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The following article is a short version of a paper by Jason Russell and Nicholas Markos of Acorn Global Investments Inc., a Canadian manager that specializes in applying systematic strategies to a diversified portfolio of liquid futures, equities and options as well as currencies. For more information, please go to www.acorn.ca

Diversification Done Right: Systematic Trading

Jason Russell

"A significant advantage is available to those who can simply take a step back to rationally observe gains and losses in the context of the big picture."

In 2008, investors learned a hard lesson about diversification as equity, bond and real estate prices plunged, buyers vanished, and financial markets buckled. For many investors, diversification failed.

Proponents of diversification can talk all they want about style differences, geographical diversification, risk management or reduced fee benefits. If the end result is investments in bonds, equities or real estate, chances are that they are going to perform much like other investments in bonds, equities or real estate. The lesson of 2008 is clear: relying on diversification across multiple managers, index funds and exchange-traded funds that invest in similar markets does not work.

The good news is that meaningful diversification is possible. To diversify effectively, an investor must consider alternatives to the same old ways of investing in the same old markets. One of these alternatives is systematic trading.

A Distinct Alternative

Trends are everywhere, whether in weather, sports, fashion, food, entertainment, health, science or politics. Some trends are long, some are short. They come and go as they always have and always will. People thrive on identifying, following and serving trends.

Market prices for metals, currencies, energies or bonds are no different. Over any given time horizon, prices go up, down or sideways. Complications arise when one tries to figure out why a market may be trending. The need for answers is served by "noise" from an endless line of newscasters, forecasters, prognosticators and gurus all competing for attention.

This external noise is often combined with internal noise created by the hope, fear, greed and despair that everyone feels from time to time, which is ultimately no more than a distraction from the stark reality of the trend in price.

Systematic trading is different from most traditional investment approaches. Yet, it has very much in common with how success is achieved in life and business by adhering to simple rules that have stood the test of time:

• Adapt to the environment as best you can.
• Have an exit strategy for when you are wrong.
• Be responsible with your resources.

Systematic traders design systems that focus on staying in alignment with the underlying trend. Because these systems are focused only on prices, they can be applied to an exceptionally large variety of markets. Price is the one thing that all markets have in common!

For risk management as well, systematic traders focus on price rather than noise. Every day, every position has an exit price. If that price is hit, the trader exits the position.

Different Markets

Systematic strategies provide direct exposure to the real goods of the underlying economy. Goods that have a liquid market made up of producers, processors and end users. Goods like train cars of unleaded gasoline for daily transportation, bushels of corn needed by food producers and cattle farmers, bales of cotton for textile manufacturers, copper required for construction, and currencies to facilitate global trade and commerce.

The majority of these markets are actively traded every day on the world’s futures and stock exchanges. Using highly liquid markets gives systematic traders a distinct advantage, allowing them to eliminate exposure rather than try to hedge it. This is an important feature. Hedging can often increase exposure and is a distant second-place option for most systematic traders.

"What Have You Done For Me Lately?" Syndrome

So, investing in a systematic trading strategy sounds like an interesting alternative. It is certainly unique when compared to traditional investments. But, what has it done lately? Not much.

In 2009, systematic traders as a group lost money while stocks made a spectacular comeback. The common reaction of most investors when they see performance like this is to politely pass on the opportunity.

This is the "what have you done for me lately?" syndrome. Academics prefer to call it "myopic loss aversion". The founding fathers of behavioral finance, Amos Tversky and Daniel Kahneman, produced a fascinating collection of research outlining the challenges and biases that can occur when human nature collides with decisions about money.

The fact is that investing in a strategy when recent performance is negative relative to other strategies has been shown to be very challenging for all but the most rational of investors. Near-term losses influence human perception strongly and cause many to lose sight of the big picture.

How can an investor handle this challenge? The answer is to recognize that human nature and investment cycles do not operate on the same schedule. One to two years of sideways or negative returns can feel like an eternity. Meanwhile, a similar timeline is considered short-term for the investment itself. A significant advantage is available to those who can rationally observe gains and losses in the context of the big picture.

First, start by taking just one step back and looking at 2008. The Barclay Systematic Index returned more than 18% from December 2007 through December 2008, while the S&P 500 lost 38.5%. Combine the last two years and the "what have you done for me lately" syndrome starts to lose its grip.

After two years, those invested in equities now have about 76 cents in their pocket for every dollar invested, which feels a lot better than the 47 cents in the depths of the crisis in February 2009. Meanwhile, in a less dramatic fashion, those invested in the systematic index have about 1 dollar and 14 cents for every dollar invested.

When this is combined with an examination of the long-term performance over two decades it is clear that systematic trading is alive and well and that 2009 is entirely consistent with the history of the strategy.

Moreover, because systematic trading incorporates a strict exit discipline on every position on a daily basis, it has a different risk profile. The declines in the S&P 500 are significantly deeper and last much longer than those of the systematic index.

While the systematic index will see drawdowns of greater than 20%, the disciplined nature of the risk management processes can provide investors with comfort that when uncertainty and emotions are running high, risk is being managed. Limiting drawdowns is a key consideration in the design of most systematic trading strategies.

Now is the Time to Diversify

Systematic trading clearly provides a distinct and liquid alternative for investors. These strategies earn solid returns while managing risk and add an essential diversification benefit to a portfolio. For many, investing in a systematic trading strategy right now can be challenging because recent returns obscure the big picture. But times like this often present significant opportunity.