CTA Investing Tips from a Futures Veteran
Commodity trading advisors offer diverse strategies. Most rely on systematic models but others mainly use a discretionary approach. There are long- and short-term versions of systematic trading. Some CTAs have a global macro strategy. What do you watch for when investing in this universe?
How do you select managers? We asked Tony Gannon, chief executive of Dublin-based Abbey Capital Ltd. The firm allocates some $1.7 billion to managed futures and foreign exchange investments across 20 to 25 managers.
Before founding Abbey Capital Mr. Gannon was involved in the futures business for over 20 years, starting as a macro trader in the 1980s. He co-founded Allied Irish Capital Management together with AIB, Ireland's largest bank. The company became one of the largest European commodity trading advisors at the time, growing from $50 million to $1.4 billion. Prior to that, Mr. Gannon created and traded the Gandon breakout trading program at Gandon Securities.
Opalesque Futures Intelligence: How did you become an investor in commodity trading advisors?
TG: Throughout my early trading career I had exposure to a wide range of styles, having traded as a macro trader, a short term trader and a trend follower. I wanted to use this trading background and experience in allocation. So in 2000 I started Abbey Capital with $30 million in assets. We've grown to where we currently allocate over $1.7 billion.
OFI: Does trading experience help in investing with other managers?
TG: We've traded successfully through war, bullish markets, bearish markets, reacting to all kinds of events. We've probably learnt as much from losses in trading as from gains. That helps us in our current role because we have the knowledge of what to expect in different types of environments. It gives us an edge. Many allocators lack trading experience.
OFI: In evaluating managers, what's the most important factor for you?
TG: Our main focus at Abbey Capital is finding experienced and intelligent traders. Behind every trading system, whether systematic or discretionary, are the people who designed it. However, a person can be very intelligent but not capable of putting together a successful trading program. For instance, an investment theory may look great in a simulation but when you try to execute it in a market, the bid/offer spread isn't there to execute the trades profitably. You want people who have both the intelligence and the practical sense to know whether a system will work in real markets. The people we invest with typically have been in the industry for several years and survived market ups and downs.
OFI: What kind of business operation do you look for?
TG: You want the type of infrastructure that is sufficient for the stage the manager is at, both asset- wise and for his type of trading. There is no single answer as to what the level of infrastructure should be. For instance, should a manager have a 24-hour dealing desk? It depends. In the case of managers who have high trading volumes and trade in markets across different time zones, a 24-hour desk may be required. In contrast, a discretionary macro trader may not have as much trading volume or be as sensitive to the spread and therefore may not need a 24-hour desk.
OFI: Do you invest in funds?
TG: Abbey Capital allocates through managed accounts and we have our own proprietary systems to supervise our accounts. We monitor for style drift and for any unexpected developments. Having managed accounts is very important – as people in the industry are now recognizing – but to benefit you do need to have the information in a usable form. Our managers may have 3,000 positions. If that information is not in a format that can be readily analyzed, it's useless. We invest heavily, not only in programming so that we can quickly see what's happening in an account, but also in our risk and research staff to analyze and value positions daily. Even with that level of infrastructure, you would not benefit from the information if you do not have expertise in the strategies. We have combined all these elements in Abbey Capital.
OFI: Let's start with discretionary strategies. How do you pick discretionary managers?
TG: Discretionary macro traders are the hardest to figure out, even though our background was originally in macro! We often hear from institutional investors that they're comfortable with discretionary macro traders but find trend followers hard to understand. We find it's the opposite. Systematic traders have a defined system and time frame. We can analyze a trend follower's returns in comparison to trend-following indexes we've constructed and see how well he's done. Whereas, with discretionary macro there is no good yardstick. Take five macro traders and their correlation to each other will likely be very low. Different macro traders may have different methodologies, so they're complicated to analyze.
OFI: Don't they tell you what they do?
TG: You can talk to a macro trader Monday and hear the 50 reasons why he loves the dollar, then find out Wednesday that he's shorting the dollar! There is usually a perfectly good reason for the change. A statistic may have come out that day which caused him to change his mind, or maybe he looked at the world from a different angle. He might tell you he is bearish equities, but then in the short term he sees an opportunity and buys equities. He's still bearish for the long haul. We tend to have more discussions with macro players because you have to monitor how their views change. You have to interact more to get an idea how they're thinking.
OFI: Is investing in systematic strategies a different experience?
TG: With a systematic trend follower, we know what types of trends the system looks for and can see that the trades in our managed account are consistent with the trends happening at that time. It's more straightforward to get a handle on where and how a systematic trader is positioned.
OFI: Are there other differences?
TG: Trend followers tend to have a reasonably normal distribution of returns whereas macro managers' returns tend to be lumpy. Some macro traders have very small positions in the market for a week or two as they wait for opportunity, then they build up a position and maybe get out in a few days. That tends to create a very different risk profile from systematic trading.
OFI: How diverse are the strategies?
TG: Discretionary and systematic strategies usually have low correlation with each other—around 0.2, we find. But there are times that they do correlate, typically at the early stage of a trend. More often than not, macro traders get in before trend followers. Say the dollar is rising. Macro traders will start buying, trend followers get in a little later when there's a new high. So at that early stage of the trend, you'll find both groups long the dollar. As the move continues, macro traders will get out when they reach their profit objective while trend followers go on with trend. Because last year the trends continued, trend followers were very successful. By contrast many macro traders shorted equities for a while but then exited the trade early. So while positive, it was not a great year for them.
OFI: Does it make sense for investors to put these strategies into one bucket, treat them like one asset class?
TG: I do not believe these different trading styles are all the same asset class. Their correlation is low. They do trade the same instruments—all our managers trade futures and foreign exchange. That's the common area they operate in, but the end product and return distribution is very different. The core of our main portfolio is trend following but we include macro as a diversifier. Separately we have a pure macro portfolio, which has low correlation with our main portfolio. We think it is worthwhile for investors to have both trend following and macro in their portfolio.
OFI: How is this year shaping up?
TG: The sharp reversal in equity markets in March was difficult for trend followers. It's always very hard to forecast trends, but big events like the US troubled asset relief program and stimulus package will likely cause changes in markets. The G20 agreement might be seen as positive for growth and hence for certain commodities. These types of events tend to create trends. What's confusing for trend followers and creates a difficult environment is when one key event that is positive is followed by another event that is negative for the same instrument, causing whipsaws and market reversals.
OFI: How are macro managers doing?
TG: Good macro traders assimilate events quickly and find the best trades to take advantage of the changes, so they should do well in this environment. But you need a skilled manager who follows the daily events. Of course even skilled macro managers can make mistakes or get blindsided by a new event, but they limit their losses when they're wrong and make big profits when they're right. You look for a macro manager who makes three dollars profit for every dollar loss.
OFI: How would you know that an emerging macro trader might be the next George Soros?
TG: One of the key issues we need to understand is the trader's logic and how he constructs the portfolio. Lets say there is a major event; what kind of position has he put on to take advantage of the event? This is not about my believing he's right but more about how he constructs a position, where he expects to go with it and how he manages the risk. He has to be able to give a good answer to a question like; what might cause your positions to become correlated or reverse against you? It's not important whether he made money last month but he should have a logical explanation of how he makes profits and losses. The other key quality we look for is the trader's self control in limiting losses. You don't get that from somebody who's been trading for just a few months; we want more experience. Investing with an inexperienced trader, you take venture capital level risk and you aren't getting rewarded for that.
OFI: How do emotions come to play?
TG: We'd be very wary of someone who thinks they are the world's best trader. They may persist in losing trades because they believe they are right! The need for self control in getting out of losing positions is what makes discretionary macro so difficult. Controlling the emotions is essential.
OFI: What is the one piece of advice you'd give to a new investor in CTAs and macro?
TG: Our basic recommendation is to seek to invest through managed accounts and with experienced traders who've been through market cycles.