I spent part of my career with a large systematic hedge fund; another part with a key participant in US cash equity High Frequency Trading. Among the many things I learned was a strong appreciation for systematic trading strategies. Why?
Most financial management we do, and like, is discretionary. We like to hear and believe stories of ‘why’: why the market is going up or down; why a company’s stock seems good or bad value; why interest rates can’t go any lower. I’m sure there’s a bit in Thinking Fast and Slow which talks about the human draw towards narratives. I believe this is one of the key reasons why:
- Financial news networks prefer talking heads (such great forecasters on these shows) to statisticians, and insist on a new reason why the market is up or down each day.
- Most people stick with underperforming active asset managers rather than passive index funds for long-equity and long-bond exposure, even though overwhelming evidence shows this is an exercise in futility.
When I began with the hedge fund, my role was to communicate to clients what the systematic strategy did, and how it performed against expectations. The first roadblock, both for potential investors and for the salespeople selling the systematic fund, was getting over the ‘black box’ fears. Because the strategy involved no person saying ‘Asset x is a good buy’, investors and salespeople assumed there was no merit to the strategy, and it was completely impossible to understand. Sigh.
Here’s where systematic trading really has the edge:
- No baggage. Algorithms really don’t care if you believe x is a good buy or not. They have no preconceived notions as to what’s fair or not; only what their told to do. This can really help in times such as since the GFC, where interest rates have been relentless in falling; most pundits believed they couldn’t go lower, but a simple momentum strategy stayed long.
- Discipline. I recently blew a couple trades because of an itchy finger – I was to fearful to keep on a losing trade, even though the probability was definitely in my favour. Once I code this and let the computer trade, these type of misses won’t be an issue.
- Diversification. It turns out that systematic trading strategies can be designed to produce very diversifying returns to the usual stocks/bonds portfolio. Although they’ve had a ton of heat in the press, systematic managed futures funds remain the best ‘bang for the buck’ diversifiers for a normal stock/bond program.
I encourage anyone to look at Anti Ilmanen’s Expected Returns, for the joys of using systematic strategies to obtain many different risk/return exposures.