Greek philosopher Heraclitus once said, “Nothing endures but change.”
While he was probably correct, this is not a sentiment that managed futures & trading system investors typically want to see expressed by their managers and system developers. When it comes to CTAs & trading systems – change isn’t always for the better.
The classic example of how change can be bad is to imagine a trading model which risks $500 per trade being stopped out of a trade at the high of the day the day for exactly $500 before the market goes back in the direction of the trade. The developer of the model, having seen this, decides that was just too close to being a profitable trade – so he or she changes the model to risk $510 per trade (hardly a significant change). Next time, the trade is stopped out by just $535, so the developer pushes the risk out to $550, and then the next time a stop out of $625 – so a push out to $750, and so on and so on.
As you can see, potentially small changes can eventually add up to a much different look. In this example, the system has increased its risk by 50%, going from $500 to $750. If you have invested in the program based on a track record which shows results based on the $500 number – but are actually getting results in real time based on the $750 number – that is a problem as the risk is not represented in the track record.
It reminds us of a line from the television drama “West Wing”:
…. a friend who just got his pilot’s license.…told me the most remarkable thing. He said a new pilot will fly into cloud cover. There’ll be no visibility. And they’ll check their gauges, they’ll look at the artificial horizon, it’ll show them level, but they won’t trust it. So, they’ll make an adjustment and then another and another… He said the number of new pilots who fly out of clouds completely upside-down would knock you out….. You keep your eyes on the horizon, Mr. President.
Developers and managers must keep their eyes on the horizon, and make sure they aren’t turning their models upside down.
But sometimes you do have to make adjustments to avoid being turned upside down, and that is where good change comes in. What if a market’s volume dries up? Would you prefer to have your manager continue to trade that market in order to say they haven’t changed anything, or drop the market due to liquidity and volume concerns? What if a market switches the bulk of its trading to electronic trading versus the pit, creating a scenario where the hours in which to trade that market expand? Would you prefer to manager continue trading the old hours for the sake of staying true to the past, or adapt with the ever changing markets?
Good change, in our experience, is best defined as the natural evolution that occurs over time to help manage risk, add diversification, and react to static changes in markets (hours, where traded, etc.). Good change is reacting to a market’s new hours and adapting the models to work with those. Good change is considering a new market which can add diversification to the portfolio when its volume and liquidity meet valid levels.
Good change can also be seen in the research and implementation of new ideas within a portfolio. While again, managers shouldn’t be changing things just for the sake of change – it also doesn’t make sense for a manager to withhold a new idea which has been properly vetted and tested just for the sake of not changing.
Think of Apple, did they stick with the ultra successful iPod? No, they came up with a new idea, the iPhone. And then the iPad. We invest with managers not just for what they have done in the past (for their current model), but also for what their model can become in the future (for any iPhone and iPads just over the horizon).
Investors should realize that strategy evolution is a healthy, but it is important to stay on top of what changes are being made and understand why they are occurring. Investors can do this themselves, through constant communication with the managers and research into what possible effects changes to all of the various parameters which go into a managed futures program or trading system will have on future performance – or they can work with Attain, whose job is to be on top of such things and report back to clients.