#Investments — 27.12.2016

Alternative Investments: “Welcome to the Machine”

Michael Baughan

When Pink Floyd made this song over 40 years ago, it was in disdain of the music industry's eternal hunger to make money as opposed to music.  Coincidentally, the album in which the song featured was released in the same year that the US Electronics Company, MITS, brought one of the first personal computers, the Altair 8800, to the consumer market and thus sparking the microcomputer revolution through the 1970s and 80s.  Bring on the internet, the digital revolution, big data and the birth of artificial intelligence, and we find ourselves in a world that has never relied on machines as much as is the case today.

On one level - call it philosophical or ethical even - it is human nature to be wary and anxious towards the acceptance of these changes, whilst on another level, technological innovation has been widely embraced as a means to lifestyle improvement.  This anxiety is also applicable to investing money, and it goes beyond a fear of the unknown.  However, human behaviour has not always proved to be rational and no less so than with investment decisions.  Which brings me to the theme of this post: a systematic and quantitative investment approach adopted through an alternative investment strategy known as the "CTA". 

What are CTAs?

CTAs are essentially algorithmic trading models that are designed to follow outbreak movements of asset prices across the full spectrum of deep, liquid markets. 

They are essentially efficient momentum or trend followers that manage risk (measured generally by levels of volatility) through sizing positions inversely to the length of time that the trend they are following has lasted.  I.e. as the price of an asset moves progressively from point A to B, the CTA will progressively reduce its position over time as the price approaches point B (potentially an inflection point in the market price). 

In short, they are not greedy, they are technical, and they abstain totally from emotional investment decisions.

Where do they invest?

In any asset class, in any market, anywhere in the world, as long the market is deep enough to support their trading needs without encountering liquidity issues from a lack of buyers and sellers.  The most advanced CTAs can have access to 400 different markets at any one time.

From where do they source their information?

Information is key, and this is synonymous with efficient data mining.  The data explosion has seen more data produced in 2014/2015 than in the entire history of Mankind and yet it is estimated that only 0.5% of all data is actually analysed.  CTAs look constantly for new sources of data to identify trends, and then test them and stress test them over time before integrating them into their model. 

As such, the models evolve continuously and the information explosion is their hunting ground.  The skill of the CTA is to identify those reliable and high quality information sources that can be applied to their investment models.

So who are the people behind the machines?

They are often sourced from very different pools of intelligence than financial managers.  Engineers, mathematicians and scientists are more likely to be sought after in the CTA space.  Rest assured that there will always be staff with a strong financial background present in the investment process too.

Where does portfolio construction fit within these programmes?

It's not all just rocket science. Principles of efficient portfolio construction and risk management are corner stones to a CTAs process. 

Once again, data management is key as cross-correlations between trading strategies and markets are compared and transaction costs are scrutinised versus trading volumes to find the optimum cost-benefit equilibrium.

How do they fare?

In one word, differently.  Despite their association to trend following, from the above description this shouldn’t come as a surprise as everything about them is different: staff, specialisation, investment universe, process and the lack of human influence on decision making make the CTA strategy quite unique.  Historical correlations to broad market indices and specialised asset class investment funds are low to negative.

As already stated in previous posts, alternative investments provide different sources of potential investment performance, uncorrelated returns and diversification to a traditional investment portfolio.  CTAs adhere entirely to this mantra and are, in my opinion, definitely worthy of consideration when seeking alternative sources of returns in an investment portfolio.

"The Dark Side of The Moon"[1] is a concept album that, arguably, addresses the irrationality of crowd-following whilst reaching the conclusion that trying to convince people not to follow the crowd, ultimately leads to a state of delusion.  It is also a great album, and was at the forefront of technological advancement in music recording techniques in its day…

"…and everything under the sun is in tune but the sun is eclipsed by the moon.  There is no dark side of the moon really." [2]    

Until next time.


[1] Pink Floyd, 1973
[2] Eclipse, Pink Floyd, 1973