Market Neutral Contrarians
In the early 2000s, as the stock price bubble collapsed, investors became more interested in absolute return strategies in the hope of avoiding big losses. But 2008 showed that absolute returns are much easier said than done. Here we provide insights as to how this elusive goal can be achieved using futures as the instrument.
Alexei Chekhlov and Peter Kambolin have successfully developed a market neutral approach. Below, they discuss what this involves and how they identify trade opportunities without making bets on the direction of markets.
The flagship strategy of their firm, Systematic Alpha Management, is market-neutral statistical arbitrage implemented in futures markets. Hence Systematic Alpha is a commodity pool operator and commodity trading advisor, but the core strategy is far removed from what most CTAs do.
Dr. Chekhlov is portfolio manager and head of research. See Futures Lab for his background in physics and math. Before he founded Systematic Alpha, he worked for Wexford Management as quantitative analyst in options pricing and trading; for BNP Paribas as proprietary trader in quantitative global fixed income futures; and at TrendLogic Associates as assistant director of research for global futures and equities strategies.
Mr. Kambolin is Systematic Alpha’s chief executive officer and chief operating officer. Before co-founding the firm, he was the founder and principal of Thor Capital LLC and worked for Fifth Avenue Research & Advisory Group in equity research, Phillip Louis Trading as proprietary trader and Unibank in operations.
This interview took place in late 2009.
“People tend to over-buy or over-sell when there isn’t enough time to process the information, creating inefficiencies that could be picked up by the computers that ‘know what to do’ and can process information a lot quicker.”
Opalesque Futures Intelligence: How did you decide to go the market neutral route?
Peter Kambolin: In 1998, I co-founded an equities broker-dealer. At that time, we had a number of high net worth clients who gave us discretion over their accounts and we traded in and out of stocks for these accounts. In 2000, it became apparent to me that the environment was very difficult and we had to put together a systematic strategy that would perform well in any market condition, good or bad. We simply could not afford to have a losing quarter, otherwise we were running the risk of potentially losing all of our clients! Around that time I met Alexei Chekhlov, who eventually became my partner at Systematic Alpha Management. It took us about a year to put together the strategy, which was a combined effort, with lots of original ideas from both of us. All of the initial back-testing was done by Alexei.
Alexei Chekhlov: We believe that one can make money consistently only with a systematic approach. It may be counter-intuitive, but the more a quantitative method goes against human nature, the more practical potential it has. Our core strategy is contrarian in a very simple way: selling a particular asset when the price is going up and buying it when it is going down. The widely used trend indicator, the Channel Rule, would tell you to do the reverse—stick with the trend, if something goes up, buy it. If you can play a “minority game” – as defined in a model introduced by Y.-C. Zhang – you can have a noticeable edge.
OFI: What about all the contrarians who lost their shirts short selling the 1990s stock bubble?
AC: Contrarian trading could be dangerous if you go against the market with one directional bet, or in outright trading. In our core strategy, we do not rely on a single trade like shorting the market and don’t have an opinion about the direction of individual markets. Rather, we predict the relationships between markets. Not all the time, of course, but when markets have extreme moves, we have a trading opinion. For example, we can say that there is a better than 50%/50% chance that a spread will narrow. Such an approach relies not on predicting the broad market direction but on relative movements of market statistics, which are more stable and predictable.
PK: The key is that we don’t trade individual markets; we identify relationships between the markets and trade the relationships. For us, short term over-reaction or under-reaction to the change in the price of the markets we trade is a lot more relevant than the longer term direction of the markets.
OFI: How did you do in 2009?
PK: We are up for the year, posting positive returns in 9 out of 11 months so far this year, unlike most commodity trading advisors that had a difficult time in 2009. We are not a typical trend-following CTA that takes directional bets in various markets, but rather a market neutral, contrarian, fully systematic manager using futures as the means to put on trades. Because we are so different, our correlation to other futures managers is virtually zero.
OFI: What happened in 2008?
PK: Like most other CTAs, we did well in ’08, but for totally different reasons. We made money but not because we caught trends in crude oil or the S&P 500. Running a market neutral strategy, we don’t care if markets go up or down. However, we are sensitive to short-term mispricing, and last year presented a lot of opportunities for us, especially during September and October in the midst of the crisis. The more volatile the markets are, the less time people have to make the right investment decisions. People tend to over-buy or over-sell when there isn’t enough time to process the information, creating inefficiencies that could be picked up by the computers that “know what to do” and can process information a lot quicker. When volatility is high, traders are mostly concerned with the direction of the market rather than how markets are trading in relation to each other. In general, we prefer more volatility, not because we’re long or short VIX, but because we see more opportunities in such an environment.
OFI: What do you see coming in 2010?
PK: We hope to see more volatility; choppiness in the markets is good for us. But we cannot make any predictions.
OFI: Are you a high-frequency trader?
AC: The term needs to be defined better. We trade tens of thousands of futures contracts per day. We hold our positions for minutes or hours. The average is probably six hours or so, which is much longer than ultra-high-frequency traders’ holding time. We do use technology that helps us save milliseconds on the entry into or on the exit out of a trade, and in that sense we are a high-frequency trader. We are very quick to enter and exit. We do not necessarily close our positions at some pre-determined time, such as the market close. That would be irrational for us.
PK: We’re open 24 hours, with 3 shifts covering the day, evening and night sessions. There are people constantly watching how the computers execute.
OFI: How did the business develop?
PK: Initially we traded small managed accounts for high-net-worth individuals starting in late 2001. In 2004 we decided to consolidate the managed accounts into the fund, so we audited the track record and launched Systematic Alpha Futures Fund, Ltd. in June of 2004. In early 2006 we launched a domestic version of the fund, Systematic Alpha Futures Fund LP, and in late 2006 started accepting managed accounts with a minimum of $5 million. Today managed accounts represent close to 50% of our total AUM, which stands at $435 million as of December 2009. Our program is also available on the HFR managed account platform.
OFI: What is the capacity limit on this type of trading?
PK: We would notice problems if we were near our capacity. So far we don’t see any signs of it. Stock index and currency futures are very liquid instruments and we’re a tiny part of the market. Currently our capacity estimate for the core strategy is set at $1 billion.
OFI: Have you changed the model over time?
AC: Our ability to extract alpha depends on constantly fine-tuning what we do. Correlations between the markets and other factors such as average liquidity change over time; we have to incorporate those changes into our models. Even if an improvement boosts the quality of a model by a very small amount, it is worth introducing, as model diversification pushes out capacity limits.
OFI: Were there other changes?
AC: We apply the same core idea to a large set of instruments that we believe have similar characteristics and to several time frames. We now have close to 300 individual fully-automated sub-strategies. Our clients understand the core idea underlying our models, but the details of implementation constantly evolve due to improvements both in technology and in our own models.
PK: Automatic trading allows us to explore more opportunities. Our commissions are now pennies per trade instead of dollars per trade, so it allows us to capture smaller opportunities. We diversify as much as possible. By breaking trades among many sub-strategies, we get more capacity as we don’t have to push a lot of volume at any particular point of time.
OFI: What’s a big potential risk for you?
AC: The source of predictability would disappear if the number of arbitrageurs gets so large that they collapse the opportunity. Then the market will become nearly efficient, close to a Random Walk. Hypothetically this can happen, but we do not think it is a likely outcome anytime soon as long as the humans trade these markets and make their own trading decisions.
PK: Some markets, in particular certain currencies, don’t offer much opportunity. We see more opportunities in global equity markets which contain a larger population of non- sophisticated retail traders who tend to be very emotional and produce the short term inefficiencies we look for. If retail traders disappear, the opportunities we seek could disappear as well.
OFI: Do you foresee novel approaches?
AC: We upgrade our knowledge with new data continuously. You have to refine and re-test the models constantly to maintain the edge. However, major discoveries are rare events.