emerging market interest rates, credit derivatives; markets which we think are more prone to liquidity gap risks. I’m interested in your perspective on how you think systematic strategies will handle this potential inflection point as we perhaps embark on a tightening cycle led by the Fed as well as extending systematic strategies to newer markets?
And finally another question I have as an allocator for everyone here is that, as Stuart pointed out, a lot of things are being wrapped in risk parity or in smart betas, so sometimes I do worry the end investor isn’t fully aware of what they are getting. For example, we often hear about investors using certain systematic strategies and risk parity approaches as a diversifier to their pro-risk allocations elsewhere in the portfolio, but then also people can be unaware that these strategies can have a very long equity positioning right now, or short vol, or long carry in some ways. I am curious to get your thoughts on those issues.
Stuart MacDonald: I think the majority of risk parity managers out there are not jumping around wildly between different asset classes or whatever they may be exposed to. We certainly have clearly defined bands for our exposures, and therefore I am not quite sure where you are coming from on that. And I really wonder why people question the concept itself. We are directly aware of nearly 20 different risk parity managers, some of whom are running more than one variation on their theme. Some are not correlated to the others at all, because they all have their different takes on what instruments to use, what mix of asset classes they use, what liquidity they want, what measures they are using in terms of backward-looking risk to make adjustments to their exposures, if they make them at all.
I find most critiques of the risk parity concept slightly fatuous if one accepts the basic premise that effective diversification is the cornerstone of successful investment and if one believes, as many do, that this can be achieved only by selection at the level of broad asset classes rather than at the level of sectors or geographies, let alone individual securities. If one accepts that as an industry, we face certain limitations in our ability to make sustainably effective predictions and if one compares the performance of such strategies against most others, then I don’t really see how the critique holds. In any case, no one would sensibly suggest that everything is put into one strategic basket, however broad it may be.
Ewan Kirk: What we, or in fact all risk parity managers are saying, is that ex ante on a risk- adjusted basis, the Sharpe ratio of every asset class or every asset is identical. That is, of course, coming
from the fact that it’s unknowable. Ex ante, I don’t really know what the risk-adjusted returns of bonds are going to be next month. So, if you don’t know, then your best guess is they are all equal, on a risk- adjusted basis. That means the Sharpe ratio of every single one of my positions is the same. If you are saying that, then that is risk parity. In fact, that is all we are saying and it seems like a reasonable thing to say. There is a discussion about how you do it, but I think it’s a great thing to do.
things like trading swaps in South Africa or swaps in Brazil or credit indices or power, and I do worry just about the liquidity impact of going into these markets, and will investors, who may think of these guys as a hedge, be surprised when we have an end of QE scenario?
“The cost of trading dwarfs the cost of management fees – it’s the cost of trading that you really need to worry about. That is why implementation of such strategies matters. We all know certain strategies work, but in the end it’s all about how do you do it.” – Ewan Kirk
On systematic managers being long equities and long bonds, what would you like us to have done last year? Systematic macro is an uncorrelated asset class. If you are going to be uncorrelated to equities, sometimes you will be long and sometimes you will be short. We are not a hedge, so by definition there are going to be long periods of times where CTA managers will be long equities. In fact, you would probably expect CTAs to be long more than you would expect them to be short, because on average it appears as if equities have gone up, and so have bonds. Therefore you would expect CTAs to be long equities more often.
Akshay Krishnan: Right, I totally get that about systematic managers, but the question for maybe Stuart and Ewan: from a forward-looking perspective, how do you think about this potential rate rising scenario and what central banks might do next year? That is question one. And secondly, maybe this doesn’t apply to Cantab, but I have seen a lot of other CTA/systematic managers get into
Stuart MacDonald: Regarding QE, I cannot tell you how many investors and consultants over the last couple of years have been riding the consensus that emerged about imminent rate rises. The question has become, for how long does the consensus have to be wrong before you accept that it may be wrong? And one of the premises on which this is based is the difficulty of making forecasts with pinpoint accuracy.
Ewan Kirk: As Niels Bohr, the Danish physicist said: “prediction is hard, particularly about the future”. The received wisdom for the past four years has been that rates just cannot go any lower, but they have. And some CTAs have made money when it’s turned around. We in particular had a very difficult year last year when it turned around, but then it has come back again. We are not pure trend followers. But if we talk about trend following here...
Oliver Prock: When I hear “predictions about the future” I need to add here that actually we do exactly that in our Directional Market Strategy. The model forecasts each market one day out, and I agree, it’s hard! Ewan, excuse me but can I ask what exactly you are into, if you’re not a trend follower?
Ewan Kirk: We do momentum, value, risk premia, some short-term trading, some cash equities, so we are systematic multi-strategy. Now, if QE ends, then presumably your world view is that rates are going to go up and bonds are going to go down. If you really have that view, you don’t need a manager, because you can just go short bonds. If you have a very clear view that rates are going up and bonds are going down, to express that view through complex, heterogeneous CTAs doesn’t seem to be the most efficient way to do this.
Now, of course the reality is, if your view is true, then presumably rates will start to rise and bonds will start to go down, and presumably that will continue and that’s called a trend. And then you would imagine that trend followers would become short bonds. So yes, we have been long bonds and it worked out well. But that’s not the same as being a long bond fund. It just means that the trend in bonds has been up. CTAs will get short bonds, but they are not going to get short bonds tomorrow. It’s going to have to cause some pain, but eventually, if it really is the case that rates are going back to say 6% next year, which is unlikely, but presumably the models will pick it up.
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