The Portfolio Doctor
In the financial industry, the title “doctor” usually refers to a graduate degree in finance, math or occasionally physics. Patrick Welton, by contrast, is a medical doctor who taught at Stanford medical school and did cancer and genetic sequencing research. On the side, though, he traded futures and designed trading algorithms. Over the past 21 years he and his wife, Annette, built Welton Investment Corp.
In a way, Dr. Welton applies a physician’s mission to money management—he diagnoses the problem and figures out a solution. Here he discusses investors’ concerns regarding managed futures and how to address those issues by constructing a truly diversified futures portfolio. His prescription: a blend of approaches that does not rely exclusively on any one style or market pattern.
“Good portfolio design has to ask timeless questions. For managed futures and global macro, the timeless question is the source of return.”
Opalesque Futures Intelligence: How did you get into futures?
Patrick Welton: My interest in quantitative methods dates back to the days when I was captain of the high school math team. I studied math and physics in college, before switching to molecular biology and other subjects. Annette and I traded with our own money in the early 1980s. First we traded US equities, then we focused on how to trade futures. We found them to be a very attractive way to take positions because it requires less capital and the market is liquid. We developed our own investment strategy through the years. Eventually we moved to trading for a professional firm, Commodities Corp. In 1989 we started Welton Investment Corporation.
OFI: Would you describe the strategy?
PW: From 1992 into the early 2000s, we offered a trend-following managed futures program. Over this decade, the firm grew to include research, trading and middle office staff to meet the needs of our investor base. In 2003, based on the input of some of our most sophisticated investors, the firm decided to pursue a different concept and started to develop a diverse set of trading strategies. Today, this diverse collection of strategies forms the basis for our flagship Global Directional Portfolio (GDP) program which is now in its sixth year of trading and manages approximately $500 million.
OFI: What was the investors’ feedback?
PW:Investor interest in managed futures has waxed and waned since the 1990s. Investors generally want the well-proven benefits—the non-correlation with markets and the big gains at times when other investments make large losses, as happened in 2008. Many would like to increase their allocation to managed futures. That being said, investors or their agents have had concerns that get in the way of making a well-supported asset allocation decision.
OFI: What are the concerns?
PW: One is that managed futures, when largely consisting of traditional trend following, goes through extended periods of disappointing performance. A corollary is that investors were not happy about the occasional sharp drawdowns that they would have to incur to stay in a traditional trend-following strategy. These concerns have been significantly recalibrated now that more traditional investments and hedge funds have shown their ability to produce even larger and swifter drawdowns of capital, not to mention the risk management failure of over-concentrated exposures.
OFI: But how can losses be eliminated? All strategies lose money some time.
PW: Sophisticated clients know that the downside cannot be eliminated, but as a manager we can try to limit the undesirable characteristics. What are needed are ways to ameliorate some of the negatives, like big givebacks in performance or sharp run ups and sharp run downs, which are a result not just of investment technique but also portfolio construction. Our approach is to employ disciplined diversification in portfolio construction to try and create more robust and timeless investment results.
OFI: What do you mean by timeless?
PW: Human beings don’t have a technology that predicts the future well even for short periods, let alone for months or years. Good portfolio design has to ask timeless questions. For managed futures and global macro, the timeless question is the source of return. Asset price fluctuations are the source of returns. There are many dimensions. The fluctuations can be fast and jagged, slow and smooth, within or between markets. A core question is whether you can design ways of reliably capturing the different types of asset price movements. The more types of fluctuations you can catch, the more timeless the entire portfolio allocation design will be.
OFI: How do you catch diverse kinds of fluctuation?
PW: Many managers have diversified across asset classes. That’s not a difficult diversification step but is nonetheless valuable. If one looks under the hood at the attributed sources of return, one too often finds less diversification than expected, often with large amounts of returns coming from a concentrated set of markets. Some managers have diversified across time frames, doing both long- and short-term trading. This has been happening in the past few years. Meaningful stylistic diversification is harder. It used to be that investors had to go to several firms to put together a stylistically diversified futures portfolio.
OFI: Which approaches have a diversifying effect within managed futures?
PW: Long-term trend following can generate wonderful returns, but there may be long periods of no opportunity for this strategy. Choppy, range-bound markets are difficult to trade if you’re looking for a trend. Oftentimes during those periods other strategies like mean reversal and fundamentals-based approaches perform normally, so including them can help diversify return source and ultimately smooth returns at the portfolio level. Relative value strategies, for instance, give the manager tremendous flexibility in accentuating profit opportunities that don’t exist in a single market. If you go below the surface of different strategic styles, there is yet another level of diversification in how the style is applied.
OFI: How many levels of diversification do you consider?
PW: There are six primary levels of diversification to consider: strategies vary by markets, timing, style basis, directionality, input foundations, and the way those styles are implemented.
OFI: What does this mean for investors?
PW: The wide dispersion of performance across managers is another issue that has discouraged investors from wider adoption of managed futures. In any given year managers’ returns from top to bottom quartile can be 10 or 20 percentage points apart, which complicates the investment decision. But once you look at returns in terms of the diversity of what managers do, you have an explanation of the extreme dispersion of returns. Tracking the diversity, you have a reliable framework for investing.
OFI: How did you diversify?
PW: In response to the feedback from investors, in 2004 we created the GDP program which does not rely solely on trend following. GDP’s portfolio architecture is the biggest design advance. Each individual component, whether it makes trade decisions based on fundamental data or statistical data, has a function in the architecture. Further diversification within this architecture is often the most robust basis to advance the portfolio quality. For example, if in commodities we have both a trend-following strategy across time frames and a fundamentals-based strategy, but no mean reversion or price discovery-based models, then it is highly probable that our clients will gain the most significant benefit if we direct our research toward purposefully filling these holes in the architecture.
OFI: How do you allocate between programs?
PW: By design we want GDP to have near-zero correlation to major markets and to other hedge fund strategies. We want to diversify broadly and to be a reliable diversification source for our investors. The systems indicate where the trades will be at a certain time but from a top-down view we prefer to maintain a reasonable balance of where the return comes from. Over the years, the portfolio is designed to make money across markets, time frames and styles, with returns balanced across the momentum, mean reversion and fundamentals groups. As we continue to fill out the different styles, momentum based returns, while still significant and valuable, will account for a smaller relative proportion of GDP’s returns. Exactly where we get the highest return rotates among asset classes, strategy types and time frames year by year.
OFI: Do investors see you as a CTA or a global macro manager?
PW: Price fluctuations across asset classes is the domain for both managed futures and global macro. These strategies are close cousins. Systematic quantitative strategies are associated with managed futures, but so are global macro funds with a broad approach. The profits generally come from the same sources. We are generally classified as diversified managed futures. Because some of our programs are fundamentally based, we at times also get classified as global macro. We explain what we do and how we do it, so investors can properly classify us according to their definition.
OFI: What’s going on this year?
PW: At any given time we can talk about what happened in the past 90 days, but while a colorful conversation, it isn’t that meaningful from a strategic sense. Most quarters present a mix of random noise and normal market behavior. There’s been a lot of noise in recent months after the dramatic 2008 trends ended. Very recently, there have been a number of positive performance contributors. This is more of a human interest cycle than an insightful way of considering portfolio construction.
OFI: What’s the right way to look at strategy?
Look instead at 30 years of managed futures performance – a period with real data through all kinds of environments – and you see that managed futures have out-performed nearly all asset classes, providing strong evidence that the strategy deserves serious consideration as a perpetual holding in any well-diversified portfolio.