FOUNDING FATHER Q&A
Diversifying Quantitative Strategies
DKR Capital's quantitative strategies group demonstrates the pivotal role of technology and model development in managed futures over the past decade. Pascal Magnollay joined DKR Capital Inc. in 1999 to manage quantitative strategies and founded DKR Fusion. Since then he has overseen the building of a range of systematic models to trade in some 100 markets and the technology used to test strategies. Here he discusses the development process and argues that diverse models are crucial for making money in varied conditions.
Dr. Magnollay has a Ph.D. in theoretical physics, a field that has given rise to a number of quantitative money managers. He worked at AT&T Bell Laboratories and started his trading career at Mint Investment Management Company, Man Group's first futures program. He was with a proprietary trading group at Morgan Stanley before co-founding KM Advisors.
The DKR Quantitative Strategies program made about 18% in 2008 and has very low correlation to major market indexes and other hedge fund strategies, including even managed futures strategies. In 2005, for instance, while a managed futures index showed a loss for the sector overall, DKR Quantitative Strategies gained 6.4%.
Opalesque Futures Intelligence: How did you develop the systems you use?
Pascal Magnollay: I've been trading and doing research on futures and FX since 1988. When I joined DKR I had a couple of models. Then over the years we built a quantitative team, now numbering 14 programmers, traders and researchers. We started with two broad strategies, now we have six strategies and 15 trading models just in our flagship product.
OFI: You said you started with two original strategies. How do you distinguish between strategies?
PM: We define broad strategies in terms of their correlation. Two ideas that generate two uncorrelated return streams are separate strategies by this definition. Originally we had a typical trend-following CTA product and an FX yield model that did carry trades. Both have a medium to long-term time frame.
OFI: How do the later strategies differ from the original models?
PM: We've expanded on all fronts. Now we trade everything and operate in all time frames, including within the hour, daily and long-term.
OFI: Why do you need so many models?
PM: Our goal from the beginning has been to diversify risk not only across a wide range of markets but also across strategies. The strategies we've introduced in the past five years are uncorrelated with trend following and other hedge fund strategies. Just as important, they are also uncorrelated with each other. For instance, high-frequency FX is uncorrelated with short-term FX momentum which is uncorrelated with the original yield model.
OFI: Wouldn't it be better to have one model that always works?
PM: Markets present a puzzle and one trading system is only one piece of the puzzle. I don't believe any single model can make money all the time. We have more tools now to take advantage of markets from different angles, in many different time frames. By adding more pieces of the puzzle, you can get a more complete picture of the market. We try to develop trading models that can handle all kinds of market situations, whether trending or range-bound, high- or low-volatility. Thanks to this diversity we've been very effective in managing downside risk. In almost 10 years of trading, only one month we lost more than 5% and that was only slightly more than 5%.
OFI: How do you allocate capital among the models?
PM: There are two levels of allocation. One, we work to develop a mix of strategies that will perform fairly well in all kinds of market situations, approaching allocation from a very long-term perspective over many business cycles. We don't try to time markets or forecast what the next quarter may bring, but target an allocation that is likely to produce positive returns in many different environments. Then at any given time, the models themselves indicate where we want to be. When a model finds a lot of opportunity, that's what we trade.
OFI: How do you decide which markets to focus on?
PM: We trade only in the most liquid markets. With quantitative strategies, it is crucial to be able to go in and out of markets with minimal impact on the market. It is very important that the trading track closely the back-testing and research. Slippage due to market impact would cause a divergence from what we expect on the basis of the research. That's why we trade only major global futures markets and currencies.
OFI: Which strategies worked better last year?
PM: Interestingly, in 2008 we found opportunities in different places. Not surprisingly, our long-term trend following did very well because the trends were so clear in the 2008 crisis. But we also found great opportunity in the very short-term time frame—high-frequency, intra-day FX trading strategies did really well.
OFI: How is trading affected by recent conditions?
PM: From a trend-following view, the trends have not been as clear this year. So far there have been trend reversals and choppy markets. But trend-following represents only about 25% of our overall portfolio. We have many mean-reverting type strategies, which in a way are the opposite of trend-following and do fairly well in range-bound markets.
OFI: Are there fewer trading opportunities this year?
PM: Even though volatility has dropped from the highs of last Fall, the recession will probably last a bit longer than many people expect. I would not be surprised if we see another short burst of volatility in the Spring before things calm down. There will probably be some interesting momentum again, though it may not be as clear as the 2008 trends. In any case, we don't just rely on trends. We're well-balanced between momentum and mean-reverting strategies.
OFI: How does that combination help?
PM:When there is a market inefficiency, either prices revert to efficient prices or they have a momentum going in the other direction. To profit from the inefficiencies, you have to understand both types of situation and have tools to deal with both. Last year we made 75% of our profit on the momentum side of the portfolio and 25% on the mean-reverting side. In a year like 2008 it's very hard to make money with mean-reverting strategies, so we're proud of that.
OFI: Do you worry that you'll run out of inefficiencies?
PM: We're finding many more market inefficiencies, even in FX markets, which are known for being extremely efficient. In our research program we tackled challenging strategies like high-frequency FX trading. It took us almost five years of research to get to implementation with that model. Now we have it running 24 hours a day. We built a back-testing technology that is capable of testing even very sophisticated models quickly.There are cycles for strategies and through the cycles there's a weeding process. Weaker traders go out of business. Using diverse strategies, you're more likely to survive through the strategy cycles. We have a competitive edge.