Blending Quantitative and Discretionary Tools
We wanted to present a distinctive global macro perspective on investment opportunities in current markets. Luckily we got hold of Larry Smith, chief investment officer and co-founder of Third Wave Global Investors LLC, an investment advisor registered with the US Securities and Exchange Commission.
Mr. Smith has a hybrid style that is an interesting counterpoint to both purely quantitative strategies and purely discretionary macro. Combining quantitative and discretionary analyses, he looks at model-driven trades from a macro economic vantage point. Here, he discusses different strategies in the context of 2008-2009 and gives examples of current applications.
Before starting Third Wave five years ago, Mr. Smith was global chief investment officer of Credit Suisse Asset Management, at the time the 15th largest asset manager in the world with around $300 billion in assets. He had responsibility for investments worldwide, including hedge fund offerings. In 2002, he simultaneously served as chief executive officer of CSAM Americas.
From 1981 to1999, Mr. Smith was at JP Morgan Investment Management, part of the time as the global head of asset allocation and balanced account management worldwide.
At Third Wave, his strategy is more systematic than a typical global macro manager’s. But it has a large discretionary component and includes economic fundamentals.
Opalesque Futures Intelligence: What’s your take on current markets?
Laurence Smith: It seems to me the environment is changing. Stocks, bonds, commodities and currencies all moved in one direction for most of 2008 and then in the opposite direction for most of 2009. We had very big down moves followed by very big up moves. Momentum-based strategies did well on the whole. But the enormous directional trades that worked in the second half of 2008 and in the opposite direction since March in 2009 are now behind us.
OFI: What does that mean for investment strategies?
LS: Strategies that rely on there being a prolonged move in one direction will have a tough time for the next 12 to 24 months. Strategies that are able to capture volatility and identify valuation mistakes have an advantage.
OFI: What’s the lesson from 2008-2009 for macro and commodity trading advisors?
LS: Almost everything that worked for a long time did not work in 2008. Momentum was the outlier; it worked even better than it did in the past. This year, there’s been a wholesale adjustment in markets and conditions are becoming more normal, so fundamentals should be the winning strategy. As a result, many CTAs are concerned about their reliance on momentum and want to diversify their tools.
OFI: How do you know economic fundamentals are becoming more important?
LS: One of the things we see is that correlations between risky markets, which all rose dramatically on the downside and remained very high for most of this year, are now starting to decline to a more normal state. Now you see days when the Hong Kong stock market is up while Taiwan is down. All markets are starting to move in directions more consistent with their fundamentals. Even in currencies, it is no longer just one big dollar trade or one big carry trade. Fundamentals are starting to differentiate markets within an asset class. So people who can correctly identify fundamentals should be in very good shape over the next year.
OFI: How do you account for fundamentals?
LS: I combine systematic modeling with discretionary global macro. There are very few managers in our niche. Most macro traders are either systematic CTAs who use trend- following rules or discretionary traders who try to figure out winners and losers based on broad economic themes. We have a model, but it is based on fundamentals rather than purely technical tools. And then we layer on top a discretionary process that looks at fundamentals in a different way.
OFI: Does your approach exclude trend following?
LS: There is some trend following but it is a small portion of what we do. Most of the time we try to figure out the direction of the market using fundamental signals, combining signals from different categories of tools.
OFI: Why don’t you let the model run the trades?
LS: Despite all the advances in technology, our ability to quantify market movements is ultimately limited. We know there are relationships out there that we can’t model. So I try to determine if the underlying economic trends support the model’s forecast. When they don’t, I intervene. One of the things the model does very well is determine the size of a bet, and this is an area where quantitative techniques have an advantage over a purely discretionary process. We therefore use the model to help figure out how much to put in a particular market.
OFI: Would you give an example of how your approach works?
LS: Take the Australian dollar, which may now be the most attractive asset on a risk-adjusted basis. Our model loves the Australian dollar. This currency has rallied dramatically over the past six months, but the fundamentals all suggest it will go higher. There is good reason to expect this. Chinese economic policy has been extraordinarily successful in stimulating growth and Australia is a beneficiary of that. China’s focus on commodities means that they will invest heavily in Australia. So we see no reason not to follow the model with respect to this trade. At the same time, our model is not particularly sanguine on the Canadian dollar, yet our discretionary process leads us to believe that it, too, will improve relative to the US dollar.
OFI: Why do you like currencies?
LS: There is a lot of opportunity in FX, in both developed and emerging market currencies. Take the Korean won. It has gained back some of its previous loss against the dollar but is still low relative to where it was before the crisis. Economic fundamentals came back surprisingly quickly in Asia and strongly favor Korea over, say, the US. There is every reason to expect the Korean won to get back to the higher exchange rate it had two years ago.
OFI: Which other markets do you like?
LS: Residential mortgages, which got beaten down so badly in the crisis, are an interesting area of the markets. Very liquid mortgages have rallied dramatically, but less liquid mortgages are still priced based on the dire default and recovery rates of the last year. Conditions will get less dire, and these less liquid mortgages will continue to recover. Credit markets, despite having rallied dramatically, have more to go. The bounce-back in economic conditions, combined with explicit government policies aimed at restoring the credit markets, will lead credit spreads to far narrower levels than exist today.
OFI: Why are investors nervous?
LS: The level of uncertainty is very high. You can’t have the greatest financial crisis since the Great Depression and not have extraordinary uncertainty. There is reason for optimism; economic data is on the margin quite positive. In other words, fundamentals are improving. Yet it is not so compelling that you can forget about the problems. Maybe three out of five data points are positive. The remainder are negative.