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Quant convictions

Published in Automated Trader Magazine Issue 38 Autumn 2015

Gernot Heitzinger is CEO at SMN, a CTA based in Vienna, Austria, operating for some 19 years. Heitzinger tells AT about his quant convictions, diversification in the current market environment, and why he's cynical about forecasts.

Gernot Heitzinger, CEO, SMN

Gernot Heitzinger, CEO, SMN

Automated Trader: How did you arrive at SMN?

Gernot Heitzinger: I started my career in equity trading and discretionary equity fund management. After some years as chief investment officer in an Austrian pension fund, I took over a continental European management role at US asset management company Invesco before I joined SMN in 2004.

I always had a strong conviction about quantitative approaches to asset management and I always had my doubts about the ability of forecasting financial markets and economic events, therefore this is a perfect fit.

AT: Doubts?

GH: Forecasting markets in a consistent way is impossible unless somebody has the ability to foresee the future and the future actions of all market participants. Analysts even have difficulties to explain the present market environment.

If you look at this summer's market turmoil, most experts blame the China story, actually, the Chinese bubble burst already in June following a crazy upswing where everybody could foresee the consequences.

Of course nobody will ever be able to find the right timing in such markets. But was it really the China story that affected global markets? What if the reason for markets finally coming down was just the fact that - apart from falling interest rates - there hasn't been a fundamental reason for them to go up over the last years? Actually it does not really matter what actually triggered the downturn.

In German language we have a saying: 'Do news influence markets or do markets make the news?' Market prices are already discounting expectations of market participants. Market cycles are always cycles of greed and fear, of market psychology, which I think we can perfectly grab with the technical trend following models we use. They are not asking why do prices move, or if an asset is overvalued or undervalued, which is always on a relative basis.

AT: Can you tell about your investment philosophy?

GH: All our strategies are focused on medium to long term trend following with risk management as an integrated part of the trading system. We do believe in the benefit of diversification. In the SMN Diversified Futures Fund we are trading 200+ markets in 10 different sectors (Bills, Bonds, FX, Equity Indices, Metals, Energy, Meats, Crops, Soft Commodities and Synthetic Markets), in the Equity Fund the universe is 2400+ single stocks and we rarely hold below 200 stocks simultaneously in the fund.

The average holding period of our models is roughly 100 days, but position size is changing considerably during this period, depending on volatility, correlations and risk regime.

Price chart of SMN Diversified Futures Fund Source SMN

Price chart of SMN Diversified Futures Fund - Source SMN

Our position size is dependent on our technical systems. If a system detects a trend in a market (long or short), this market will be allocated according to its individual risk budget. If all our systems show the same kind of signal, the market is allocated according to its maximum risk budget. This maximum risk budget is dependent on volatility, correlations and risk regime.

The higher the shorter term volatility of a market, the lower your exposures will be to keep the risk budget constant on a risk-weighted or volatility-weighted level.

Our proprietary risk management tools, SMN Risk Index and SMN Correlation Overlay are highly valuable inputs to our investment process. We have developed these purely quantitative tools completely in-house. We do calculate our own risk index - knowing that there are many similar indices offered on the market - because we are less dependent on outside data and we better understand the ingredients of the index.

This risk index is one import factor to individual position sizing. If the index is risk on, it might add some points to the risk budget of markets that are systematically perceived as 'risk on' markets. The correlation overlay constantly measures the correlation of the overall positioning of the fund, which avoids clustering of risks to one single trade. It takes out risk from positions that are highly correlated to each other.

The correlation between our SMN Diversified Futures Fund strategy and equities was almost zero since inception. In addition the correlation of our fund to all the big names in the managed futures space has traditionally been relatively low.

At the moment, we are in the final stage of launching a fixed-income-only futures strategy as a diversifier for traditional fixed income portfolios in the current market environment.

AT: What kind of tech do you rely on?

GH: Technology-wise our strategies are not too demanding. Of course it helps that processing times have decreased over the years, especially in the context of the equity strategy with its large investment universe. Being a medium to long term manager, we are not depending on tick data for example and technology does not play the biggest part, we are trading each market several times a year, not a day or a minute.

Of course we need a lot of programming in our research process. Our trading software has been originally based on our Trading Bloxx software which we have customised to our own needs. We have developed our proprietary administration software by our in-house programmers. This was done in C#.

The investment universe of our equity strategy consists of 2,400 stocks and has changed considerably in the past according to index constituents. During the research process we often need to backtest certain ideas over 15+ years. This can be challenging and time consuming but in the end you can still run that on a nice normal PC.

AT: CTAs have had a very bad time, and then picked up a bit. How has it been for you?

GH: A CTA in the US, AQR, did a very interesting study. They did a backtest of all the markets that were around 100 years ago - of course, there were no futures markets but there were bond markets, etc.

They found that there was always a trending environment that was better over the last 100 years, than in the four years that we saw between 2009 and 2014.

Sometimes it can take a while until good trends emerge, as it has been the case between 2009 and 2013, nevertheless this could be compensated by great trends in 2014.

Our best year was 2008 where we had 58% rate of return. We had a very good year in 2014, 57% return based on our target volatility of 20%. Largest drawdown between 2009 and 2013 was 37%.

All we need is trends in markets. Especially in the current environment this will prove as an asset as we are not depending on a further rise in asset prices or a further decline in interest rates. As one of a few asset classes we can also benefit from an opposite scenario, like a deflationary one.

I am convinced that there will always be trends as long as markets are driven by human market participants.

But even if you put psychology aside there are more and more reasons to explain the existence of trends - like risk budgeting, VaR-based models, political cycles. Given the current market environment it will be more and more difficult to detect asset classes that can really show absolute returns.

During the years from 2009 - with the help from governments and central banks - it was too easy to achieve good risk-adjusted returns. These days will be over sooner or later. This will also give some tailwind to the CTA strategy as it will be more important to add uncorrelated strategies to any portfolio.

With the achievement of our AIFM (Alternative Investment Fund Manager) licence we have started to reach out to investors all over Europe and we see the first positive reactions.

AT: Are there any regulations keeping you up at night? Like AIFMD?

GH: All assets traded by us are very liquid, our funds are always in a Luxembourg fund structure, which always had an independent custodian. Most of the topics that came into play because of AIFMD, we already had in place. So we never had these problems with regulation. And the advantage is a Europe-wide legal framework, which, for a company that has a relatively small home market, is a definite advantage.

Regulations that concern us are sudden market interventions like short selling bans or transaction taxes which might cause problems for trading oriented long/short managers.

Other things are workarounds to UCITS (Undertakings for Collective Investments in Transferable Securities). If I am not allowed in a UCITS environment to use commodities, why should I be allowed to use commodities in a swap construction?

We would love to have that the regulation should make sure that there are no work around at all. So, if I trade my commodities exposure somewhere at the 'creepy' end, which is then owned by an SPV (special purpose vehicle), and the SPV is part of the UCITS fund - I am not sure that this is getting less risk to the investor.

And it's of course a lot more costly because you have to meet some kind of workaround features that don't diminish risk but just add a lot of counterparty risk.

These rules that just look at legal formalities rather than inherent risk is something we look at with a bit of concern. Apart from that, running liquid straightforward strategies, we are not afraid of further aggravations there.

AT: What have been some of the major surprises?

GH: I would not have expected, after 2008, that just through monetary policy, you could really blow the whole debt inflated balloon up again and again.

I could imagine central banks intervening, but what I would not have imagined is their power. That they could really drive not only the interest rates down, but drive equity prices up that far. That without resolving the fundamental problems that we have in our economy, we are getting lower and lower growth, it was possible to have such an equity rally.

Fortunately we do not face too many surprises as we don't make forecasts. Which takes us back to the start of our conversation.