Leda Braga is an unconventional trailblazer. When the Brazilian-born derivatives expert joined London-based hedge fund firm BlueCrest Capital Management in 2001, her first order of business as head of research was to set up a library of complex equations and advise co-founders Michael Platt and William Reeves on pricing the various securities and products they wanted to trade. But Platt, who had worked closely with Braga at J.P. Morgan & Co. for seven years before launching BlueCrest, had bigger plans for the talented mathematician. With his encouragement she also began moonlighting — designing and experimenting with various systematic trading programs.
“I asked Mike, ‘Look, why don’t you go and hire someone who has done this before?’” recalls the 43-year-old Braga, who has a Ph.D. in engineering from Imperial College, London, but had never designed a trading program before working at BlueCrest. “I’d come from investment banking, and systematic trading is a highly specific discipline. But he was very insistent, so I started looking into it.”
Within a year, Braga had winnowed down various quantitative strategies to the one she thought held the most promise: a trend-following managed-futures program. It was a surprising choice, as Braga herself admits. After all, managed-futures specialists — also known as commodities trading advisors, or CTAs — have long been stereotyped as speculators who charge rich fees, use excessive leverage and generate enormous volatility. They have also been largely shunned by institutional investors. Braga, though, wasn’t distracted by the credibility problem that plagued the industry.
“Trend following didn’t look at all glamorous,” she says. “But I thought it would be a powerful strategy and have a lot of capacity.”
Today Braga manages about $7 billion in the BlueTrend Fund, a systematic-trend-following investment vehicle launched by BlueCrest five years ago. Capacity, however, wasn’t much of an issue in the early 1980s, when CTAs first gained a foothold. They were met with skepticism because they professed to be able to beat the markets using unfamiliar technical trading methods, searching for simple directional patterns such as price breakouts and trend reversals. With the explosion in computing power, however, managed-futures strategies began to attract the attention of highly skilled mathematicians and traders like David Harding, founder and managing director of London-based Winton Capital Management; Martin Lueck, co-founder and director of research at London-based Aspect Capital; and Kenneth Tropin, founder and chairman of Graham Capital Management. Drawn by the challenge of discovering ways to exploit price movements in the markets by designing complex proprietary trading algorithms, they threw themselves into their research — and a once-speculative trading style morphed into a scientific discipline.
Over the past few years, this transformation has accelerated at blinding speed. Out of sight of most investors, who were focused on more popular, more easily understood strategies like long-short equity, managed-futures traders have become engineers of change, fusing academic research with new technology. The most successful among them — including Braga, Welton Investment Corp.’s Patrick Welton and Quantitative Investment Management’s Jaffray Woodriff — have put a new spin on trend following. In addition to using the familiar longer-term models, which look for confirmation that a price move is firmly established before investing, many funds now deploy high-frequency trading strategies capable of profiting from intraday price moves; pattern-recognition models that may, for example, tease out opportunities arising from changing correlations among asset classes; and even fundamental factor models that try to determine how changes in interest rates, inflation and oil prices may affect the price movements of a given futures contract.
Investors, however, have been slow to acknowledge the shift. This may have more to do with macroeconomics than with any lingering resistance: Throughout the 1990s, as the bull market in global equities raged, investors weren’t particularly interested in CTAs’ uncorrelated systematic global macro strategies precisely because they didn’t match the phenomenal returns of the broader markets. Even after the Internet bubble burst at the start of this decade, investors chiefly sought to mitigate the risk that equity markets might decline, a focus that fueled the popularity of long-short equity strategies. In recent years the flood of financing available to hedge funds, coupled with pension managers’ need to fund their long-term liabilities, helped spur the growth of a range of arbitrage strategies that seemed to offer the unbeatable combination of strong incremental returns and little or no apparent volatility — and CTAs were ignored yet again.
“I think people also used to say, ‘It is just a black box. I don’t really get it,’” says Graham’s Tropin, whose firm operates out of a century-old stone mansion in Rowayton, Connecticut. “‘I don’t really understand how these guys make money or what their source of return is, so I’m not going to invest with them.’”
It is not a mistake investors will want to repeat. In the aftermath of a financial crisis so powerful that it destabilized the global banking system and nearly sent the hedge fund industry into free fall, investors have awakened to the value of diversification. During the three years through 2008, assets invested in CTA strategies rose from $130.6 billion to more than $206.4 billion, according to Fairfield, Iowa–based database provider Barclay Hedge; assets in systematic trading strategies now constitute almost 70 percent of global CTA assets under management. In 2008 the Barclay CTA index was up 14.09 percent. The Barclay Systematic Traders index did even better, rising by 18.16 percent — a remarkable achievement in a year that saw the Standard & Poor’s 500 index crater by 38.5 percent and the typical hedge fund fall by 19.03 percent, according to Chicago-based Hedge Fund Research. Some CTAs, like Braga’s BlueTrend, really shone: At the end of 2008, the fund was up a net 43.4 percent and had $7.83 billion in assets under management.
At New York–based Permal Group, a 30-year-old alternative-asset firm with $19 billion under management, global macro constitutes the largest single hedge fund strategy. Permal invests in both so-called systematic macro funds, which include CTAs and managed-futures firms running computer-driven, algorithmic trading programs, and discretionary macro funds, where trading decisions are the purview of an individual manager or an investment team.
“We like to use macro in all our multistrategy funds as a diversifier — and what we call a bear-market antidote,” says Omar Kodmani, London-based senior executive officer of Permal’s investment management services group, who is responsible for monitoring its international investment activities.
Permal has had a major allocation to macro strategies, including CTAs, for more than 15 years. Other institutional investors are just beginning to consider incorporating systematic macro funds, whose structural advantages are gaining attention because they permit investors to retain a remarkable amount of control. Rather than requiring investors to pool their money, many CTAs allow them to set up managed accounts. Although futures themselves have built-in leverage, the funds don’t require any financing at the brokerage level, a factor that helped insulate them during the crisis: Because managers simply post margin with regulated exchanges that usually amounts to about 15 to 20 percent of an investor’s capital, the remaining 80 to 85 percent is available for third-party cash management.
The strategic element that makes CTAs so valuable during market turmoil is their ability to diversify any portfolio. Since January 1980 the Barclay CTA index has delivered a compound annual return of 12.19 percent with zero correlation to the S&P 500 and microscopic correlations of 0.04 and 0.16, respectively, to U.S. Treasuries and world bonds.
But current market conditions may test the mettle of the best systematic macro managers — and try the patience of their newest investors. Although global equity markets were up this year through August, they have been choppy and trends have proved elusive and fleeting. No one knows when the U.S. and the U.K. will return to positive GDP growth, although France, Germany and Japan have recently posted modest upticks in economic productivity. Without appreciable trends to pursue, systematic macro strategies are having a hard time making money, and many are slipping into the red: Through June 30 the Barclay Systematic Traders index was down 3.45 percent even as hedge funds across the industry rose by an average of 9.13 percent, according to HFR. For the newest managers in the industry, like Braga, whose fund was down 5.17 percent through June, current markets are providing a clear challenge.
In its earliest form trend following was pretty simple: Traders would find a commodity- or financial-futures contract that was clearly moving and follow it up or down with the market. None did it better than Richard Dennis, a larger-than-life character known as the Prince of the Pit at the Chicago Mercantile Exchange, who pioneered trend following in commodities futures during the 1970s. Instead of “scalping” profits quickly over the course of a trading day, Dennis began experimenting with longer holding periods. His legacy looms large. In 1983, to settle a debate with his friend and fellow trader William Eckhardt about whether successful trading can be taught, he trained a group of individuals to follow a set of well-defined, technical trading rules. The lessons he imparted to his so-called Turtle Traders traveled widely as the futures markets expanded, spurring the development of dozens of CTAs.
Dennis had helped jump-start the managed-futures industry by showing that anyone could implement a technical trading program. But gradually, as the first financial engineers and statisticians got into the game, barriers to entry began to go up. One of the earliest firms to apply statistical analysis to the markets in the U.S. was Mint Investment Management Co., founded in 1981 by Michael Delman, Lawrence Hite and Peter Matthews. That same year another systematic trader, John W. Henry, opened his eponymous business in Irvine, California. In 1983, London-based commodities brokerage Man Group, recognizing that a major portion of its futures business was coming from investment advisers in the U.S., bought 50 percent of Mint. The trading house delivered annualized returns of more than 20 percent net for the remainder of the decade.
Even as the Mint founders flourished, however, another talented trio was about to make its mark — and ultimately upstage Mint — by developing groundbreaking new quantitative models. Michael Adam, David Harding and Martin Lueck came together at Brockham Securities, a London-based CTA run by Adam’s father, Cyril. Charged with the task of automating the daily update of commodities charts, the younger Adam bought a Hewlett-Packard workstation; his father later suggested using the computer to test various technical indicators, and he began writing code. His efforts quickly attracted Lueck, a friend from Oxford University. Together they persuaded Harding, a graduate of Cambridge University, to join them. When their ambitions for Brockham diverged from Cyril’s, the three men left and in February 1987 founded Adam, Harding & Lueck (later renamed AHL).
“We were always in the process of conducting big experiments that would involve computers running all weekend,” says Harding, who — as part of a recent project at his current firm, Winton Capital — is now studying the greatest market dislocations of the past 400 years. “There was definitely a degree of intellectual excitement interspersed with a lot of anxiety, too, because things were always breaking down.”
Despite the technical challenges, AHL thrived. The firm’s success caught the attention of Man Group, which wanted to diversify away from its investment in Mint. Man bought AHL in three stages, starting in 1989 and ending in 1994. “They sort of hosed us down, dressed us up and took on the distribution of the AHL strategy,” Lueck quips. In the 15 years since completing the acquisition, Man Group has become the largest publicly traded hedge fund firm in the world, with $46.8 billion in assets under management, powered to that position by AHL, which runs $20.4 billion.
AHL provided a clear example of just how potent and profitable systematic macro strategies could be — evidence that wasn’t lost on Quantitative Investment Management’s Woodriff, co-founder, chairman and CEO of the Charlottesville, Virginia–based hedge fund firm. When he started his global trading program in 2001, Woodriff saw that its returns were slightly correlated with those run by more established trend-following CTAs and decided to eliminate the overlap. After paring models that pursued long-term trends, he focused on short- to medium-term price patterns, gravitating to the most liquid futures markets, such as that for equity indexes.
From a strategic standpoint, Woodriff is less concerned with price moves than with deciphering the herd mentality that drives them. His approach, which he calls “quantitative behavioral finance,” is built on the premise that profound inefficiencies in the interpretation of information flow are the norm. Different market participants interpret data in varying ways, creating a time lag between information stimulus and response.
“What we’re doing essentially turns Efficient Market Theory on its head, because we’re pursuing a form of statistical prediction,” Woodriff says. “The more liquid a market is and the more diverse its array of participants, the more significant the resulting patterns are, which leads to better returns for us.”
In 2008, QIM’s flagship Quantitative Global Program delivered a net return of 11.94 percent, with most of those profits coming from trading deep, liquid futures markets: currencies, energy, stock indexes and metals (the only sector in which the fund lost money was interest rates). This year it was up 12.11 percent through July, owing chiefly to the performance of stock index futures. Since inception the program has delivered an annualized return of 19.3 percent, with annualized volatility, as measured by the standard deviation of its returns, of just 11.78 percent.
AS TREND FOLLOWING HAS evolved, so too have investors’ attitudes. When Braga, now president and head of systematic trading at BlueCrest, began meeting with investors in January 2004, she struggled to explain the necessity of upgrading the trading model.
“I would tell investors that we were quite committed to the idea that we needed to evolve the model, but clients didn’t like hearing that,” she says. “They would ask, ‘Why are you doing upgrades? Aren’t you confident in your model? If you keep changing it, how are we going to know if it works?’”
In contrast, Braga notes, investors today want to know about her firm’s research pipeline, which has expanded quickly. BlueTrend launched five years ago with exposure to 80 markets; it now trades in about 150 markets around the world on a 24-hour cycle. Like many of its peers, the fund has become more opportunistic, taking advantage of shorter-term trends — price movements tracked over a few days or weeks.
Braga and her team pay particular attention to controlling volatility and transaction costs when modifying BlueTrend’s model, which distributes capital across markets based on an algorithm designed to rebalance according to its highest-conviction positions. Maintaining broad diversification is critical, however: Even in choppy markets, where trends aren’t readily apparent, the program avoids the outsize risk of heaping assets into one particular trade.
“We actually get really happy when we see risk go up in the system,” Braga says, “because it means that the model is finding opportunities everywhere.”
Since its launch, BlueTrend has found a wealth of opportunity. It delivered a net annualized return of 19.9 percent through June 2009 and is now responsible for more than half of BlueCrest’s $12.4 billion in assets under management. Although the fund has not suffered a down year to date, it has had some wild swings: In April 2008 it fell more than 6 percent, only to end the year up more than 40 percent.
Despite such turbulence, Braga remains confident that BlueTrend will appeal to new investors in the wake of the financial crisis. She has been working closely with Bank of America Merrill Lynch Fund Solutions Group to develop an onshore version of BlueTrend in Europe and Asia. By tailoring it to meet the regulatory requirements for undertakings for collective investment in transferable securities (UCITS), BofA Merrill Lynch can apply to distribute the fund throughout the European Union based on authorization from a single member state — in this case, Luxembourg.
Industry veterans like Welton Investment’s Welton firmly believe that as investors reassess their core allocations in the months and years ahead, systematic macro strategies will finally be recognized for what they are: true alternatives.
“The crisis of 2008 revealed a failure of primary reasoning about what constituted good asset class diversification,” says Welton, whose Carmel, California–based firm manages $500 million. “We are seeing a much broader base of professional investors looking at global macro strategies now — including managed futures — and trying to figure out what it is that we do, how we do it and why the strategies deliver noncorrelated performance even under great market stress.”
One such investor is Emily Porter, who was recently hired to launch the inaugural hedge fund portfolio of the Universities Superannuation Scheme, the U.K.’s second-largest pension fund, with $35.2 billion in assets under management. Porter, who was previously a portfolio manager and investment director at London-based fund of hedge funds Key Asset Management, is just starting to look at systematic macro managers.
“They are definitely on our radar screen,” she says, adding that these strategies could ultimately make up 10 percent to 15 percent of USS’s total hedge fund allocation. “There are a lot of differences in how CTAs are being run. And that evolution may be one of the key changes in the industry that I’ve observed — there seems to be a lot more differentiation now than there was even five or six years ago.”
If the past is any guide, those differences are only going to become more evident as systematic macro managers engineer innovative ways to capitalize on the flow of information in the markets they trade. Trend followers they may be, but they’ve now created an investment trend all their own.
