Butter, milk, Indian rubber, the Colombian peso, Nigerian naira, Spanish power, Southern California electricity.
Such markets may not have a familiar ring for many CTAs, but they form the staple of a new class of systematic strategies trained on niche or exotic trading opportunities. And diversification remains the name of the game.
These so-called alternative markets strategies, which apply CTA approaches to non-traditional CTA markets, often OTC, have been attracting strong interest from sophisticated allocators. It is becoming a hotbed of launch activity.
The space has seen new products from the likes of established CTA players such as Aspect Capital while GAM Systematic has also started trading a new investment program designed to harvest uncorrelated returns from idiosyncratic global markets.
In March, US commodities specialist Gresham Investment Management quietly launched a quant fund applying modern trend-following technology to commodity futures markets in which systematic managers do not typically trade, or play a minor role relative to physical producers and consumers.
The concept is not new. Many larger, diversified CTA managers have long sought to add new and uncorrelated markets to their flagship portfolios. This has seen some move beyond traditional exchange-traded futures to OTC markets, cash equities and more recently cryptocurrencies. But firms are now packing such approaches into standalone products.
The poster child for this new breed of CTAs is Man Group’s AHL’s Evolution program, which launched in 2005. It employs a trend-following approach to OTC markets which are generally not traded by other CTAs.
Evolution initially traded swaps on credit indices before adding interest rates swaps, OTC commodities, cash equities, volatility indices, and European power contracts. It now trades over 100 liquid markets.Enjoying reading this article? Want to see more?
Man Group notes that many of these markets have been less influenced directly by the “risk on/risk off” fluctuations that have been triggered by the ongoing sovereign debt crisis. Others in the space point out they also benefit from lower participation of other systematic trend-followers due to the high barriers to entry.
As a result, AHL Evolution generated strong returns between 2009 and 2013 when CTAs in general struggled. Indeed, it outperformed the other CTA funds in the AHL stable (see chart below).
The strong performance has helped Man raise billions for the Evolution program. It took in $450m in the first half of this year and now has $3.4bn in assets.
An even more niche product, the Evolution Frontier fund, was opened in May 2015 to create additional capacity after Evolution soft-closed in September 2014.
Frontier, which manages around $500m, extends the Evolution concept to less liquid markets which may have regulatory, tax or legal challenges. Both funds are were up nearly 15% this year through October.
The compelling track-record and asset-raising success have led other firms to follow the Evolution path. And a number of the key figures behind these strategies have worked at AHL.
Systematica Investments, run by Leda Braga, launched its own product in November 2015 called the Systematica Alternative Markets (SAM) Fund. Systematica product manager Matthias Hagmann was formerly head of equities at AHL.
SAM has raised $1.3bn and now trades over 200 markets, spanning interest rate swaps, emerging markets FX, CDS, customised equity baskets, and alternative commodities. Many of the markets had been traded in Systematica’s flagship BlueTrend Fund.
As a standalone product, SAM was up 20% this year through October, according to HFM data, while BlueTrend suffered losses over the same period, although it has a 7.4% annualised return since its 2004 inception.
The recent performance differential between the trading traditional CTA markets and more niche or harder to access markets, even within the same firm with the same people, has led others to refocus their offerings.
London-based Florin Court Capital changed its strategy in April to focus only on what it calls “exotic assets”, including emerging and frontier markets as well as new asset classes such as cryptocurrencies.
Florin Court includes “synthetic assets” in its exotics portfolio: trading spreads and combinations of assets to create something new. The firm also trades cash equities, but as a moderate portion of total risk.
The Florin Court Capital Fund was up 15.5% since making the change in April through October, according to HFM data.
CEO Doug Greenig, who was formerly chief risk officer at AHL, said the firm had started out two years ago with the notion that it would construct a “maximum diversification” portfolio consisting of both exotics and traditional developed CTA markets.
It had been trading more than 300 markets, about half exotics, half developed. But its returns in developed markets, as with other shorter-term CTAs, had been uneven in recent years, while Florin Court’s “exotics trading” had performed consistently well.
Greenig said the refocus on only exotics markets was driven by this performance differential as well as feedback from investors and Florin Court’s principal sponsor, Brummer & Partners.
“We kept getting feedback from allocators that were speaking to us saying they loved our exotics program,” he says.
“And they really didn’t need another short-term or medium-term developed markets CTA component, because they already had that.
“It’s not so much a change of direction, it’s a focusing of the portfolio on something we were already known for. We decided to focus on our comparative advantage.”
While the strategies applied to alternatives markets are broadly well-known CTA models, albeit with some recalibration to reflect the higher trading costs typically involved, there are higher barriers to entry.
“It’s all more labour-intensive both in the research set up as well as the operations and trading of it,“ says Christopher Reeve, director of investment solutions at London-based Aspect Capital, a $7bn manager.
Aspect had previously incorporated alternative markets into its flagship diversified medium-term trend program.
In recent years it introduced cleared OTC interest rate swaps for countries where there aren’t liquid futures markets on their fixed income, emerging markets FX forwards, and less liquid commodity futures. But in November it launched a standalone
Alternative Markets Fund trading around 150 markets with a capacity of around $1bn. Around half of the markets it trades are newly added, such as CDS indices, ETFs and equity swaps.
In reference to its Frontier product, Man Group points out that besides the significant research effort required to investigate these markets, their operational complexity means that access is limited to managers with scale, strong industry links, and meticulous counterparty risk management.
“The challenges for CTAs moving beyond traditional futures markets aren’t research challenges that can be solved by throwing Phds at the problem,” says Rob Carver, an expert on systematic trading, who was formerly head of fixed income at AHL, and was responsible for managing the majority of the Evolution trading strategies, before leaving in 2013.
“The operational difficulties are different for various markets,” notes Greening.
“Sometimes to trade a market you need to become a member of an offbeat exchange. Sometimes you need to address custody issues for an exotic asset. There are a whole range of issues.
“The focus is not on adding bells and whistles to various models in highly liquid markets. The focus is figuring out new and interesting markets to trade, markets where special work may need to be done but which add real performance and diversification to the program. If it were easy, everyone would already be doing it.”
Eddy Mann, co-PM of Systematica Alternative Markets, says it requires a larger operations team with experience managing complex derivative portfolios.
A lot of the senior staff at Systematica have a derivatives background and were trading OTC markets at BlueCrest. CTAs trading many OTC markets will have to set up and maintain relationships with one or more prime brokers in addition to their futures clearing agreements to trade futures.
SAM’s Mann adds: “OTC trading is not anonymous and non-centralised and to maximise liquidity and obtain the most competitive pricing it is important to maintain a large roster of specialist counterparties.”
Trading OTC markets also necessitates having a large, experienced execution team, says Mann, noting Systematica has 11 people dedicated to this, located in Asia and Europe.
Carver points out that in contrast to trading futures on centralised exchanges, which have systems and protocols that allow trading to be automated, OTC trading may be spread across numerous venues.
“Degrees of automation vary, with some markets only accessible via voice broking, messaging systems, or bespoke user interfaces without the APIs needed for full automation.
“Price quotes captured for processing may not be reliable or dealable, or will be stale by the time the order comes for execution.”
Carver thinks that CTA managers entering the alternative markets realm may need to look to the wider job market to hire execution traders with the specialist knowledge required.Enjoying reading this article? Want to see more?
“When you step outside futures markets, the credit, OTC swaps markets and ETFs all have different operational challenges where you need relationships with enough executing brokers to get good prices and to guarantee you will have liquidity when you need it, all of which takes a set up which is beyond the reach of a start-up,” says Reeve.
Data also has to be obtained for trading these alternative markets. Historical price data can be sought from vendors, but trading costs and volume data is harder to gather.
“Getting the history is one thing, getting it on a day-to-day basis in a timely enough fashion to be able to then trade on it is a separate challenge all together,” says Reeve.
There are also back-office considerations.
“The back office for a futures-only business can be relatively slimline, with automated processing doing the bulk of the work,” Carver says. “In contrast OTC operations teams need to be larger for a given AuM, and will often require specialist knowledge.”
Back to the future
Trading conventions in many alternative markets may not suit CTA systems either, requiring a re-engineering of pricing models to trade them systematically.
“IRS and CDS instruments in particular have more complex life cycles that feature events such as coupon payments, credit events, coupon blending, compressions, novations and so on,” says Systematica’s Mann.
Reeve says Aspect broadly aims to take current trend-following technology and apply it to esoteric markets with adaptions which are necessary, but no more than that.
“There are some things that have to be adjusted and some things that are sensible to adjust, but our approach is to not over-optimise or tinker with model parameters for every single individual market,” he explains.
“That means it’s a great out-of-sample test for the strategy of trend-following as a whole, but also for all the research enhancements we’ve made to it.”
Florin Court’s Greenig says the non-traditional CTA markets are “less crowded, less efficient and exhibit behaviour that is more similar to what it used to be like 20 years ago in the developed markets”.
A systematic manager at another alternative markets CTA likens it to “going back to the future”.
However, Reeve notes: “We don’t believe these markets have a structural propensity to trend better, we think the value in this comes from diversification.
“Markets are less correlated to each other and more diversified. When you combine them together they are more diversifying from each other. So you end up with portfolio returns that might even prove superior to trend-following in vanilla markets.
“We are aware it might happen. We don’t believe there is any implicit premium from trading these markets whereby they are in anyway better for trend-following individually. But a portfolio of more diversified markets all with the same ‘trendiness’ should outperform a portfolio of more similar markets, on a risk-adjusted basis.”
Reeve acknowledges in the past few years, some of the harder-to-access markets have trended better.
But adds: “We don’t believe that’s a structural long-term phenomenon which we can be statistically confident will persist in the future.”
GAM, the Swiss asset manager which acquired Ewan Kirk’s $4bn Cantab Capital Partners last November, will launch a fund this quarter focused on niche markets, called GAM Systematic Discovery.
It will trade around 200 unusual and difficult-to-access markets, such as exotic futures, credit, alternative ETFs, interest rate swaps, spreads and options, according to a person familiar with the product.
Discovery will aim to offer effective diversification from traditional CTA and systematic macro strategies due to its low direct exposure to large liquid futures contracts.
However, the fund will be limited to $500m due to the illiquidity of these markets, the person said.
Greenig also points out that capacity is limited in this space, suggesting “it helps to be a bit smaller and more nimble.” But he welcomes the competition.
“This has become an actual space. It’s becoming a category which makes it easier for investors to understand what it is and compare offerings from different managers who each have their own flavour,” he says.
“There are always new markets; exotic markets that other people ignore. Applying CTA technology to those markets has proved very productive. We will be pushing the boundary continuously, wherever we can safely add performance and diversification.”
All participants in this emerging space expect more entrants to follow, however the challenge will be doing it well.