whatever market we try it on, be it Google, or Soy Beans or dollar/Swiss or Two Year. Ideally what we're looking for are things that are very, very consistent across asset classes and across all 54, 56 markets that we test them on. That gives you a large number of observations. A lot of people don't do it that way. A lot of people have specific systems, bi-market, bi-direction, and that's OK too. There are a lot of different solutions to this problem, but that's how we do it.
Niels
I agree simplicity often leads to more robust outputs in the long term. Looking at all those things, trying to determine what, in lack of a better word, indicators to use in order to describe that, is there anything that you found that you generally think works better when you want to achieve that kind of thing? Some kind of a favorite indicator that actually is usually more robust than others when it comes to trying to do things in a simple way?
Roy
Well, If I'd found the Holy Grail I certainly wouldn't be discussing it in a public forum like this. I hope you'll... if I demur on that particular answer. Do we have a few things that we really feel are the most important things to look at? Yes. I also want to point out one more aspect of our research that I think is very, very important, again, completely based on good scientific research in general and that causality. The final piece of what we do is that everything that we try has to have some relationship that we can understand to what we're trying to predict. So the relationship of the independent variable to the dependent variable should not be some magical, unknowable relationship that just happens to work, but something that we really believe in. As a toy example, of course this is absurd but if someone told you that the phases of the moon... when the moon was in a gibbous waxing, then the stock market performs 3% per annum better than when it's a waning crescent. What's the causality? It might be an incredibly high correlation, but there's no reason that I can think of that there should be causality there. A lot of what passes for technical analysis I think fails that test. You don't really know why a market should do it, and the people say it's a self-fulfilling prophesy. That's not enough for me. I want to understand why a market's doing it and believe that before I even test the hypothesis. That's a very, very good way to begin scientific research in all aspects. Frankly I think it's a very good way to run ones... to believe or not believe in certain things. I have a particular view on global warming based on its causality and falsifiability, but we'll leave that one out for now.
Niels
Sure that's fine. Just out of curiosity, in terms of... there are obviously certain ways to get into a trade, getting out of a trade... do you believe in stop losses? Is that a philosophy that you subscribe to? Stop profits, or do signals have to change direction or how does that work in your part of the world?
Roy
That's a very good question. I think one answer is that short term traders typically don't have much impact of stops as long as you're getting out of most of your trades or all of your trades in a very short amount of time, it pretty much doesn't matter what you want to do intra-day because the fact is, during the catastrophies,when you really wish you could get your stops hit, you're not going to be able to. Of course, the prime example of that is 9/11 where all the sell stops in the world wouldn't have helped you when that second plane hit. Even just in October of this year when we had that enormous intra-day fixed income rally, you were going to get filled right on the high no matter what your buy stop was if you happened to be short that day.
So my view is you pretty much have to take positions that you're going to take an event risk on no matter what that event is and be able to come back and trade the next day. If you're going to be long in the stock market, you have got to be willing to take a 5% or 10% loss in the stock market, intra-day with no warning and have no ability to get out and that's what happens fairly regularly. So for short term traders, just getting out of everything serves as your stop. Now that having been said, we actually do have, on our trades a catastrophic exit point. It's not hit very, very often. It's our hope that maybe it will save us a little bit, but we don't really rely on it, and it occurs very, very rarely. In terms of exits, for us the exits of a trade are tied in with the entries. We're in a trade for a particular reason with the exit in mind as part of the reason that we're doing the trade, so we use all variations and a number of others of what you mentioned and the interaction effects of all these models is actually very, very important: how the exits of one model effect the entries of another and so on.
Niels
Now you know that certainly in trend following I think a lot of people over time have articulated that position sizing is actually quite an important element of the success of trend following over time and just how the positions are sized based on volatility and all of these things which, you know, to people doing it may seem trivial, but maybe for people are not that into it, it is a slightly different concept. But in the short term space, does position sizing play as important a role do you think or not so much?
Roy
I think it certainly impacts your volatility. I think having a good understanding of covariance and volatility in your position sizing and how your models take positions and when they're going to get out, it certainly helps. I don't think that because you're dealing with fairly small moves that occur in a day, if you happen to overtrade by 20% on one position it generally won't have that big an impact because there's so many positions that over the course of a whole year are going to add up to your return, so any one position that you have, if you make a mistake and you're 7% over or trade only 80% of it, it is impossible for it to have a material impact. Now obviously if you're going to trade for a year, and you have three or four big positions and you miss 20% of a big position. Then that is a big issue. So I think the bigger each individual position is, is relative to your total return, the more important it is to size it exactly right. I think short term trading generally it's possible to get a reasonably good estimate of volatility. I think we've done a pretty good job of keeping our volatility exactly where we want it to be, which, by the way, is about 16% or 17% annualized. We know exactly what to do to keep it there. We know exactly what our risk is and of course it's only a measure though. It doesn't help you when you have a potential 9/11 on any given day or a flash crash. Those are unpredictable events, and you just have to assume that your risk is only one way of taking the temperature of the market and be willing to take a certain amount of unexpected volatility.
Niels
Yeah, absolutely. The next topic I just have a couple of questions too actually. It's... I call it trade implementation, but we've already talked a little bit about it. It's actually also, I ran into someone that you may know here in Switzerland, and I'll just say his first name, he's called Matthias and he... I think you've met him a few times, and he sent me a question today, because I mentioned that I had the pleasure of speaking to you and he sent me a question that was a little bit about slippage. I mean for a short term manager, how often do you have to improve or rewrite your execution models or systems or code in order to keep up and keep slippage to a minimum?
Roy
We moved to algorithm trading about ten years ago and now, almost 100%, it's probably 99% of our orders are done by our algos. They're all done immediately when the signals come up and are sent directly to the algos for execution. We have a very, very careful measurement of our implementation shortfall based on what we believe we should be able to achieve. Of course arrival price is one benchmark one can have, but there are others too and it gets rather intricate and arcane the different ways of measuring what your slippage actually is. One of the things I've always pointed out to people is that slippage is actually the flip side of performance. That when you're performing really well, and your models are really smart about which way the markets are going to go, you're going to get worse slippage and that might be OK. Whereas if you're always wrong and you're 100% accurate, you can have tremendously fantastic slippage and have almost no implementation shortfall what-so-ever, but you'll be 100% wrong on every trade. So there's a balance to be had. That having been said, the models that we use, we have two guys that focus exactly on that. That's all they do, and they're very, very carefully evaluating our performance over algos in each market and we believe that we've been able to keep up. The numbers suggest that we have not had any decay in our algorithms. In fact, we think we've improved it over time.
Niels
Next topic is one of my favorite topics. It's risk management, because I think it's such an important part of what we do. I just wanted to ask you sort of broad term, how do you define risk? What is risk to you?
Roy
I think volatility is one synonym for risk. I think there're different aspects of risk that go beyond that. There's... you can have a very quiet program with liquidity risk, and you have a left tail that doesn't appear until you actually need it. I think people learned that in 2008 that just volatility wasn't enough. As long as you're in the most liquid markets, and they're open almost all... 99.99% of the time to 100% of the time, then volatility starts to be a closer measure to what your risk actually is, at least in terms of your static position. There's also the question of what you're going to do.
Your risk is not just what you have, because maybe if there's an event risk situation, sure, but there's also what are you going to do? If your strategy is going to hold for an hour and get out, that's very different from a strategy that's holding for six months. So that should affect your estimation of your risk. There's co-variance, so it's not just what's going to happen, but how confident are you that the risk that you've calculated will continue to be that risk if the correlation of say stocks and bonds goes from -.4, -.6 in a shock event to +.4 in a taper tantrum or something like that. So you have to be aware of the limitations in both the variance and covariance. How much can those change? How volatile and how much can the interaction vary of markets to each other? There's systemic risk. What do you do if your lines are severed to your executing broker or the exchanges, in our case, and you can no longer execute your strategy?
You can just go right down the list of potential risks and it ends up being a big DDQ that the risk of someone stealing your strategy, the risk of someone front running your trades because they've been able to figure out what your strategy is. I heard someone that was making money from front running the trades that one of the major CTAs that you have interviewed, that the person had been so forthright about their strategy that this gentleman had made money just front running a trade of this manager. So there's publicity risk. I hope you don't mind if I'm being a little cagey about what we're actually doing and how we do it.
Niels
No, absolutely.
Roy
So I guess the short answer is there are a lot of definitions of risk and it's really a very, very broad and intricate topic that merely a VAR is just the first slice through a very complicated situation.
Niels
Sure, now you mentioned in your documentation, sort of, that... and honestly I don't know whether this is something that is being used on a regular basis, or not, but you mentioned the fact that from time to time one needs to step in and use discretion to reduce risk. How does that work at the same time as trying to be non-emotional about these things and so that would be kind of the one question. The other question I have is, have you measured whether these sort of manual changes if we call it that or over-rides, whether they actually help or deter performance over time?
Roy
We have gone through a number of phases of our use of discretion. I think the trend has been downward. Coming back to this aircraft metaphor that I love to use, just as a 747 in 1967 when it first came out. You pretty much had to fly the plane by yourself. Now you pretty much just watch, and it's almost a danger that the pilots can fall asleep. In fact, their lack of flying experience can actually be an issue, so that's really with us we've tried to quantify almost 100%. Whereas in the past we really tried to be a little more proactive and allow a lot more discretion in the timing of our execution, let's say, and even in some of the way we use some of the strategies back in the day.
These days... I think there's just been one instance in the last two years where we have stepped in, and it was a very, very small change that we made. The one area where we think humans are pretty good at it is recognizing the limitations of quant strategies. In this particular case the limitation... what we were concerned about was that the historical volatility of a particular market was not reflective of what was actually going on in the market and in that particular day if something had really changed in its level of volatility. We felt that the VAR numbers that our models were seeing and our whole position sizing algo was not reflecting of today's true risk, so we basically turned the whole thing down.
Niels
Sure, sure, makes sense. The next topic I wanted to jump to is obviously related to risk management. It's a little bit about drawdowns, and in particular I'm interested in what do you learn from going through a drawdown, because drawdowns are so difficult for investors to go through and we talked a little bit about that, but you as a manager, what do you take away from going through a drawdown, other than the pain?
Roy
(laugh) We certainly take that away. I think the experiences that we've had, and we've had some significant drawdowns, every one of them has resulted in a far stronger program than we had before. It's like annealing of the strategy - a crucible where it forces you to examine every piece of your organization, every piece of your strategy, and say what do I want to be doing to avoid this? Is it appropriate to be making a change right now? Is this in this mission of the firm, and is this strategy creep or is this a change that would essentially make a material difference to what our clients expect, and just on, and on? When I look over the course of 22 years, we've survived a number of significant drawdowns.
Part of the issue that we have is we have tried to be true to our mission of being negatively correlated, and we've worked really hard to do that. The reason that we were so good in 2008 left us vulnerable in 2009 and beyond over the next few years when things just rocketed back up with a tremendous lack of volatility, which is the best way to describe the QE years. It forced us, in those years, to develop ways of maintaining the core mission of the firm to be protective, yet to do it without spending as much money on losing trades to maintain the negative correlation. I think we have learned, unfortunately with the benefit of hindsight, but through the crucible of our worst drawdown that we had - through 2012, to become so much better at making money during a QE type environment yet maintaining the negative correlation that we always have provided.
We just had a great test of that in the last 8% or 9% drawdown that the equity markets had, our models did exactly what they are supposed to do. They made a tremendous amount of money on the downside, but then the market came rocketing back up again, in it's typical fashion, at least for the last 5 or 6 years and we didn't give back very much at all. In fact I think already we're on new asset highs right now after the lows, so I feel very, very good that the experience of that particular drawdown has created... it exposed a part of our strategy that obviously in hindsight we wish we had been able to change beforehand, but it's certainly made us a stronger manager. The fact that we've survived 22 years and we're still here and trading and have a very strong operation, I think we're doing that with a much stronger platform and a much stronger strategy than strategies that have not really been tested with their particular Achilles heal.
Niels
On that point, something I noticed, and I really don't have perfect insight here about AUM, but I seem to get the impression that, although you refer to a tough time and a big drawdown a few years back, you seem to have been able to maintain your asset base and I would say that most people going through a drawdown of over a long period of time and with some depth to it probably most of them are out of business today. How do you do that Roy? How do you keep investors in through a tough time?
Roy
I think we have really defined in advance for people that this was not going to be a 1.5 sharp strategy as long as the stock market didn't go down. We had prepared people for some volatility and we also told people that if you want something that's going to protect you, it shouldn't be the kind of thing that tries to ratchet down and if it has a 2% or 3% loss in a month just shuts off, because then you lose the potential that the strategy can really protect later on in the month, let's say, and even October was a great example. We started off down, and I think it was very good that we were able to continue to trade through the middle of the month when it got very volatile.
So first is preparing people for what can go wrong, and not believing that... we had a nine year run from 2000 to 2008 where we had a 1.5 sharp or almost 2 sharp and still with the negative correlation, but I don't think anyone believed, in our operation that we are a 1.3 sharp strategy if we're going to have five years of volatility going down by 90% and stocks rallying 300%, so there was some clarity with the clients and I think also people have made a lot of money with us for those previous years, so they're comfortable with the strategy and they believe in the core in the strength of the operation and the team was all here and I think on every other aspect we still had the operation that we had at our asset highest. We also demonstrated, I think, that it wasn't the fact that we had grown that caused the drawdown.
We had pretty much our high NAV in assets was before 2008 and then we were up fifty some odd percent on the maximal assets. I don't think people can say, well they got too big, it wasn't that. So some of the normal reasons for people pulling money might not have been there. Now did we have redemption? Sure, after you have as tough a time as we did it's very, very hard for people to look at 90% of the managers in their portfolio making money every single years strongly as stocks rallied and then to have that lousy Niederhoffer negative correlated showing up at the bottom, but I think we may be in the other end of that cycle right now and it feels to me very much like it did in 2007 where there's incredible interest in our strategy right now. I think before the volatility really hits with the end of QE just like August of 2007; it was kind of a shot across the bow of the 2003 to 2007 equity rally.
October of this year... October of 2014 showed people what can happen in portfolios. The fund the fund index, if it had marked at noon of October 15th it would have been down almost 5% which would have made this the worst month except for September, October 2008 and August of 1998. It was really that bad. The same thing happened in August of 2007. The hedge fund and traditional investments were down tremendously, and it came all the way back and made a new high in October of that year. Then you know what happened next. That's where it feels we are right now and I think if people... and we have been able to articulate the reasons to invest in our strategy and why it's important to have this kind of asset, a negatively correlated asset with positive performance over time, now is the time when people are going to start probably to come back, that have even left and we've already seen that. It is I think, something that we've always been clear about and perhaps avoided the catastrophic existential risk of having this kind of drawdown, where people thought we weren't being true to our strategy and we had shifted, etc.
Niels
Now, you've clearly done a great job in keeping investors comfortable but what about yourself? How do you personally deal with a drawdown? How do you switch off emotionally, if I can put it that way to make it easier, because we all know as managers it is tough in itself to go through the drawdown, but it's even tougher when you know you're also taking client money along for the ride, so how do you balance that in your personal life?
Roy
That's a very good question. I guess there're two answers. There's both a personal balance and how do you keep your business going as well, and I think, for better or for worse that's a related answer if you're worried about the stability of your business and your ability to continue then it certainly can add some stress and effect your decision making. Even after 2009, we'd been in business 16 or 17 years, and I'd had significant drawdowns before and I was prepared for this. It wasn't something that I never thought could happen and so to me it was, OK let's sit down, roll up our sleeves and let's figure out what is going on and I think we were a little bit too slow to react, if I had to look back. I think we really underestimated just how successful QE would be in raising asset prices and depressing volatility, but that having been said, having a great team and having a head trader who is really steadfastly with me in believing in the strategy and a lot of researchers who are working very, very hard certainly made it a much easier experience on the work side.
I also have a very wonderful family situation too. My wife is incredible, and I have four beautiful kids. I come home, and they don't care if I'm up a percent or down a percent today, or if I'm down 10 or up 10 on the year. They want to play with Dad so that's been a tremendous help, I think in some of the tough times and so I think, that having been said, the fact that we also did have an enormous year on over 2 billion dollars, gave me the financial stability that I was never worried for even a second. I could have not a single client at all and stay in business for 100 years if I wanted to. So it's really not a... there was never an existential threat to the firm from an asset point of view, and I think that also after... it's easier to maintain stability and confidence through a drawdown when you've been in business 17 years than it is if you've been in business two years.
Niels
Yeah, absolutely. Now just a final question on this topic. Is there anything out there that you see right now that might keep you awake a little bit at night when you see the world? Is there any risk in the system or anything out there where you say, "you know, I wouldn't want that to happen overnight because we would suffer through something like that?" Because we all spend so much time on trying to mitigate risk, but obviously we know that we can't mitigate all risks.
Roy
Normally I would have said here, more government intervention. If you had asked me five years ago I would have said just an effort by the government to control the direction of the markets, which would change the impact of the strategies... the success rate of the strategies that we employ which are designed to capture the impact of individuals and systems and things like that - the normal participants. However, I think what's happened is that there's such skepticism about government intervention, at this point, that the threat of a lot more of it is now starting to have the opposite impact. I think we first started to see that with Abe and his massive QE program there in Japan, and I think for example if the US were to vastly expand the QE again from zero, where they are right now, it would be seen as such a negative for the economy that it might actually have the opposite impact. So I'm less concerned with that type of money printing, that type of intervention. A more direct intervention like making it illegal to sell the stock market the way they made it illegal to buy silver in the 1970s that obviously is something that keeps me up at night. Then of course things like the potential for events like a terrorist attack, that would just shut everything down and just be utterly catastrophic, I think. Those keep everyone up at night, not just short term managers.
Niels
The next topic I wanted to touch upon is research, but I actually only have one question that I want to pose, and that is how do you measure the effectiveness of your research?
Roy
It would be easy to say if it doesn't make money or not, but there's a lot more to it. Just like in portfolio construction, your best performers are not the only piece of your portfolio and to think that you're... the smarter you are that the smart pieces of your portfolio are only the things that are going up is, I think, naive. So the effectiveness of our research would be do we feel that our new strategies, let's say that we're using in 2005, perform better from 2005 to 2008 than the strategies that we had in 2000. In that sense, the mix of the portfolios should continue to improve over time. Unfortunately there's a huge confounding factor which is the paths of realized volatility - is it a high vol period, a low vol period; is it a very trending period; a period of a lot of intra-day reversal, so there are tremendous confounding factors. Unfortunately, therefore, my answer has to be it's a rather qualitative and subjective assessment of the quality of research. I don't think pure quantitative results are the whole answer. Obviously that's a simple answer to it. What is your sharp ratio? But at the same time, what are you able to withstand in the future? How are you fulfilling your mission?
As I said, we have made some sacrifices in our own sharp ratio. We know that we could have made more money had we added some more risk-on. But we chose not to in order to maximize our alpha. So if we continue to produce significant amount of alpha and even better an increasing amount of alpha that would make me happier than just looking at performance.
Niels
Sure, sure. I have another topic, I call it the business side of your firm, but it's not really sort of specific to that, but there is one question I thought would be quite interesting to hear your opinion about since you have studied the human mind in detail and it goes something like this. It's related to mindset. Now, you started out in 1993 and obviously as a small manager, like all small managers you probably had little to lose, so to speak. So you go in, and you start a business, you start your trading strategy and you have a certain risk tolerance, a certain risk profile. Then 10 years, 15 years, 22 years later you're very successful. You've make a lot of money. You have a big business. You have mouths to feed. You have significant clients to look after. How does this change... this success, how does that change your mindset as a manager when it comes to risk? Do you, despite having studied the brain, do you also become a little bit more risk averse in that sense because you have more to lose?
Roy
I think I, perhaps unusually, can say that there has been absolutely no change in our tolerance for risk and the type of models that we employ. I think if you look at our quantitative statistics, the proof is in the pudding. So it's true, that a lot of managers as they've grown, have gotten much less volatile. They're trading different mixes of assets. They're correlation to equities is... we've talked a lot about that already in this interview, that that is a natural tendency, and it's not just that stocks are going up. It's that managers want to provide that institutional longevity.
We have set a very, very specific mission in the firm and that is we are going to be consistently negatively correlated to the equity markets, and we're going to provide a 16, approximately, annualized standard deviation to our clients enabling us to provide not just negative correlation but a significant amount of downside protection. Not just +.2% if the stocks are down 8%, but to make 5%, 8%, 10% in these equity drawdowns and have the ability to essentially be an heroic addition to a portfolio and be up 30%, 40%, 50%, 60% in a big, big volatile year to really help people's portfolios.
We started with that; we did do that in 1997, 1998 during some of those big drawdowns. The long-term capital situation was enormous for our strategy, and it continues to be the case all the way through this last month in October. So I really can say with great certainty, that for better or for worse our risk parameters, our correlation, and my risk tolerance are exactly the same as they used to be on day one.
Niels
Yeah, fantastic. What's the biggest challenge today, do you think when you look at being a manager in this space and so on and so forth? What do you think is the biggest challenge that you and maybe the industry faces?
Roy
I think, for us the biggest challenge and one that we really try to face every day is continuing to come up with creative, interesting ways of improving the strategy without merely fitting the data more effectively. That's, unfortunately or fortunately the very, very same challenge that I had when I sat down in front of my computer and put the first opening brace of the code that was then going to turn into our whole background, and this was in October of 1992. It's still there; it is exactly the same problem that we had at the beginning - challenge I should say, not problem - and it will never change. The nice part about it is you are constantly tested by the markets, every day is different, every year, every month, every single trading day gives you new challenges in ways to improve. You can learn new things from the markets every single day, and a very lovely thing, or horrible thing about the trading world is that you really are judged objectively by your results and there are not too many fields where you can say at the end of the day, this is how good I am; this is how bad I am and the proof of the pudding is in our track record and what we've been able to do for people's portfolios.
Niels
Sure, great. A couple of more questions on this topic and then we go to the final section Roy. If you could ask a question of my next guest, peer to peer so to speak, and let's just, for argument sake say that the next guest was David Harding, which, unfortunately it isn't. I still hope that he will pick up the phone and come on, but what would you like to ask someone like that who has been so successful in this industry?
Roy
Hmm, what would I like to know from other managers? Am I wearing just my intellectual curiosity hat or is this more...?
Niels
You can wear whatever hat you want really.
Roy
What are the most illuminating questions that one can ask a manager that you should be asking?
Niels
Well that's part of the next question I would say, but just specifically, if you had a chance to sit down with David Harding and ask him a question that you thought was interesting to you, what would it be?
Roy
Some of the more interesting questions that I'd like to know the answers to really are some of the things that you've asked: has there been degradation of model versus actual performance over time as a result of factors like high frequency trading and decreased liquidity? That would be one. I think an interesting question to ask managers is to really assess out who is a short term trader, I like to suggest that people ask not what is the duration of your average trade, but the duration of your average position? In other words, if you're long, how long do you stay long until you go short? That is another way of saying, what is the relative contribution of different durations to your strategy. I think honestly the questions that I have... I certainly respect tremendously what all the other... you have a roster of superstars on your program and I'm really honored to be part of this, so I would first say that I am in awe of what everyone on this show has produced and David, of course perhaps without equal has produced something extraordinary.
So the questions that I have for managers are things like how do you raise children with good values? Being a person of wealth and success and with tremendous demands. Maybe things like personal asset allocation, what do you think about the world; some things about managing a business along the lines of what you talked about. Just really to compare notes in running significant operations, and lessons learned. I think some of the challenges that one faces as an entrepreneur and hopefully an entrepreneur with success over time are more of the personal nature - some of the things you've articulated: what makes you excited to go to work every day; what sacrifices do you think one can avoid making with the benefit of hindsight?
Niels
I don't know whether it was kind of in anticipation of my next question, this area, but I do want to ask you also, and maybe the answer is a little bit different, you've been in hundreds of due diligence meetings and you've probably seen...
Roy
It might be thousands...
Niels
Thousands, yes, and calls and what have you, but what do you think investors are not asking you actually that they should be asking you when they come and do their due diligence?
Roy
I will tell you that my answer to that question is a lot shorter than it used to be. I used to give, actually, a talk on that very topic. I literally could go on for half an hour about that. These days people are getting a lot smarter about it. I think there's a lot more understanding of the space. I think the most effective due diligence is typically from people that have actually tried to solve some of the problems themselves, so I always like talking to people who are traders or model creators. People who have actually gotten into the data and can really understand some of the strengths and weaknesses of different approaches to it and almost speak the language. So I think I like to have people asking a lot about the models and things like that and really get into the weeds of model creation.
Some of the... I don't know; I don't want to even suggest too much about what's not being asked because I feel like these days people are asking it. I think most people do a pretty good job. I think if I had one suggestion I would make, is still the incredible overuse of recent track record, and also the tendency to pick All-stars, rather than to pick a portfolio of managers. I think if there's one mistake that I've made and learned not to make in our model creation, it's to believe our own bullshit a little too much, to put it bluntly. I think where we've really improved over time is to be very, very humble about what we can do, and I think that humility is a very good quality in portfolio construction and understanding that most of your managers are going to regress to the mean in their performance no matter how good your due diligence process is, chances are the average manager that you pick is likely to produce average returns and that, if you structure your portfolio with that sort of humility and lack of expectation of out-performance, you actually end up with a portfolio that's more likely to succeed better in the future. The simpler and the more humble, the better in portfolio construction.
Niels
Let's jump to the last section which I call general and fun, and so...
Roy
Well there's nothing more fun than talking about yourself for two hours. It's fascinating for me. (laugh)
Niels
Good, let's continue. In a sense, you touch a little bit upon in, but I do want to hear in your own words. Clearly you've been exceptionally successful, you've built a great company, you don't need to work another day in your life, but why do you keep doing it? Why do you wake up in the morning and feel the urge for, let me go into the office and continue to build my business?
Roy
I think there's a lot of intellectual satisfaction in my job that I'm not sure I would find anywhere else. It really does force me to keep my mind questioning and active and engaged with the world of macro and news and then into the nitty gritty of individual system performance and statistics. It provides a certain level of intellectual stimulation that I find very, very rewarding and as a result I love coming to work, I love the people I work with, and I love just sitting there in the trading room and a lot of time there just talking to people about what they're doing and how to do it better and what's going on in the markets, what can we learn. I think the markets provide a certain level of novelty and demand a certain level of attention and creativity that very, very few jobs do, so that's a big piece of it. I also feel like we're doing something good. I feel like we're, by helping people's portfolios, and really providing downside protection at times that feels really good.
The reason that people buy us... we've actually been pretty good at doing for a very, very long period of time and I felt like, in 2008, we saved people's jobs, we saved people's portfolios as we had many times before, and then one of the things I'm even more proud of is, right after Madoff, we got about a 600 million dollar redemption because one of our fund the fund clients couldn't get out of their locked up managers and they had redemptions which they had to meet, and we gave them 600 million dollars, on a days notice, and I feel like we did exactly what we were being paid to provide: liquidity, protection, and essentially a daily liquid strategy that protected my client. So I feel like there was a tremendous amount of satisfaction that one can get from doing the job that we are supposed to be doing. Have we done it perfectly? Absolutely not, we will never do it perfectly. Do I wish we would have been better than...? Of course, and that's what I'm here to do. There's a lot of satisfaction that I get from staking out a particular mission, as we've talked about a lot, and really trying to fulfill it day in, day out, and I think getting better at doing it. It's constantly challenging; it's very, very exciting, and I get to work with really, really smart people.
Niels
Have you always had the entrepreneurial gene inside you, do you think, or did that come later?
Roy
Well, you heard when I was 13 I had a pretty successful business, and I had a couple even in college, so yeah, I always have. I love creating something and working hard to make something small into something really big and successful with a clear mission.
Niels
Was that in your family? I'm curious, were your parents entrepreneurs, or was it just something that came through you, so to speak?
Roy
I certainly had the example of my brother who had been first in mergers and acquisitions and then, as I mentioned, very early on in short term trading in the late 1970s. So I realized that one could start a business, but in terms of computing, I was really the first in the family to go down the programming route. I love computers and what they can accomplish and I think, even now, the code that we write here is, I think it's particularly good and fast and does the job effectively and some of the lessons that I've learned from being right in the heart of things at the very beginning have been very helpful in getting that to work.
Niels
If you were going to recommend a book for people to read that you feel could improve their knowledge about trading and so on and so forth, is there any one in particular that comes to mind?
Roy
Well, the classic books, Extraordinary Popular Delusions and The Madness of Crowds, and Reminiscences of a Stock Operator; my brother likes to recommend books on turf betting, but for me, I think the best book on trading is actually a book that's not about trading at all for the most part. I think of it like the bible in that sense that you can just open it to any page and you can just study it and if you're thoughtful you can probably come up with something interesting from every single paragraph of the book and it's a book called Thinking, Fast and Slow by Kahneman. It has very little to do about trading, and a lot to do about the brain and how people think and how we don't think clearly, effectively because of these cognitive biases. You literally can open that book to any page and learn something about trading even though 98% of that book has nothing to do with financial markets.
Niels
Interesting, interesting. Based on everything that you've learned, if you had the chance to go back and speak to your younger self 20 years ago, 25 years ago, what do you think you would have done differently if anything?
Roy
I would say, don't believe your own bullshit. Be humble, the simpler, the better, these are things I've talked about already in this interview. I think the tendency of quants, the tendency of quant managers is to constantly try to improve and optimize and go in the direction of additional complexity. I think with a lot of good science and with good trading strategies going in the opposite direction is actually the optimal path. To simplify and favor robustness over the highest possible optimized results. So that's what I would tell my younger self.
Niels
Sure. I wanted to ask if you could share a fun fact about yourself, something that people don't usually know about you, and I will throw in the one thing, that I didn't know, which is that your office was very close to being part of the movie Wall Street 2, so that doesn't count. You're welcome to elaborate on this, but I also wanted to see if there was a fun fact about you that even people who know you might not know about you?
Roy
Well, just a little aside about that movie. We have a big video wall that has about 160 screens on it and that contains the displays of all of our strategies and markets and it just gives us a very good visual reference with what's going on in the world with our own strategy, but I always tell people that this is the result of growing up without a television. So that's one little fun fact that I grew up without a television. I think maybe a more interesting fun fact is that I think most people don't know though anyone who's been to one of my parties does know is that I can pretty much play any song on the piano from memory in any key, and sing it. I think if the hedge fund thing doesn't work out I'm going to play piano in a piano bar.
Niels
The new Liberace perhaps (laugh). Actually, before I go to the last question, I do want to ask you one thing that just springs to mind here. You know, I struggle a little bit about reconciling the fact that you see managers who have been around for 20, 30, 40 years who have done well, yet their asset base is shrinking, or it's not growing. On the other side, and maybe it pertains quite a lot to some US firms, not that many as far as I can tell, but certainly quite a few European firms and some of them certainly have been a guest on my show who have done very well in attracting assets. You can't really say that it's down to track record, you can't really say that one is better than the other, what do you sense from your experience... investors... how should I put it... why do some managers seem to attract more assets than others even though their strategy and maybe even their track record isn't really that different? Is there some other aspect of this whole process that we may not be focusing on today?
Let me just throw in my own observations here. Very often when you come into a managers office in one part of the world, say the US, you get a certain feel for it. It's built in a certain way; it looks in a certain way. Then you come to London, and very often their offices also are built and look in a certain way and their very scientific. You see computers, banks of Ph.Ds., it's very clean, it's very neat and tidy. Do you think that that basic... frankly, I'll be very open about it, I spoke with Jerry Parker earlier today and we talked about this aspect and I was just curious to find out whether investors, when it comes down to the decision, are influenced do you think emotionally by this neat looking, streamlined setup that very often you see in London, that sways them in the direction of those kinds of managers, even though deep down, it doesn't matter what your office looks like.
Roy
That's a really good question. You're probably asking the wrong guy because I've never seen anybody else's office (laugh).
Niels
No, but you built your own office in a certain way, didn't you? You're doing it maybe, I don't know if it's deliberate or not, but when people come into your office and they see 160 screens it all looks very scientific, it probably looks like NASA office as well, maybe that gives people some level of comfort. That it's better than an office where people sit in a small corner and maybe they don't have the latest computer, I don't know, I'm just curious?
Roy
It's an interesting question. I will tell you that it was very helpful at the beginning. When we started, Paul and I and Jill and my ex-wife Kara were together in a room. We had about 15 computers around the perimeter of my living room, and we had a very, very advanced operation for the time. We had real-time VAR, we had prices being fed in automatically - for the early 1990s it was pretty high-tech and I think it was very helpful coming out of the box for people to see that we had 10s of thousands of lines of code and a really robust operation even though we happened to be in my living room and then clearly we moved very quickly and we got off to a very fast start. So it certainly helped.
These days, I don't know. I think it depends on the strategy. For us, we really do need 100s of cores. Short term trading three shifts - we need a lot of people, and there has to be IT guys and a lot of quants to run and create the strategy. We are not a discretionary strategy. We're not long term trend followers, which may be less intensive in terms of its needs in trading, let's say. I think in a lot of ways though the office environment, and the appearance of a manager can tell you a lot about the manager.
For me the way we designed our office was to make sure that everybody could see everything - that it was very open. We even in the architecture, in the design process talked about that it was a marketplace of ideas: that it was designed to be in the shape of the Agora. It was very much an open area where people could come together and talk about the strategy and there are other managers that have a different, more of a hierarchical approach and probably their office is... they would probably... you can get a sense of their world view and management style from that. Maybe you have a glass wall versus a thick wall that's totally soundproof and a door that's closed. My door is always open. It's completely glass, and I can see the trading room and all the screens from my office. Not everybody thinks about their strategy that way. So I think there may even be some hints that you can get about the strategy from the design.
I think a more likely answer is that people that are very clear about what they're trying to accomplish: who can articulate the benefits of the strategy; that are clearly providing the level of institutional management that will give people comfort; that there's a lot of openness, that they have smart people, not just at the very top, but all through the operation; and that people understand what's going on; that they're not peons and secretaries; that they're really providing significant value to the operation that investors can talk to, and I think most successful managers are able to show that.
Niels
Yeah, absolutely, I appreciate that that's interesting. I asked you earlier today whether investors were asking the right questions, so obviously I also want to make sure that we've covered all the ground that we should. Is there anything that you feel I've missed that you would like to bring up? I just want to make sure that I've done justice to you and to your business today.
Roy
I think I just want to talk a little bit about the question of downside protection. That is something that... I use the word negative correlation as a shorthand for providing downside protection, but it actually has to be more than just a negative correlation. You have to be consistently able to protect portfolios in order to really make a difference. I think we have really made this a piece of the strategy that might make us, I don't want to say unique, but highly unusual in that we focus so hard on these particular periods. It's not something that falls out of the strategy accidentally, but it's something that from the very, very top down, as we decide what we're going to do, we are saying, how can we help a hedge fund portfolio? How can we help an equity portfolio the most? What will be the most beneficial to our clients, and that's an unusual way to think about the world, at least in our business.
Because people perceive the allocation process as All-star team - I have to be the best; I have to have the highest standalone sharp ratio. You get beta creep, and short volatility creep and that has worked phenomenally well for the last six years. I believe that we are at the most dangerous point that I have ever seen because it has been the longest that I've ever seen since there's been a true burst of volatility. There is incredible danger out there hiding in the weeds and I believe that the time at which the typical most common investment strategy, which you look at say five-year track records, to have your portfolio increasing because of performance in the managers that have done well over the last 5 or 6 years. There's never been a time, that I can remember in the 30 years that I've been doing this that what has occurred in the past has the potential to be so different from what occurs in the future and why diversification is so important right now. I know this is going to be on the internet forever, so we'll see out to the Roy of 2015 and 2018 just how right I was, but if I have to make a prediction, I'm going to say that what occurs in the future is going to be ridiculously unpredictable from what we see right now and unknowable to a point that the most diversified you can get is the best way to survive it.
Niels
I think that's a very important message, and I tend to agree with you on all that, so thank you for that.
Roy
I also have to say one more thing. To anybody that's made it this far, thank you very much for your attention. I really appreciate that you care about what I have to say this much, because I admire you.
Niels
Yeah, no, I should thank every listener every time that they get to the end of a two and half hour interview.
Roy
There should be a special prize at the end for getting there.
Niels
Yeah, absolutely, I need to find a sponsor for that, actually, that's a good idea. Anyway, before we finish, Roy, and let the listeners get back to their normal duties, is there a good place for people to reach out to you and your firm and learn more about it?
Roy
Sure, certainly they can contact us. My email is [email protected]. You can easily Google me and find the company and call me. We're very, very open. We love to have people come in and talk with us and even if they're not serious potential investors, I feel like I have staked out a role, that I like to teach people about the industry for people that are new to managed futures and new to short term trading. I love to talk to people that are just entering the space, so I'm absolutely welcome to have people come and visit and knock on our door and say hello.
Niels
And see the 160 screens, which is a rare sight.
Roy
(laugh) I hope that... we have a pretty good view too I guess you could say.
Niels
Absolutely, well I might even take you up on that one.
Roy
Please do that would be great.
Niels
But Roy, thank you so much. It's been fun. It's been great conversation. It's been incredibly insightful and it's been wonderful to get a true contrarian in the conversation and just see the world a little bit differently which we can all learn from, so thank you so much, and I will say to the listeners, of course, that there will be plenty of details on the website, in the show notes and of course all the things that Roy just mentioned about contact details.
Thank you so much, and best of luck and I hope to catch up in the new year.
Roy
It was a pleasure...likewise, take care.
Niels
Take care, bye, bye.
Ending
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