December 30th, 2013
As a Managed Futures Fund Advisor, we are always assessing sub-advisors on behalf of our clients. Our investment team reviews multiple shops each week. We like learning about and understanding new algorithmic shops for various reasons, not the least of which is that they usually are the best innovators. Many of them have physical science backgrounds that have found a way to apply to finance what they know from their science fields. We actually prefer PhDs to MBAs.
But we reject many more than we potentially use. The reasons are various and discovered through extensive operational, quantitative, procedural and qualitative due diligence. We can write a book describing the right way to assess an advisor, I tried to do just that in my book, The Future of Hedge Fund Investing: A Regulatory and Structural Solution to a Fallen Industry. Suffice it to say that the folks who really know how to look at managed futures are the ones who have traded them because the reality of implementation is often quite different than the theory.
We recently rejected an interesting case of a shop that claimed to have found an anomaly in, and therefore could arbitrage, an overnight futures market. But when we looked under the hood, all they were doing was trading liquidity overnight, which as any seasoned trader knows, is dangerous. Liquidity dries up in many overnight markets, so taking positions in them is quite risky. The big risk in this was the overnight news risk exposure. Their "algorithm" was based on this supposed anomaly.
A good managed futures manager is a good risk manager. There are a number of ways of controlling risk in a managed futures program: from properly selecting markets to allocating capital and sizing positions. But limiting losses is also accomplished through a simple tool - the stop order. The big assumption here is there is enough liquidity to get out of your position. But if everyone is heading for the exits at the same time, that becomes problematic.
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