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Pattern Recognition Pioneer

We've wanted to talk with Troy Buckner for a while. In the 10 years or so since he started NuWave, he made fairly steady and robust annual returns. The compound rate of return for NuWave Combined Futures Portfolio (2X) is more than 15.5%.

Then in 2008 two notable  and conflicting-developments occurred. Combined Futures Portfolio (2X) returned 52%. But because of the financial crisis, NuWave became an open “ATM” for clients who scrambled for liquidity as many hedge funds froze redemptions.

In 2009 Mr. Buckner's long-term track record drew recognition and he received two awards from HFM Week. Combined portfolio took the top spot in the CTA category while a separate high-frequency equity fund was first among newcomer equity funds. NuWave assets recovered and are around $685 million.

Here he explains his distinct pattern recognition strategy, which underpins both the flagship combined portfolio and the newer equity fund, and discusses the roller-coaster of the past two years.

Troy Buckner, "When trends are not evident or there are turning points, NuWave can hold opposite positions to trend followers."

Opalesque Futures Intelligence: How did you get into futures trading?
Troy Buckner: I started my career with a broker's perspective in 1986 at the futures and options department of Salomon Brothers, where I generated ideas for clients. Later, my responsibilities expanded to equities and portfolio trades for large clients. After three years there, I left the firm for a proprietary trading position, primarily in commodity futures. This was a change from what I did at Salomon Brothers, where I focused on financial futures.

OFI: Why did you prefer to trade commodities?
TB: I found it easier to hedge my risks with spread trading, like gasoline versus heating oil or heating oil versus crude. In addition to seasonal spreads, I used calendar spreads such as three-month versus nine-month contracts.

OFI: What was your strategy?
TB: During the time I traded independently, I developed the pattern recognition technology we use today. I traded by day to support myself and at night worked on the intellectual capital that is now the basis of NuWave's trading. When I launched NuWave 10 years ago, I applied the basic model and software to diversified markets, including stocks as well as financial and commodity futures.

OFI: What is pattern recognition?
TB: Our model generates probabilistic forecasts based on patterns in prices. We forecast weeks or months ahead whether a price will be higher or lower, and with what probability, to determine whether we should risk capital. This methodology was novel at the time we developed it in the 1990s. It was nowhere to be found.

OFI: Is this similar to trend following?
TB: There is common ground. What we share is a focus on persistent directional moves, looking for moves that diverge from the mean, which is another way to say that we trade trends. If there are strong directional moves, the industry will tend to converge to our position or we will converge to the industry position. We have about a 0.5 correlation with trend followers.

OFI: What's the difference?
TB: The difference is how we understand market moves. Trend followers typically do not forecast. They follow a heuristic process, for instance buying if the price moves above a 60-day high. By contrast, we don't follow behind market moves, but rather forecast ahead those moves that have the greatest probability of occurring. It's a matter of different perspective and timing.

OFI: In 2008, were you long oil during the first half of the year and short oil in second half. like everybody?
TB: Our perspective does not imply participation in a trend at any price. When trends are too strong, the risk can be too high. While crude oil rose to $145 in '08, we were out of oil at $118 because we lost faith in the ability of that trend to continue. Our two-to-three month forecast was a lower price. For a significant time we were on sidelines, but we started very early on to move into short trades in energy and grains. That was in June 2008. As a result, in July and August ‘08 we made big gains while trend followers were still long oil and lost money as the trend reversed. Eventually the industry converged to our position.

OFI: Are you a contrarian?
TB: Not typically. But we can disagree as to whether to be exposed to a trend and the likelihood of a correction. We continually forecast directional opportunity. When that directional forecast is powerful, it indicates a high probability of continuation. When the direction wanes, we exit our position because there is higher probability of correction. We don't want to stand in front of the trend and take the opposite position at that stage, but we will exit, as we did the long oil trade in June '08. At that time we were flat and moved toward being slightly short, although we don't seek contrarian trades.

OFI: How do investors categorize NuWave's futures portfolio?
TB: We are often grouped with trend followers, but we're rather unique within that category. When trends are not evident or there are turning points, NuWave can hold opposite positions to trend followers. Like many CTAs we did very well in 2008, but we had a negative correlation with certain CTAs, some of whom have the largest assets under management. Our monthly return profile was different. We all had a very good year, but approached the problem differently.

OFI: What happened in 2009?
TB: We followed our best year ever with our worst year ever, but fortunately the upside was over six times the downside. In 2009, we experienced a headwind for our style across multiple sectors due to choppiness and a lack of direction in many markets. There had been significant downward trends in equities, commodities and the US dollar; followed by a ricochet off the lows. That was a painful transition. By mid-year trends were in place, but, except for equities, you were mostly chopping back and forth. The dollar and energy were very difficult to trade. Only equities had the type of moves that we profit from. Your return depended upon how early you got into the long equity trade, but for most diversified CTAs that was not enough to carry the entire portfolio.

OFI: Is the 2009 pattern continuing in 2010?
TB: So far, yes. Commodities, energy in particular, are very choppy. But the stronger dollar looks like an emerging trend. Since November we've thought that markets are very stretched and subject to correction. Equities are up hugely from their March lows and energy has doubled. Though choppy, markets still had significant overall moves. We're happy to be less exposed during the past three months.

OFI: What do you see looking forward?
TB: We anticipated the corrections that happened early this year. I think that several sectors -equities, bonds, energy - are still not clear of speculative excess and there is still significant risk. But after the corrections, the latter part of this year should offer very good return opportunities.

"We applied the same theory and pattern recognition modeling to high-frequency equity trading…"

OFI: Has your approach changed in the 10 years since you started NuWave?
TB: Our philosophy has not changed, but the models do evolve. The NuWave Combined Futures Portfolio consists of three sub-portfolios, each with a different time horizon-referred to as Alpha (long-term), Pattern Pecognition (intermediate-term) and Beta (short-term). We could have offered these three as separate products, but because they complement each other well and have low correlation to each other, we offer a blend that exhibits the most compelling risk-adjusted returns during a variety of market environments. Over time, we developed variants of each, so now the combined portfolio has 33 sub-strategies. It is all systematic, including the risk overlay.

OFI: How does the risk overlay work?
TB: Our three main sub-portfolios operate independently of one another. You can think of them as separate managers. At times they may take similar positions. The individual strategies do not recognize macro factors, such as markets becoming highly correlated with each other. The overlay steps in when analysis indicates that the environment is overly risky. It reviews net positions created by individual strategies and can reject certain trades that might exacerbate the overall risk to the portfolio. These past three months the overlay has been very restrictive and caused our margin exposure to be half of our norm.

OFI: Does the short-term sub-portfolio use high-frequency trading?
TB: No, but we have a separate long/short strategy that trades individual US stocks, not futures, that is high frequency. We applied the same theory and pattern recognition modeling to high-frequency equity trading to develop a market-neutral strategy. This portfolio started equities only trading in February 2007, and now has a three-year track record. It is relatively small - about $55 million, compared to the $630 million in the Combined Futures Portfolio - but growing. The performance is exceptional, with a 1.64 Sharpe ratio. Initially, we thought the business would grow more on the equity side than in futures, but as it turned out the futures side grew more quickly.

OFI: Is this a statistical arbitrage strategy?
TB: No, as in our futures portfolio, the style benefits from directional markets with some volatility. The past three years were favorable for this approach. For instance, Aug 2007 was a very difficult month for statistical arbitrage, but our best month ever! We were able to capture the dislocation that month in both directions. NuWave's Long/Short Portfolio is slightly negatively correlated with the HFR market neutral index-unlike many market neutral managers, we tend not to focus on mean reverting opportunities but on divergence from recent prices.

OFI: Did you need new trading capabilities for high-frequency trading?
TB: We've had fully automated trading since 2001. It has recently become much more fashionable, but it's not a new thing for us.

OFI: Have investors' attitudes toward managed futures changed?
TB: CTAs have become more sophisticated and accepted as part of the alternative investment pie. Institutions, in particular public and private pensions, have become active in this space. But we are subject to the vagaries of the general environment. In the 2008 financial crisis, people took their money out despite the favorable return environment experienced by many CTAs! While it was bitter-sweet to see money going out the door, we saw the flip side of that in 2009 and experienced a good opportunity to raise capital.