Innovative Approach to Managed Futures Portfolio Allocation and Risk Management Found in Sweden
"We take a macro market environment outlook as it relates to managed futures risk management," said Mikael Stenbom, the CEO and founder of the firm, who sat down for a rare interview to discuss the firm's methods on managing a CTA investment by recognizing market environments.
The RPM managed futures portfolio system might be considered one of the more sophisticated approaches due to its use of these proprietary market environment risk management indicators.β This isβ coupled with correlation analysis and worst case scenario planning, which is then communicated to clients on a daily basis.
According to Mr. Stenbom, RPM's primary indicators include the Coordinated Market Selloff Indicator, which considers the potential for markets in general to reverse course; the Market Friendliness Index, which determines the force of a market trend; the Economic Surprise Index, which measures the surprises in economic statistics and then relates this analysis to the strength of the trend following market environment.β The firm also utilizes methods to analyze correlation of various CTAs to one another, utilizes a method to invest in various CTAs on a drawdown and considers market positioning on a daily basis, analyzing worst case scenarios relative to expected returns. These indicators do not predict the future with a crystal ball, but rather help RPM determine their opinion on mathematical probability.
"If we accept that markets are at times inefficient, we thought that we might find statistics or measures of market behavior give us a clue as to the probability of occurrence of such reversal events in the future," Mr. Stenbom said. "We cannot predict the behavior of any individual market.β β What we can attempt to determine is the general behavior of the markets as an aggregate.β The traders, the CTAs, are looking at individual markets, the sectors.β As a portfolio manager we are taking more of a macro approach."
RPM's market environment indicators are generally not geared to a specific market or sector, but are rather general in nature.β "We are looking at all financial and commodity markets as one.β We look at correlation and volatility of all markets and make portfolio management decisions to re-allocate or reduce manager exposure accordingly," he said.
Coordinated Market Selloff Indicator:
Perhaps RPM's most significant indicator, according to Mr. Stenbom, is one that determines the potential for a trend reversal to enter markets.
"There has been an increase in the frequency in seemingly random market reversals," he noted.β "Such reversals typically occur in environments where the speculative activity is high, at the peak of equity bull markets.β We observed the frequency of reversals occurs at this point, impacting trend followers as well as long only investors."
The Coordinated Market Selloff Indicator is designed to address these issues because it is based on the degree of speculative positioning, namely the recent performance of risk seeking strategies and general consensus in positioning of market participants.β "When this indicator reaches a high level, then RPM may reduce exposure to trend followers or those traders that are positioned the same way as the general consensus.β We also may reduce positioning in traders who typically employ "sticky positions," that is a trade position slow to change.β When the indicator reaches a high point, we might increase allocation towards traders that utilize a shorter term time horizon, are more nimble and may benefit from short term volatility."β Different trend following programs can exit trades or reverse positions at different times, which is a component of the CTA's risk management plan.
Market Friendliness Index
While the Coordinated Market Selloff Indicator might determine when a market trend has potential to reverse, the Market Friendliness Index attempts to determine the strength of the trending market environment.
"We measure the absolute price move over corresponding volatilities over different time horizons," Mr Stenbom noted.β "We correlate the time window based on the individual trader's trade execution strategy.β For instance, a long term trend follower this measure could be calculated over a 90 day rolling period, a medium term trend follower might potentially have a 60 day rolling window while a shorter term trend follower might have a 30 day rolling window."
In 2008 the index indicated a very favorable environment for trend followers, while 2009 the trend index identified weak conditions for trend following, according to Stenbom.β "In 2008 the stress in the markets were so intense, investors were scrambling to get out of the same door at the same time.β They wanted to reduce their equity exposure, increase their fixed income positions, reduce their long only commodity positions, buy the U.S. dollar.β Essentially risk assets were sold and safe haven assets were purchased.β Trends in all other markets were really expressions of stress in the equity markets."
This market stress that occurred during the 2008 time period culminated with one of the best environments for trend following programs, which generally ended higher on the year, with the Barclay Systematic (Trend Following) Index up 18.16%.β Contrast this with 2009, where a generally trendless market environment produced the third worst yearly performance in the history of managed futures indexes.
Economic Surprise Index
Another innovation is the use ofβ Economic Surprise indices.β Another counter-intuitive model, these indicesβ attempt to determine the level to which economic numbers are surprising markets.β Environments where surprises are generally occurring imply a correlation to trend following, in Mr. Stenbom's opinion.
"An Economic Surprise index is a mean reverting time seriesβ where realized economic statistics such as jobless claims, housing starts, etc., are correlated with expected statistics .β When that index is in negative territory, meaning the investing world is negatively surprised by economic numbers, that tends to correlates highly with trend following performance," Mr. Stenbom said, providing interesting insight.
Investing on a Drawdown:
Interestingly, RPM uses many of its indicators as a counter-intuitive measure, investing in various strategies after they have experienced a sustained period of negative performance.β "Typically we increase allocations to various strategies after that strategy has experienced a sustained period of negative returns," Mr. Stenbom said.β The strategy is to accumulate a stable of what it considers strong CTAs and then invest in these CTAs when they reach their average drawdown point.β "This significantly increases the expected rate of return over the first year."
While investing in a drawdown of the wrong CTA can lead to enhanced risk, the RPM approach of recognizing when to allocate to appropriate managers has been utilized as a key component of the firm's portfolio management regiment.β "Investing in drawdowns is one key to success in managed futures," Mr. Stenbom said.β "This is counter -intuitive for investors.β Investors have great difficulty with this concept, and typically invest exactly when they should not invest, at the point of an equity peak."
The RPM approach is to invest around one standard deviation below the mean and reduce exposure when, say, 1 β½ standard deviations above the mean.β "Time series has a memory in it and cyclicality to it.β It is not easy to exploit but it is exploitable," he said.β "Ideally we may have a low reading on the Market Friendliness Index, a low reading on the Coordinated Market Selloff Indicator, if we have a seasonality situation, if the Economic Surprise Index is below zero.β This is an ideal allocation point."
Risk management and Diversification
"Occasionally we have situations where a majority of different strategies in the world are essentially in the same position," noted Mr. Stenbom, highlighting a truth of computer-based trend following algorithms and how they may react, particularly during times of crisis when markets may be strongly trending in one direction.β This type of high correlation of position concentration is considered a risk factor.
Risk management through diversification is an important component of the RPM portfolio management process.β On a daily basis, RPM calculates various worst case scenarios. "We ask the what if all positions in CTA accounts move against us by two standard deviations? What would be the expected negative rate of return on a daily basis." Such worst case risk management projections are communicated to clients on a daily basis.
A key component of RPM's portfolio risk management occurs through diversification, where they are considering the impact of a breakdown in correlation structure of various CTAs and then considering the economic impact, looking at the relationship between inherent risk and observed risk.β In this case, RPM considers the expected returns and the worst case scenario returns, and this points to the effectiveness of diversification, he said.β "A high degree of diversification in a CTA portfolio is generally considered as good. But the flip side to diversification is that it implies a high dependence on correlation stability. When standard risk measures like VaR is significantly lower than our stress measures, then proper portfolio adjustments are considered."
MANAGED FUTURES IS NOT APPROPRIATE FOR ALL INVESTORS.β IT CAN INVOLVE VOLATILITY AND RISK OF LOSS.
While this article is written with balance and accuracy in mind, the content is designed for sophisticated qualified eligible persons.β It is not appropriate for all individuals.β
User represents themself to be a sophisticated investor who understands volatility, risk and reward potential.β User recognizes information presented is not a recommendation to invest, but rather a generic opinion, which may not have considered all risk factors.
User recognizes this web site and related communication substantially represent the opinions of the author and are not reflective of the opinions of any exchange, regulatory body, trading firm or brokerage firm. The opinions of the author may not be appropriate for all investors and there is no warrantee relative to the accuracy or completeness of same.β The author may have conflicts of interest, a disclosure of which is available upon request.β
Opalesque Futures Intelligence
Friday, December 02, 2011
Sweden's RPM: the largest managed futures manager few in the U.S. Know