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Quantamental solution to CTA underperformance proposed

By: Aref Karim | 13 Jan 2015

Systematic investing, in the form of managed futures, often called CTAs, rose to the attention of
the wider investment community particularly through its performance in 2008, when it delivered
strong returns against the dramatic losses posted by most other strategies. In the following years,
however, its performance has been somewhat lackluster, prompting several market
commentators to wonder if the managed futures strategy was ever to come back and whether the
diversifying performance of 2008 was something of the past, never to be seen again.
All strategies go through periods of underperformance and managed futures is no exception. The
long grind however did open up potential for some managers to evolve their systems to better
adapt to unusual conditions in future.
One type of evolutionary model that has developed is a combination of traditional Systematic
investing with fundamental macro. This strategy aims to take the positive attributes of systematic
investing, particularly those that make the strategy so powerful, whilst reducing the impact of its
shortcomings. This solution preserves the power of systematic investing while addressing the

The positive attributes of systematic investing

Systematic investing has the ability to neutralise the negative impact of emotions, fatigue and
cognitive biases within human decision making. Systems, by design, entail the consistent
execution of a set of rules and are hence immune from the natural vagaries of the human brain.
The approach allows the benefit of seeing how an idea would have performed in the past if
consistently applied. Simulations got man to the moon. We build cars, airplanes and explore into
the outer realms of space through testing in the lab for the unknown. Unusual environments can
be synthesized and simulated to test out ideas; the ideas in turn can be stress tested to pull and
stretch our imaginations.
Therefore, it has the power to efficiently process huge volumes of data, delivering a doubleadvantage: maximising the information content which can be extracted from the analysed data,
as well as providing the broadest possible opportunity set of assets to select from.
Through a systematic approach we can also significantly reduce a companys reliance on key
individuals. No matter how influential a key person is in the development of a system, the
knowledge is incorporated in the model which survives as an asset of the firm through its
intellectual property. This can be invaluable.
Drawbacks of systematic investing
As with all investment strategies, a traditional systematic approach comes with some intrinsic
It is important to note the dependency on past data, and therefore the inherently backwardlooking nature of the systematic approach. True, techniques have been developed to minimise
the drawbacks from this, but it is an easy temptation to fit the approach to conditions of the past,
believing they will repeat. Sheer speed of computational power increases that temptation of data
As a result of the above, there results with the benefit of hindsight a self-perpetuating practice of
changing parameters or models frequently, often known as optimisation. The quant nature of
the approach exposes it to the risk of over-engineering, such as a proliferation of variables,
dependence on too many signals, constant tweaking of parameters. The negative outcome is a

model that is overly back-fitted to past conditions, with the risk of decaying quickly or, even
worse, being suitable only for the specific conditions it was developed in.
There is often an inability in this approach to put an economic or financial connection to the data
analysed. The system by design typically treats the data in an aseptic manner, overlooking the
conditions which generated such data in the first place. This black box approach leads to a loss
of intuition in system behaviour dealing with certain market environments.
In systematic investing often times different models are used to deal with specific environments.
Subjectivity hovers around how much capital to allocate to say trend-following, mean-reversion,
pattern-recognition, or other strategies.
The above weaknesses in the systematic approach lead to an inability to look forward and
prepare for sudden, and frequently dramatic, changes in market paradigms. These have been
most visible in the economic environment post-2008 crisis, with the disappointing performance
of the strategy for an extended period of time. The exceptional intervention of financial and
monetary authorities to avert a global meltdown has essentially overridden market fundamentals
in this period. The consequence has been trendless, choppy, risk-on/risk-off markets, depressed
volatility and spiked up correlations between assets. These are all unfavourable conditions for
systematic investing.
A potential solution
One compelling solution to the problem is a combination of the systematic and fundamentalmacro approach, in the belief that it can deliver the positive attributes of both while hedging
out the negative ones. A relatively new foray into such an approach of combining fundamentalmacro and systematic is in quantamental investing, at this stage practiced mainly in equity
Fundamental-macro investing at the core
The fundamental-macro approach, based on the insights of experienced investment managers, is
by nature, both forward-looking and deeply connected to the changing economic and financial
conditions affecting markets. This makes it particularly suitable to spotting dramatic changes in
market behaviour. Furthermore, expert fundamental-macro investing harvests risk premia while
hedging with risk-averse, defensive positions. This serves as the right antidote, therefore, to the
backward-looking traditional systematic approach that lacks in economic intuition.

In mitigating the over-engineering risk of systematic investing, the fundamental-macro approach,

again, comes to the rescue. It is generally parsimonious when it comes to the number of variables
and simple in terms of the interaction between analytical parts: it has to be, given the inability of
the human brain to effectively process such large volume and complexity of information.
Blending systematic investing with fundamental rationale
Unlike traditional systematic investing, a combination or quantamental approach can be put
together in a unique fashion so as not to require different types of models, thus eliminating the
need to make the capital allocation decision between them.
It is worth noting that the evolution proposed here is not the same as making divided allocations
between the two approaches of fundamental-macro and systematic investing. It is not also a
mishmash of the systematic and discretionary approaches, where the disciplined decision making
of the system is tampered with by discretionary considerations. Rather, the unique approach is
based on the expert combination of the rigour coming from systematic, and insights coming from
the fundamental-macro, where both approaches preserve their full integrity and effectiveness and
work as one in perfect synergy.
For example, imagine removing from systematic investing (i) excessive dependency on price
moves as a primary indicator of opportunity; or (ii) the tendency to readily exit from losing
positions to go to cash when relief may be available through non-correlated risk-averse assets in
the portfolio; or (iii) unconsciously foregoing the all-important portfolio balance and increasing
risk in the sole pursuit of market direction for gains.
To conclude, the outcome of the evolutionary process described above is a parsimonious and
adaptive model that is systematic-quantitative but predicated on solid fundamental-macro
thinking. Such an approach should reap the rewards in most environments and market cycles,
whilst softening tail risk in crisis periods and also deal effectively with unusual distortions as
those introduced by the recent aggressive monetary easing.

Aref Karim is founder, CEO and CIO of QCM, a systematic global macro manager with 20
years operating history