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FOUNDING FATHER Q&A

Winning the Trend Rodeo

Trends can be wild. How does one ride and survive the gyrations year after year? Ken Tropin, founder and chairman of Graham Capital Management, tells us how he approaches market trends. The funds he manages had varying positive returns in 2008—the flagship Graham Global made 36%. The firm managed about $4.9 billion as of February.

Before founding Graham Capital in 1994, Mr. Tropin was president and chief executive officer of John W. Henry & Company. Earlier he was director of managed futures and as president of Demeter Management Corp. at Dean Witter Reynolds. He has served as chairman of the Managed Funds Association and helped found its predecessor organization.

Opalesque Futures Intelligence: Are there always market trends for you to follow?

Ken Tropin: I would not say there are trends all the time that we can take advantage of. It varies year to year. Broadly speaking there are four main sectors that firms like ours trade in—foreign exchange, fixed income, stock index futures and commodities. In an average year, there are two or three significant trends in those sectors. In a very good year from our perspective, there are significant trends in perhaps three of the four sectors we trade.

OFI: How long do those trends last?

KT: It depends on your time frame. At Graham we use four different times frames. The long-term horizon typical of the industry is for us a holding period of more than 30 days. There are meaningful long-term trends in most sectors maybe once or twice a year. Besides those, we pursue intermediate, short-term and high-frequency trading models—high-frequency meaning the trades last less than one day on average.

OFI: What do systematic models do?

KT: In general, they identify trends. Different models have different time horizons. A long-term model might indicate that over the past several months energy prices declined. This is not predictive, not a forecast that energy prices will go down, but an indication that the prevailing trend will continue. We try to get in early in a trend and go with it as it gains momentum. There are many different ways to do this. Our firm has 33 separate trading strategies in our trend following programs. These programs time the market differently and use different ways to decide when to buy or sell.

“In this business you need to have ample payoffs from your winning trades but make sure your losing trades do not generate big losses.”

OFI: How do you know it'll work?

KT: Over a number of market cycles there are enough situations where a prevailing trend does in fact continue for some time so that a significant number of trades are successful. By having 33 models that operate independently of each other, we try to get the best statistical advantage that we can and have as many data points as possible, so that over time we have the highest probability of profitable outcome. One model may have a great year and another model a sub-par year, but the overall performance of our portfolio is what matters.

OFI: Trends sometimes reverse abruptly. How do you control the loss when what looked like a persistent trend reverses on you?

KT: That's the art and science of what we do. There are many techniques. At a minimum we have a stop-loss order on every trade, so that if it turns out that we came in at the peak of a trend and it reverses against us, we lose a modest amount of money and exit the trade. It is inherent in trend following that you allow profitable trades to continue but do not allow losing trades to generate substantial losses.

OFI: You have some winning trades, some losing trades, how do you know you'll come out ahead?

KT: In this business you need to have ample payoffs from your winning trades but make sure your losing trades do not generate big losses—so the returns have a fat right tail but not much left tail! Suppose over time you make money on half your trades and lose money on the other half. If the winning trades are double the size of the losing trades, then you have a pretty profitable investment.

OFI: Why is managed futures seen as very risky?

KT: Many investors become overly reliant on strategies that have high Sharpe ratios. These are strategies that can have significant left-tail risk—when they lose, they lose a lot, whereas their wins are modest. We saw that in 2008. For instance, for many years convertible arbitrage had 10% to 12% returns with a high percentage of winning months. Then in 2008 convertible arbitrage in general experienced substantial left-tail losses.

OFI: What's the mistake investors make?

KT: People do not spend enough time focusing on stress periods for markets and the strategies that perform well during those periods. It's one thing to construct a portfolio that will perform well when the stock market goes up double digits, another altogether to construct a portfolio that will perform well when the market goes down. Most hedge fund styles correlate with equities, but not managed futures. Last year, among all the hedge fund strategies only short sellers and managed futures had gains.

OFI: How should investors view managed futures?

KT: Investors should not look at the returns and volatility of a trend follower as if this were a standalone investment. They should consider the effect of a CTA on their whole hedge fund portfolio, especially during stress periods like 1998, 2001-2002 or last year. Then they will see the value of what we do.

OFI: Why was 2008 a banner year for trend followers?

KT: It was a confluence of factors. There were solid trends in every sector where we trade. In the first half of the year our firm did well being short equity index futures and long commodities, in the second half of the year we reversed those trades. Because we have so many programs, we were able to take advantage of the market from many different time horizons. Later in the year we were long fixed income and the US dollar.

OFI: What's the outlook for 2009?

KT: Early in 2009 it was a little choppy, but Graham had a profitable start. I think it will continue to be volatile and usually that is constructive for trend followers. It's hard for us to make money when markets trade in narrow ranges, but that's unlikely this year with so much going on in the world. So there are opportunities that we hope to use successfully. But in this business you can't take anything for granted!