Ways of Sharing Systems
By Chidem Kurdas
New technology facilitates the creation of large numbers of trading systems, algorithms, quantitative portfolio construction methods and other financial knowledge. Hedge funds and commodity trading advisors typically use such information internally, in their own investment programs. But some traders and research businesses make money by selling the right to use their intellectual property. These arrangements take various forms-some more common than others.
What are the benefits of sharing systems or methods? What are the risks? How can you protect yourself? Here we offer insights from three people with wide experience.
Alex Montagu of MontaguLaw is general counsel to a number of companies where he helps manage the companies' intellectual property portfolios and advises on other legal matters. Darren Duffy is global head of strategy at Lipper, part of Thomson Reuters. Lipper creates and licenses indexes and other information.
Our third contributor, Tyler Wood, works for Worldwide Futures Systems, a brokerage that offers a way to use selected trading systems belonging to third parties. Below, he discusses how this works.
"These are their crown jewels so they need strategic thinking as to how best to protect and monetize trading algorithms."
In other parts of this issue, you see interviews with managers who develop funds from indexes built by other parties. Thus United States Commodity Funds LLC introduced a diversified commodity fund on the basis of an index created by two Yale University professors and their research firm (as discussed in the previous section). A WisdomTree fund is based on Alpha Financial Technologies' trend-following program.
Licensed intellectual property is not necessarily protected by copyright or patent. Alex Montagu points out that it is very difficult to get copyright protection for investment methods and trading systems. Moreover, patenting is not a practical option-you will likely not get a patent and in the process will have to reveal the secret sauce.
Keeping information as a trade secret protects it, but in a licensing deal information has to be given to another party.
Information provided to licensees can be limited so that the full methodology is not revealed. Consider a method or formula for building a portfolio of funds or other investments. The licensor will decide which funds or investments go into the basket and how to rebalance the portfolio based on a formula. The way to do it is to keep the formula secret, but have a contract ¢â‚¬â€œ the licensing agreement ¢â‚¬â€œ to provide the right list of funds and the rebalancing, Mr. Montagu explains.
A licensor with a brand name can get trademark protection. If licensees want to use the brand name for the products they develop, they license the trademark as well as the investment method.
Darren Duffy of Lipper says the firm is in the business of creating research output and licensing to others who can create products. In this process, some information may be disclosed to people about the company. But the company requires a clear agreement and restrictions on how the information can and cannot be used when licensing data, indexes or a model portfolio to outside parties. License prices depend on the depth of the knowledge provided, with one price for basic information, another price for detailed disclosure.
* In this type of transaction often one partner sells his interest to other partners, who are already familiar with the trading program. But the seller may retain the right to use the same system.
Besides formal agreements, having the right type of client offers protection for the information disclosed. Lipper works with firms looking to create investment products. "We would not license our information to other firms in the same index or research business, who have no valid application for the information," Mr. Duffy said.
"Mostly we deal with investment institutions that are not in the business of creating indexes or methods but are in the business of creating products based on our research. Half of the battle in ensuring that what we license does not get abused is choosing the right clients."
He sees growing demand for independent research to create investment products. Objective, third-party research adds to the credibility of investment firms as the science behind investment methods continues to evolve and technology enables more advanced methods, he says. Licensing looks to become even more common.
The same approach can be applied to trading systems. A software developer not in the business of trading might come up with an algorithm and license it out to any number of trading shops, Mr. Montagu pointed out. Legally this would be similar to the developer of an index licensing it to investment firms. "I don't see why that model can't be applied to trading algorithms," he says.
How Leasing Works
For brokerage customers, leasing is a relatively easy way to take advantage of complex trading systems. Some of these have been traded for long periods and have impressive track records.
Tom Reavis, founder and president of Worldwide Futures Systems, was an independent trader and market maker at the Chicago Mercantile Exchange for 30 years, starting in 1973. In 1983 he began developing and consulting in the development of futures trading systems. Worldwide Futures offers several trading systems, owned by third parties, that he has tested and invests in himself.
Clients of Worldwide Futures Systems can choose to lease one or more of the systems offered by the company and trade them under a Letter of Direction. This allows the brokerage to trade their account for them.
"It is like giving power of attorney to a software rather than a CTA or a hedge fund manager," says Tyler Wood, who recently joined Worldwide Futures. Letters of direction are nothing novel; they're widely used to give financial brokers power of attorney over an account.
Customers are not given the software but they know what it does and they know how it performed in the past. They can watch all the trades happening in their account in real time.
Mr. Wood says that leasing a system is substantially more cost efficient for the investor than paying the usual 2%-and-20% fees to a CTA. Moreover, it is an inexpensive way for CTAs and commodity pool operators to fill gaps in their investment programs-for instance, if they want exposure to certain markets but don't have an effective way of trading in it, they can lease a system.
Each of the systems offered has been tested and traded by Worldwide Futures. Three of the best have been combined in one portfolio, called the Survival Plan. It trades a diversified portfolio of 15 commodities. The three systems trade in different time frames and have different methodologies and zero correlation to each other. Perhaps more importantly, there is no correlation to a standard stock and bond portfolio.
Remarkably, the Survival Plan had returns of over 100% in both the bear market of 2008 and the bull market of 2010. Of course, the usual warning ¢â‚¬â€œ past performance is not necessarily indicative of future results ¢â‚¬â€œ applies.
Contracts, Contracts, Contracts
Some brokerages offer large numbers of systems. Some Third-Party developers who provide these may continue to use them but not necessarily. For instance, a CTA who retires from managing money might lease his systems to others via a brokerage.
Could a client replicate the trades elsewhere? One protection against copycats comes from the complexity of the systems-they can contain hundreds of algorithms. Still, a knowledgeable competitor might be able to reverse engineer.
A similar question gets asked about private accounts with fund managers. A client with a private, separately managed account sees the trades in real time. This is one of the objections by hedge fund managers to separately managed accounts. Such trade transparency may be a threat to proprietary systems or models-managers have been known to vow never to allow a separate account.
To protect against the misuse of trade data in separate accounts, Mr. Montagu says there should be a contract that clearly states the users are not to reverse engineer the algorithm and if they do, will be liable contractually. With a properly drawn contract that includes dispute resolution mechanisms, managers can do private accounts and protect themselves, he said.
But they need to pay attention to the issue: "These are their crown jewels so they need strategic thinking as to how best to protect and monetize trading algorithms."
Intellectual property issues arise also when a system developer leaves a hedge fund or CTA firm. Does the system belong to the developer, who can take it with him, or does it belong to the firm? The contract should be clear as to the ownership. When partners split and form new businesses, who has the right to use the existing trading systems becomes a key question. Again, clear contracts with ways of resolving conflicts are the way to avoid expensive lawsuits.
Many hedge fund people say they would never manage an exchange-traded fund. A strategy wrapped in an ETF gives away a lot of information, revealing its holdings for all the world to watch. Commodity ETFs are vulnerable to others trading the same futures contracts ahead of them, moving the price against the ETF. Certain investment strategies do not belong in an ETF. But the scope of alternative ETFs and exchange-traded notes is expanding, as the interviews in this issue show. Less predictable commodity trading programs are less vulnerable, and that's the direction the products have taken.