FOUNDING FATHER Q&A
Building a Better Mousetrap
Peter Matthews developed the trading system of Mint Investment Management, which was the basis of Man Group's products until AHL took its place. In 2000, Dr. Matthews retired from trading other people's money. But he kept his interest in markets, continued doing research and chaired the Foundation for Managed Derivatives Research.
In 2004 he came back with a new model and in 2005 started to trade for Caxton Associates. Subsequently he founded PJM Capital and got seed money from a large fund of funds and a bank. Below he explains how markets work, why he built the new system and how it differs from other trend following models. He made 28% last year.
“I was curious whether one could look at markets from a fresh perspective and develop a better mousetrap.”
Opalesque Futures Intelligence: How did you get into futures trading?
Peter Matthews: I heard about futures in the late 1970s, when I was doing graduate work in statistics. Someone said you can put in only 5% and if you get it right, you can make 10 times on your money. I thought, Why didn't they tell me about this sooner? So I tested different ideas and found that trend following might work. Back then it was so much harder to do research. You had to find data and get time on a mainframe computer to do the programming. I was so obsessed with finding a way to make money trading futures that I would replicate the computer simulations by hand. I could not trust the computer.
OFI: How did you end up in a partnership with Man Group?
PM: Back then Man had a small brokerage and we did our trades through them. They noticed that our trades tended to work out while many of their other clients blew up. That was bad for the brokerage because it meant they always needed new clients. So the brokers branched out and started to market our system. They took a 50% partnership in 1984.
OFI: What helped Mint grow?
PM: Futures products were a hard sell in those days—and still are to some extent. They were thought of as too risky. We were the first to come up with a guaranteed fund. That was the key to making the product acceptable to the mainstream. Our first guaranteed fund was sold in Australia. The product has been much copied since then. Mint started with $2 million, grew to $1.1 billion by 1991. We were by far the largest in our field. I stayed in the partnership till 2000. I felt I had done all that I wanted to do, so I retired.
OFI: Why did you return to money management?
PM: In retirement, aside from the usual golf, I pursued the same intense interest I've had for decades in what makes markets tick. I was curious whether one could look at markets from a fresh perspective and develop a better mousetrap. With the Mint, we used a statistical approach, that is, we looked at the data to design models and back tested them using historical data. Empirically, it worked. But I've always wanted to know why it worked. Once I understood that, I built a trading system based on a grounds-up understanding of markets.
OFI: How does this system differ from the previous statistics-based models?
PM: There is a science behind investment markets, which are complex adaptive systems. Many processes, from earthquakes to evolution, work this way. Complex adaptive systems may go into equilibrium from time to time but there are tremendous underlying forces that disturb the equilibrium. So a positive feedback occurs and a trend develops. That's the way these systems work. By late 2004, I had designed a trading model based on first principles compatible with the workings of complex adaptive systems.
OFI: Which markets does this model apply to?
PM: I still trade in the same markets and follow trends, but the tactics I use differ from other traders'. All liquid futures markets that you can trade electronically – commodities, currencies, bond futures – are examples of complex adaptive systems with the same potential paths and risks/rewards.
OFI: Is your new model better?
PM: Since I built the original Mint systems, I have an apples-to-apples direct comparison with the way I used to do things with the Mint models. The science led me to a better solution. Once you realize how dangerous complex adaptive systems are, you know it's all about risk and survival. You have to focus on risk because anything can happen. Focusing too much on identifying trends is a mistake. The issue is always risk.
OFI: What do you do about risk?
PM: If markets go against you, you need to get out. As an industry, we do that. What I do is a more scientific version. I make sure that the model adapts. Many people in the investment business do not cut their losses until it's too late. They say their value at risk is such and such, but they don't take action when the risk numbers are hit. When I talked to an endowment over a year ago, I explained how they could lose out in every one of their asset classes. They thought that explanation did not apply to them, but in fact they had a terrible time in 2008.
OFI: Did your system adapt last year?“There is a science behind investment markets, which are complex adaptive systems.”
PM: What happened in 2008 was not surprising if you think in terms of complex adaptive systems. Markets going down 40%, big shifts in trends—none of it is surprising. People were surprised because they think in terms of normal distributions. We've been using the model since 2004. The past year was the best possible test for it. All kinds of unprecedented things happened, like Lehman Brothers going under. Yet when you look at our daily returns, they're smooth as silk, because our model adapted to the changes. In 2005 and 2006 we did all right, but getting through 2008 was the real test. It showed that our system adapts.
OFI: What's going to happen this year?
PM: I do not make predictions. Complex adaptive systems have so many potential paths, you can't predict which one will happen. Most risk is not contained in value-at-risk bounds. I can say that managed futures are not just an alternative investment, we're the solution to the problem investors have. We're the real hedge funds. Strategies like long/short equity just track the market.
OFI: Will there still be trends to trade on?
PM: There will be trends because the nature of complex adaptive systems is that equilibrium is not sustainable. Equilibrium is the best time for us to invest, because it looks like everything is quiet but underneath the surface the plates are shifting and there's potential for an earthquake.
OFI: What could go wrong with your model?
PM: It's not about the model but the whole game would change if the government takes control, nationalizes banks, takes over commodity exchanges. Then there will no longer be a self-organizing market, so it won't be a complex adaptive system. If someone imposed control over the many people that make a market, the market would no longer work through adaptive processes. That would be a sign to me to simply stop trading. That's the advantage of knowing what makes markets behave the way they do.