David Rudd, Senior Vice-President, Refco Futures
Professor Luis Seco, Associate Professor, Mathematics Department, University of Toronto
IMPORTANT RESEARCH: SKILL; INVESTING WITHOUT MARKET RISK
Chairman: Ann Curran, Third Vice-President, The Empire Club of Canada
Head Table Guests
Douglas Todgham, Vice-President, The Canadian Institute for Advanced Research and a Director, The Empire Club of Canada; Rev. Canon Paul Feheley, Rector, St. George's Anglican Church, Oshawa; Althar Kamal Malik, Grade 12 Student, Ursala Franklin Academy; Ken Shaw, National Editor, CFTO Television and a Director, The Empire Club of Canada; Daniel Han, Director, Canadian Society of Technical Analysts, Applications Specialist, Bridge Information Systems Canada Inc.; Nancy Fortner, Director, Human Resources, Bridge Information Systems Canada Inc.; Peter Gee, Director of Finance and Administration, Bridge Information Systems Canada Inc.; Dennis Slocum, Reporter, "Report on Business," The Globe and Mail; and Blake Goldring, CFA, President and COO, AGF Management Ltd. and a Director, The Empire Club of Canada.
Introduction by Ann Curran
In describing his experience on Wall Street during the stock market decline of 1973/74, Robert Rubin, the U.S. Treasury Secretary was recently quoted in the Wall Street Journal as saying: "The smart and shrewd lost a lot of money. Those that weren't smart and shrewd were wiped out." That is a direct quote from the man charged with preventing a global economic firestorm.
I am here to talk about how to insulate ourselves from market risk.
For those of you who don't know our firm, Refco Futures is probably the world's largest trader of futures for clients. By that I mean our trading is all for clients and we do not have a proprietary book. Globally, we act in a fiduciary capacity as an agent, helping hedgers reduce their risk and helping informed speculators trade for profit. We don't have significant retail penetration, but instead look to use our specific expertise to work with firms that do!
Futures have extraordinary price and credit integrity. At any time there may be 50,000 people watching and trading U.S. bond futures and 5,000 traders watching coffee futures. All of these people have an interest in price and they all can participate if they abide by the rules of futures.
Futures are open to everyone. Every trade is public and open to those who have an interest. This level playing field creates tremendous price liquidity and permits a very distinctive style of trading for profit in a highly creditworthy environment. Many of you may not know that The Bank of International Settlements (the bankers bank) considers futures THE most creditworthy investment vehicle.
With that as background, let's review recent events. World equity markets are down anywhere from 20 per cent to 80 per cent from their highs. Stocks which seemed to be "go-to stocks," Nortel, Newbridge, Newcourt, and the Banks are proving to be fair-weather friends.
When the chips are down, we realise we cannot count on any stock or any central banker to deliver returns. The market delivers. Any hint that global growth is threatened is death for equities, regardless of the skill of the trading manager.
So where does an investor go if he is concerned about exposure to economic growth?
The knowledgeable investor knows that the market does not owe anyone a retirement! I want to point out the importance of the year 2001. In 2001 the first baby boomers turn 55 and will begin retiring.
If the market does suffer a setback they may have run out of time to earn it back! Their exposure to the market personally and through their pension plan is simply stunning! History tells us the equity market will at sometime suffer a significant and lasting decline! In the last major decline, the equity market didn't take out its 1968 highs until 1984-85. If we look at the opportunity cost of money, equities didn't break even until 1994.
Earlier this year, Professor Seco of the Mathematics Department at the University of Toronto concluded that returns not correlated to the equity market can be obtained if we look at skill rather than markets. The daily demonstration of skill is the best assurance that returns come from the manager rather than the market.
For instance, a strategy which entails shorting U.S. Treasuries and buying out-of-favour debt does not demonstrate skill; it is a strategy. A bond fund that buys corporate debt is not a skill; it is a strategy. Owning commodities is not a skill; it is a strategy. Skill will generate a return regardless of whether the market goes up or down. A strategy will pummel the investor when market conditions change.
I want to urge everyone in this room to make it their business to learn more about a group called Commodity Trading Advisors (CTAs) who continue to make money, year in year out, regardless of the economy. These managers trade commodity futures in oil, wheat, French bonds, Japanese yen and many others for profit and make money when futures prices go up and when they go down.
Refco's Index of all CTAs is up 17 per cent for the year. Refco's Canadian Managed Futures Trust which embraces the methodology Prof. Seco will talk about has done significantly better than that since its launch in April. Our fund for Japanese investors which was launched six years ago has generated consistently positive returns while their stock market has lost 70 per cent of its value.
A major reason why profits are consistent is the non-correlated price action of commodity futures. This is seldom seen and its importance can not be overstated. Think of cocoa and U.S. Treasury bonds. Think of currencies and cattle. Do you see the non-correlation? I contrast that with the very concentrated bet on economic growth that equities imply.
Another reason why profits continue is the liquidity of futures. This means we can reverse or close a portfolio in one day with no price damage. An equity portfolio can take months to unwind. To give you an example, our
Canadian futures contract in Montreal has more liquidity than Microsoft! Do you see why participation might be less risky than many assume and why non-correlation can save a portfolio from harm?
As we all know, things are not always as they seem! Trading global commodities professionally for profit has a solid history of returns, but sounds iffy! Although bong hedge funds sounded safe, those who participated were recently traumatised as the hedge funds paid lip service to non-correlation. Many hedge funds bought cheap bonds and sold expensive bonds as a hedge. When Russia defaulted on its debt, the strategy collapsed and it became obvious most funds had essentially one correlated transaction. As prices went against them, the hedge funds continued to add to concentrated positions in illiquid securities, making their exposure worse!
I contrast the returns of hedge funds and the equity market with those of the Commodity Trading Advisors. August and September have been their two best months this year. The Refco Index of over 500 managers gained 13.8 per cent in those two months. Some of the more skilled managers did extraordinarily well.
These advisors in Professor Seco's study have no belief in the fundamentals. They use proprietary technical trading models to identify price trends and superior money management techniques to eliminate losers. They just want to participate in price movement up or down. They are not gods. They do not pretend to predict the future. They always play defence because they are often unsure of where trends will develop or when they will end. If price moves against them, they want out immediately!
The unparalleled liquidity of futures means that it's inexpensive to liquidate and re-establish positions. A long-term view in these markets is fatal as prices of debt, currencies and commodities all show an astounding tendency to retrace past-price history as price performs its traditional function of balancing supply and demand.
Because each of these managers can be in 60 or more non-correlated markets such as cocoa and the French franc and could be long or short, their returns are not hurt by systemic events like a debt default or a slowing economy. Recent history shows they probably will profit from it. I truly believe that an investor who wants to protect his portfolio should ensure returns come from these non-correlated sources.
I like to illustrate what we mean by skill with the story of the money manager who happened to meet Bill Gates, of Microsoft at a conference in the mid 1980s. Microsoft has been a huge part of his very successful investment portfolio ever since. His returns are top quartile and big money has flowed to him to manage. My question to you is: "Has he exhibited skill?" He has made one decision in 13 years. Can this manager make money regardless of the market and protect a portfolio from harm? The actual demonstration of skill is difficult!
When Refco looks at the performance of Commodity Trading Advisors, we want to see thousands of uncorrelated trades. We want to see how they maximised their profits and how they kept losses to a minimum. We want proof of skill in all markets. We know skill exists in these markets just as plainly as it exists in golf, hockey or chess. Once we are convinced this manager has skill, we want to see how we can combine the returns to reduce risk even further.
Earlier this year we presented Prof. Seco's research at a seminar sponsored by Federated Press. Our thesis was then as it is now that true skill will save a portfolio from significant damage. An important part of the presentation was the assertion that "No one is on the lookout for events which can truly damage a portfolio." Don't forget that an 80-per-cent decline means the investor needs a 500-per-cent gain to break even so the smart investor should want to cut losses quickly. Events at that seminar made us realise that it is up to the investors to protect themselves and the reason is the advisors don't get paid for performance; they get paid for relative performance.
If each of these Commodity Trading Advisors that we study can make money each year, is there a way to combine their skills to reduce risk even further? For example, can we combine the skills of trend--following managers with say shorter-term counter-trend traders to reduce or eliminate drawdowns when there are no price trends? If both styles make money or break even, we can combine the very best to generate consistent returns with low volatility.
About a year ago, we asked Risk Lab of the Mathematics Faculty of the University of Toronto to conduct a comprehensive review of the monthly returns of the more than 500 successful managers who use futures for profit. His comments and his study which he will share with you have helped and will help in the development of products with consistent returns and low volatility regardless of whether the Dow goes to 14,000 or 4,000.
You recall the quote from Robert Rubin earlier about how the smart and shrewd lost a lot of money in the downturn of 1973/74 and those who were not smart and shrewd were wiped out? There was a third option then and there is now!
All of us at Refco truly believe the strategy of using managed futures to generate a consistent return and insulate one from the risks of the market.
Finally, whether the stock market gains 20 per cent or loses 20 per cent is not the issue. The issue is we can reduce our large exposure to the equity market and generate a consistent return.
Professor Luis Seco
I wish to thank the Empire Club for the invitation to speak here. This is a privilege and an honour.
The University of Toronto has, for some time, been trying to bring its research component closer to the industrial community. I joined that mission in 1996, participating in the set up of a new group. That group would do research on topics of interest to the finance sector. We called it Risk Lab, and it is a joint initiative of the University of Toronto with Algorithmics Inc. The group consists of myself as academic director, Rafa Santander as industrial director, and a selected group of PhDs and graduate students.
In 1997, Refco approached us with an exciting question: to view investments from a skill perspective and, based on that, explore the risk/return profiles of skills portfolios.
We quickly set to work. The questions to be determined were the following:
1. How do we identify skill?
2. How do we measure its returns?
3. How do we assess its risk?
4. What do we gain from diversification strategies?
Skill. What is skill? It is well known that if we can get 100 monkeys making trades in a random fashion, the best two or so will show a fantastic performance. Do they have skill?
In the course of our study, we learned that Commodity Trading Advisors can be classified according to their trading styles or characteristics. Trend followers do that: follow trends. Short-trend followers extract value from frequent short-time trades. Etc. Is that skill? One could easily imagine the same population of monkeys, following the same "style," and still having the top 2 per cent showing remarkable returns. We needed to look at returns in an objective way.
Math comes to the rescue. Given a population--like the monkeys--it is possible to factor out all that "noise," look at the group as a whole, and decide whether there is indeed a group tendency. This is called an "index"--not unrelated to the DJIA or S and P, for instance. This has been well known since the beginning of the century, and is now a common technique used for a variety of purposes, from making marketing decisions for shoe companies to the prediction of the weather.
Well, guess what? The index for the monkeys is flat. Armed with this classical theory and with a software implementation of it, we prepared ourselves to analyse the population of CTAs inside each of those trading styles. The first thing to try out was return. If the indices showed a positive return, there would be skill. Otherwise, probably not. Returns were positive. And roughly comparable to average market returns.
Is that the end? Have we concluded that skill is there and is useful as an investment vehicle? No. Why? Because we still need to assess its risk.
Few people, specially lately, want to hear about investment returns unless the risk involved is within reasonable bounds. In fact, the question often asked is not so much the expected returns, but the return per unit of risk. Fortunately, having developed the concept of the index, measuring risk is a matter of a calculation. The results for each skill were reasonable--returns similar to those in the markets and similar risks. However, the interesting aspects of this arise when combining skills. A dramatic effect occurs when one applies usual portfolio theory to skills.
Markowitz obtained the Nobel price for economics for his understanding of risk, and his ability to measure that on an equal footing with returns. Since then, it is well known that proper combinations of uncorrelated investments can dramatically reduce the risk without affecting returns. This is a beautiful theory which is often underutilised, applying it to simple combinations of bond and equity instruments. One could take it much further if only one knew of larger families of uncorrelated investment products.
Skill provides exactly what is needed: Our study showed a large class of skill-based instruments with nice returns, regular risks and very low correlations. Should we try portfolio theory on that?
We did. The results were very attractive. Keeping the same returns, we saw the risks reduce considerably through proper diversification exercises. Returns per unit of risk were comparable to, or better than those observed in financial markets.
Note that the interest of the results is the alignment of three events: good returns, reasonable risks and low correlations. One can easily imagine investments that achieve one, or maybe even two of these properties at the same time. Finding one that satisfies all three is rare.
I will end with the conclusion which I consider to be important: Skill allows for investment vehicles that provide market-like risk/return profiles, but are market independent. While none can predict future returns, risk reduction through diversification policies is known to be a stable phenomenon.
The appreciation of the meeting was expressed by Daniel Han, Director, Canadian Society of Technical Analysts, Applications Specialist, Bridge Information Systems Canada Inc.