‘Quantamental’ solution to CTA underperformance proposed

By: Aref Karim | 13 Jan 2015

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Systematic investing, in the form of managed futures, often called CTAs, rose to the attention of

the wider investment community particularly through its performance in 2008, when it delivered

strong returns against the dramatic losses posted by most other strategies. In the following years,

however, its performance has been somewhat lackluster, prompting several market

commentators to wonder if the managed futures strategy was ever to come back and whether the

diversifying performance of 2008 was something of the past, never to be seen again.

All strategies go through periods of underperformance and managed futures is no exception. The

long grind however did open up potential for some managers to evolve their systems to better

adapt to unusual conditions in future.

One type of evolutionary model that has developed is a combination of traditional Systematic

investing with fundamental macro. This strategy aims to take the positive attributes of systematic

investing, particularly those that make the strategy so powerful, whilst reducing the impact of its

shortcomings. This solution preserves the power of systematic investing while addressing the

drawbacks.

The positive attributes of systematic investing

Systematic investing has the ability to neutralise the negative impact of emotions, fatigue and

cognitive biases within human decision making. Systems, by design, entail the consistent

execution of a set of rules and are hence immune from the natural vagaries of the human brain.

The approach allows the benefit of seeing how an idea would have performed in the past if

consistently applied. Simulations got man to the moon. We build cars, airplanes and explore into

the outer realms of space through testing in the ‘lab’ for the unknown. Unusual environments can

be synthesized and simulated to test out ideas; the ideas in turn can be stress tested to pull and

stretch our imaginations.

Therefore, it has the power to efficiently process huge volumes of data, delivering a double-

advantage: maximising the information content which can be extracted from the analysed data,

as well as providing the broadest possible opportunity set of assets to select from.

Through a systematic approach we can also significantly reduce a company’s reliance on key

individuals. No matter how influential a key person is in the development of a system, the

knowledge is incorporated in the model which survives as an asset of the firm through its

intellectual property. This can be invaluable.

Drawbacks of systematic investing

As with all investment strategies, a traditional systematic approach comes with some intrinsic

weaknesses.

It is important to note the dependency on past data, and therefore the inherently backward-

looking nature of the systematic approach. True, techniques have been developed to minimise

the drawbacks from this, but it is an easy temptation to fit the approach to conditions of the past,

believing they will repeat. Sheer speed of computational power increases that temptation of data

mining.

As a result of the above, there results with the benefit of hindsight a self-perpetuating practice of

changing parameters or models frequently, often known as optimisation. The ‘quant’ nature of

the approach exposes it to the risk of ‘over-engineering’, such as a proliferation of variables,

dependence on too many signals, constant tweaking of parameters. The negative outcome is a

model that is overly back-fitted to past conditions, with the risk of decaying quickly or, even

worse, being suitable only for the specific conditions it was developed in.

There is often an inability in this approach to put an economic or financial connection to the data

analysed. The system by design typically treats the data in an aseptic manner, overlooking the

conditions which generated such data in the first place. This ‘black box’ approach leads to a loss

of intuition in system behaviour dealing with certain market environments.

In systematic investing often times different models are used to deal with specific environments.

Subjectivity hovers around how much capital to allocate to say trend-following, mean-reversion,

pattern-recognition, or other strategies.

The above weaknesses in the systematic approach lead to an inability to look forward and

prepare for sudden, and frequently dramatic, changes in market paradigms. These have been

most visible in the economic environment post-2008 crisis, with the disappointing performance

of the strategy for an extended period of time. The exceptional intervention of financial and

monetary authorities to avert a global meltdown has essentially overridden market fundamentals

in this period. The consequence has been trendless, choppy, risk-on/risk-off markets, depressed

volatility and spiked up correlations between assets. These are all unfavourable conditions for

systematic investing.

A potential solution

One compelling solution to the problem is a combination of the systematic and fundamental-

macro approach, in the belief that it can deliver the positive attributes of both while ‘hedging

out’ the negative ones. A relatively new foray into such an approach of combining fundamental-

macro and systematic is in ‘quantamental’ investing, at this stage practiced mainly in equity

portfolios.

Fundamental-macro investing at the core

The fundamental-macro approach, based on the insights of experienced investment managers, is

by nature, both forward-looking and deeply connected to the changing economic and financial

conditions affecting markets. This makes it particularly suitable to spotting dramatic changes in

market behaviour. Furthermore, expert fundamental-macro investing harvests risk premia while

hedging with risk-averse, defensive positions. This serves as the right antidote, therefore, to the

backward-looking traditional systematic approach that lacks in economic intuition.

In mitigating the over-engineering risk of systematic investing, the fundamental-macro approach,

again, comes to the rescue. It is generally parsimonious when it comes to the number of variables

and simple in terms of the interaction between analytical parts: it has to be, given the inability of

the human brain to effectively process such large volume and complexity of information.

Blending systematic investing with fundamental rationale

Unlike traditional systematic investing, a combination or ‘quantamental’ approach can be put

together in a unique fashion so as not to require different types of models, thus eliminating the

need to make the capital allocation decision between them.

It is worth noting that the evolution proposed here is not the same as making divided allocations

between the two approaches of fundamental-macro and systematic investing. It is not also a

mishmash of the systematic and discretionary approaches, where the disciplined decision making

of the system is tampered with by discretionary considerations. Rather, the unique approach is

based on the expert combination of the rigour coming from systematic, and insights coming from

the fundamental-macro, where both approaches preserve their full integrity and effectiveness and

work as one in perfect synergy.

For example, imagine removing from systematic investing (i) excessive dependency on price

moves as a primary indicator of opportunity; or (ii) the tendency to readily exit from losing

positions to go to cash when relief may be available through non-correlated risk-averse assets in

the portfolio; or (iii) unconsciously foregoing the all-important portfolio balance and increasing

risk in the sole pursuit of market direction for gains.

To conclude, the outcome of the evolutionary process described above is a parsimonious and

adaptive model that is systematic-quantitative but predicated on solid fundamental-macro

thinking. Such an approach should reap the rewards in most environments and market cycles,

whilst softening tail risk in crisis periods and also deal effectively with unusual distortions as

those introduced by the recent aggressive monetary easing.

Aref Karim is founder, CEO and CIO of QCM, a systematic global macro manager with 20

years’ operating history