FOUNDING FATHER Q&A
How to Hedge Irrational Markets
Certain strategies work well at times of financial stress. Mark Rosenberg, chairman and chief investment officer of SSARIS Advisors LLC, explains why. Paul Lucek, the firm's director of research and senior portfolio manager, adds his observations.
The SSARIS Diversified Trading Program made about 52% in 2008 and has returned almost 18% annualized since inception. The firm manages several other strategies and runs a fund of funds business for State Street, the institutional asset manager and custodian. The fund of funds arm won two industry awards this month. State Street Global Advisors and ABP, a European pension fund, are majority owners of SSARIS.
Mr. Rosenberg became aware of financial markets at age 14, when he asked his father whether there was a way to make money without working in a factory. He started trading futures in 1968 and founded a commodity trading advisor business in 1983—that was the inception of the Diversified Trading Program, which has been in operation continuously since then.
“Managed futures is a powerful tool. It does not hurt a portfolio during stable markets, but its real contribution comes at critical times.”
Opalesque Futures Intelligence: How did you develop an investment philosophy?
Mark Rosenberg: I always thought markets run on fear and greed and go through booms and busts. Markets are mostly efficient but are at times irrational. You have to have ways to make money in both situations, be prepared for irrational markets as well as efficient markets. Convergent strategies are about prices converging in efficient markets. That's the kind of bet Long-Term Capital Management made. In 1989 the Asian crisis frightened investors, who sold the under-priced assets LTCM had bought, causing the arbitrage strategy to collapse. But there are other strategies – like managed futures – that can make money in irrational markets.
OFI: What does that mean in terms of returns?
MR: During periods of relative calm, convergent strategies tend to make stable, attractive returns. In an extreme event, however, there is the tail-risk of a large loss. By contrast, divergent strategies perform best when volatility and uncertainty rise. I have not found many truisms in markets, but this is one of them. The convergent/divergent distinction is the real difference in investment strategies, as 2008 showed. If you take the worst months for stocks, you see our diversified trading program tends to move in the opposite direction at those times—it becomes negatively correlated to stocks. Ditto for the worst months for bonds.
OFI: Are most investments convergent?
Paul Lucek: Being long stocks and bonds is a convergent strategy, so vast pension assets are convergent. Most hedge fund strategies are relative value based, so they're convergent. Managed futures is one of the few true diversifiers.
OFI: Why does managed futures perform well at such times?
PL: One, unlike equities we're not limited to a single market. We can trade everything. If an event happens in the currency market, we have the currency program running, for instance. Another reason is that we follow the momentum, so when it over-shoots we make money.
OFI: Does that mean investors should go for divergent strategies in turbulent markets?
MR: It's too late if they wait for the event to happen. Investors should always have divergent strategies like managed futures as well as convergent stock and bond strategies in their portfolio. We saw this in our funds of funds. The managers with divergent strategies came through. Managed futures is a powerful tool. It does not hurt a portfolio during stable markets, but its real contribution comes at critical times.
OFI: Why do some people stay out of managed futures?
MR: Managed futures are slightly more volatile than equities on a monthly basis, but they're perceived to be very volatile. If you add a more volatile but non-correlated asset to a portfolio, you improve returns and reduce the overall volatility of the portfolio. That's well established, but it may not be intuitively obvious. I think investors will change their view about this when they see the benefit of having managed futures in their portfolio.
PL: Can anybody provide a good reason why managed futures should not be in a portfolio?
OFI: Isn't it a problem that many investors can't understand the black box models used by CTAs?
MR: There is a concern, but I don't think it's valid. We can describe our system, take you through what we do, how we select our markets and trades. We'll tell you everything about our program, except the algorithms that make the decisions. Some fund of funds managers don't like the idea of a systematic, computer model-based strategy. In fact, the biggest black box is a discretionary manager—nobody knows what he'll do! What is more, the odds of repeating a successful run is much less when there's no systematic program. Computer models pick up changes quickly, whereas discretionary managers are easily whipsawed by market changes. If somebody in the market knows about an event and is trading on it, a good model picks that up.
OFI: CTAs trade equities, bonds, commodities or currencies. Where do they fit in an institutional portfolio?
MR: Managed futures goes into the alternatives bucket. For decades there was no such category, which was an institutional barrier to investing with CTAs. Many institutions are increasing their allotment to managed futures.
OFI: Can futures absorb a lot more capital? So far it's been a small niche.
MR: Underlying futures are the world's largest markets—currencies, equities, fixed income, commodities including metals. At some point potentially there's a capacity constraint for any one individual style, but there are many different styles of managed futures. Some go long, others go short. Our CTA program could handle several billion dollars.
PL: Last year, when many bonds and even some stocks became illiquid, futures markets stayed open to trading. Futures may be misunderstood by the public. Unlike over-the-counter derivatives, futures and options have traded in highly-rated exchanges for decades. If anything, futures markets are more highly regulated than equity markets. Anyone can trade stocks, but to trade futures you have to register and fulfill regulatory requirements.