Alexander Mende: Risk Managing the Risk Managers

Today’s conversation is with Alexander Mende, Senior Investment Analyst and Head of Investment Research at RPM Risk and Portfolio Management in Stockholm, Sweden. RPM is an alternative investment firm, focusing on directional investment strategies, specifically Managed Futures and Global Macro. Alex is responsible for portfolio management, quant and macro research, manager screening and selection at the firm.

We spend the first few minutes discussing the experience of living with COVID-19 in Sweden before moving onto the technical discussion. We explore the evolving role of managed futures and trend following both in terms of client expectations and how managers have adapted strategies to deal with the current macro-environment.

In contrast to many similar firms, RPM takes an active approach to manager risk exposure. Alex describes how the firm manages risk both “horizontally” – by changing relative manager allocations through time – and “vertically” – by scaling exposure to the overall portfolio in response to proprietary models.

Alex “opens the kimono” on two of RPM’s most useful indicator suites, the CoMaSe model designed to identify conditions that may lead to coordinated market selloffs; and the MDI model that measures the aggregate “trendiness” of market conditions. We walk through case studies to better understand how RPM uses the tools in practice and their potential value-add.

Alex is clearly a passionate, no-nonsense quant and it’s clear RPM thinks about the problem in a novel way, with commensurately attractive results.

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Dr. Alexander Mende
Senior Investment Analyst
RPM Risk & Portfolio Management AB

Alexander Mende is a Senior Investment Analyst at RPM Risk & Portfolio Management AB in Stockholm, Sweden, where his responsibilities include portfolio management, quant and macro research, manager screening and selection. Before joining RPM in 2005, Alexander studied economics at the Leibniz University Hannover, Germany, where he attained his diploma in 2001 and his doctorate (PhD) in 2004.

His research interests include foreign exchange trading, international finance, portfolio management, and alternative investments, in particular managed futures. His work can be found in journals such as the Journal of International Money and Finance, the Journal of Financial Markets, and International Finance. Before his academic career Alexander was a banker at the NORD/LB in Hannover, where he was born in 1972.

TRANSCRIPT
Adam:00:00:00Today, we’ve got Alex Mende. Alex where are you calling in from?

Alexander:00:00:06I’m calling in from Stockholm Sweden. I’m working for RPM Risk and Portfolio Management.

Adam:00:00:12Right. You spent the weekend in Germany. You also play for a band right?

Alexander:00:00:17I also play in the band. I was in Germany from last Tuesday until this Sunday.

Adam:00:00:21And you do that a lot. You travel back and forth and play some gigs. Do you play some gigs in Sweden too or only in Germany?

Alexander:00:00:28Yes. Pre-Corona I traveled a lot every month but now it’s more twice since then. Things have come down significantly.

Adam:00:00:37Are you noticing that things are starting to pick up again from a Corona standpoint or what is the situation there?

Alexander:00:00:47Well, there are no shows, live theater stuff like that in Sweden. We have like 50 people max target threshold. So any event above 50 people is not allowed and in Germany they have over the summer adjusted it to I think depending on what kind of event it is to 10 or 20% of the regular, the normal capacity. For example last Friday we played a show at a venue with like 400 people and they sold only 60 tickets and you have to buy the table like at CTA conferences or awards. So you had to buy tables for four people or eight people and only when you sit down at the table you’re allowed to take off your mask, otherwise you have to move around with a mask.

Adam:00:01:41Incredible. Do you find it changes the vibe at the performance?

Alexander:00:01:47Yes, totally I would say. But we’re not going to do it again I think.

Adam:00:01:51Really? That’s too bad. Things are really ramping up there again. So it’s not going to get better in the near term probably.

Alexander:00:01:59No. I think these emergencies temporary solutions they will be gone before the year end and they were going to be too strict. No like social distancing rules and no concerts, no football, no nothing.

Adam:00:02:16Again yeah. So you operate RPM out of Stockholm and that’s your full-time job. So tell me a little bit about RPM.

Backgrounder

Alexander:00:02:31What I know is that RPM started in ’93 and it is owned by our CEO and two other partners and since then we have been doing basically the same thing, we are a fund of funds but especially first of all we don’t invest in funds, we only invest in separately managed accounts. So we have full transparency and daily liquidity to all the investments that we make in our managers. Second thing is that we don’t invest across the whole alternative investment strategies universe, we only invest in strategies that trade futures and exchange trade options so basically your CTA strategy or systematic global liquid global macro kind of strategy. That’s the two main things to know about us, otherwise, we apply strategy balancing so we invest in not only in trend for the CTAs but across the whole spectrum but we have identified at this point four to five sub-strategies within the CTA space that we invest across and what I hear I don’t know, but what I hear is that what sets us apart from other people like Efficient or Epi for example is that we are quite active in managing the overall location to our managers horizontally in terms of allocating between managers and strategies but also vertically in terms of managing the overall trading level or the leverage if we see opportunities going forward or if we think the environment for CTAs is too risky.

Adam:00:04:13What are the…you mentioned four or five categories. So what are those categories and how do you define them?

Investment Categories and Allocation

Alexander:00:04:18The main category is trend following although I have to admit that this category has evolved significantly since 2008. So there’s something that we call hybrid trend following or trend following plus X because none of the new managers that started trading after 2010 is doing pure trend following these days. They’re adding something else to the mix, that’s why we call it trend plus X or hybrid trend falling. That’s the first category. Second category for us is short-term trading we call it, but that is technical which is not trend but we would call it directional technical trading. So contrarian strategies, mean reversion kind of strategies, that area. Third category is a systematic global macro or what we could call fundamental trading, so typical manager names there would be a QMS from the US or IPM from Sweden or ADG from London, these kind of managers. So global macro but in a systematic way. Fourth category which we started allocating to almost five years ago is VIX volatility trading and the managers that we find there can trade the strategy directly through VIX futures or options based, but neither they are exposed to volatility as a risk and reward factor. The last category which we just identified in the beginning of this year is what we could call systematic commodity trading which is typically your relative value calendar or inter-market spread kind of trading strategy. We’ve known some of the managers in that area for a long time, but as a group we have identified them first this year because it’s a retivalic … trading has always been a part of other strategies not earnest in the long basis.

Adam:00:06:24Right. How do you allocate between the different types of funds? Do you sort of you have them you group them up and then you allocate a certain amount of risk per group and is that relatively stable or is that dynamic through time?

Alexander:00:06:41Let me share this live with you over our investment process. I hope this works now. So this is our investment process here, you can see that I hope. Basically at RPM we have three decisions to make. One is which managers do we select or which accounts do we close, that’s decision number one. Second decision is how much weight do we want to put on each sub strategy as you can see this is quite an old slide we haven’t added VIX or commodity trading there yet. I need to talk to some guys here at RPM about that. Typically our weight to trend following would be 50% or higher the trend falling strategies and 50% or lower to all diversifying strategies combined and there we have a quite even distribution between the diversifying strategies. Third decision we can make here is as I said in the beginning adjust the vertical, the trading level of the overall portfolio so normally we move between 120% of long-term target risk to 80% of long-term target risk. That’s our fluctuation band so to speak. We take in on this slide two kinds of information sets, macro and market data like everybody else, but given that we all have separately managed accounts from our managers and we have quite an extensive database which in back almost 20 years we also make use of proprietary position data and strategy/sub strategy performance data and so forth and have built some indicators based on that that help us with our decision making. So, let me stop sharing the screen here.

Adam:00:08:35On the trend side, does a manager go into the trend style bucket by virtue of what they say they are or do you have some other sort of style analysis or returns based analysis that you’d conduct to ensure that they are mostly trend or complementing the trend sleeve?

Alexander:00:09:01Well, that’s part of the due diligence process I would divide into three stages. First one is monitoring where you basically you try to achieve…you think you know what’s going on in the universe, new managers the development of S&M management what strategies have performed well or bad. Second part is manager screening that is basically when we have a manager that we find interesting is on our watch list, we don’t have a medium long or short list. We call it watch list that’s always two to twelve managers on their pairs per sub strategy and until this stage I would you know basically go with what the managers say they’re doing, so I would take their word but once we get to the real investment due diligence or operation of due diligence process where we do the number crunching and check correlations performance crisis alpha characteristics and so forth, there I would check how much trend following that actually is, or that what the manager say.

Adam:00:10:08Do you try to balance the trend allocations along the trend term structure and across different specifications to trends? So sort of the time series momentum, the moving average crossovers, the breakout strategies, that kind of stuff. What’s the thinking around that?

Alexander:00:10:27The breakout stuff which has maybe a holding period of below 15 days we would actually put that in the shorter trading bucket because that can very much be a reversal kind of trading in the larger trend moves, otherwise in the trend following bucket itself we are diversified across trading horizons as well, so we have I would say the most long-term manager that we have only reallocates monthly, that is something that we find very unique among the trend fund managers and we have a manager that is very short term with a 20% trading horizon. So everything in between there and most of the managers also with multi-time horizon trading, we’re set up across time horizons I would say.

Adam:00:11:14So, the manager that trades, they trade monthly?

Alexander:00:11:19Well, they have a reallocation on a monthly basis but they have risk management of course on a daily basis if anything goes

Adam:00:11:24Interesting. And when they trade monthly is it the same day every month or do they trade like one twentieth of their portfolio every day?

Alexander:00:11:30Yes.

Adam:00:11:31Wow. Interesting.

Alexander:00:11:36We like unique managers, it can be unique good or unique bad but in the mix even unique bad can add value to the overall portfolio. As long as it’s something that contributes to keeping diversification within the portfolio high, that’s something that we like.

Adam:00:11:55One thing within the trend I’ve always been curious and I’ve chatted offline with Marat and some of the other people at Abby for example that run a fund of hedge funds or a fund of managed accounts for in the CTA space and I always wonder just how much diversity can you get from multiple managers in the trend space. There’s only so many ways to define trend and so many different time horizons for look back, shapes of the look back structure that you can use. We’ve done some decompositions for example, if you take everything from five days to 300 days time series momentum, moving average crossovers, double moving average crossovers, triple moving average crossovers, breakouts et cetera, and you examine the time series and you can do this with just like Brownian time series or with real-time series and what we find is that there’s really…You can decompose and capture 80 or 90% of the variance of the entire trend space with eight different trend specifications. I always wonder just how much extra diversity do you find you can get by adding an incremental trend manager.

Alexander:00:13:17Well, the best example is to look at real performance which I think is during this year’s Corona crisis and I think it was also the year 2019 when there was a big rather large dispersion across trend following on a yearly basis, and my view or our, RPM’s view on this is that there are so many degrees of freedom you can play with in your setup of the program that it makes the managers quite different from each other even if the underlying risk factor they’re trying to exploit, time series momentum is the same. For example just if you have fixed sector allocations or you have dynamic sector allocations it makes a huge difference. One trend follow manager we have doesn’t trade any commodities, is all another manager has actually by design almost 50% of the exposures commodities. So that makes a lot of difference and the same with the time horizons. You can have fixed time horizons, or you can have dynamic shifting of your models towards different time horizons and once you add what we call hybrid trend follow measures to the equation you can have all kinds of performance if you…for example- So example a measure that we were invested in until last year was John Street and they have one third of their trading is a relative value calendar commodity spread trading. That definitely gives a different profile to the other trend following managers.

Adam:00:14:51Got it. Out of the five…I think they were five sleeves. Let me go through them so there’s trend, short term, fundamental-

Alexander:00:14:59Fundamental, VIX, commodities. Yeah. Five.

Adam:00:15:01What was the fifth one then? That was four.

Alexander:00:15:04Systematic commodity.

Adam:00:15:05Systematic commodity. Out of the five sleeves I know like obviously trend has had a very difficult five years arguably, most trend has had a relatively difficult 10 years. Any strategies stand out over the last five or ten years that have made up for the challenges for trend?

The Challenges for Trend

Alexander:00:15:28Trying to generalize I would say short-term trading or which has not in absolute terms but in terms of portfolio protection has shown it’s worth during the VIX events 2018 and again this year, so that is a strategy that we are very happy with. On the other hand, the short-term trading universe is so diverse within itself, so many different kind of strategies during the…In the midst of the Corona crisis we had a manager up to 32%, another manager down 28 or something at the same volatility target, so that can be even more heterogeneous than the trend falling block.

Adam:00:16:15Yeah no doubt.

Alexander:00:16:17Otherwise in the VIX volatility trading space there is the most going on in terms of new managers and new interesting ideas, I would say not two managers I’ve met since the last three years are doing the same thing in the VIX volatility trading space. So that’s where really I feel there is currently the managed futures creativity hotspot so to speak.

Adam:00:16:49Got it. How are you observing that trend managers? What do you call them hybrid trend or trend X or hyper trend or something? What are they adding typically or what are some of the things that they’re adding to the mix? I guess they’re adding it because trend itself is just not quite reliable enough anymore on its own for a single manager to be able to generate the profit profile that will attract investors.

Alexander:00:17:20Generally, the whole idea of this hybrid trend following is the same as with the multi-strategy measures such as QMS for example or is to smooth overall performance. That’s the whole point. To overcome the drawbacks of a pure strategy. In terms of trend following, you can choose to either smooth your whipsaw losses during times where there are no trends or to try to counter to give back losses when there is a major reversal, and different hybrid trend following managers have chosen different paths so to speak. The managers that we have now I would say, one is trying to…there will be less down in February and more up in March because they are profiting from the reversal and another hybrid trend following manager will be less down during whipsaw periods like for example this summer.

Adam:00:18:21What are some of the other edges that they’re adding to the trend following sleeves to increase stability?

Alexander:00:18:31Through this kind of diversification within the trend following space there are in the gray zone for example between short-term trading what we call short-term trading and trend following and so we basically have this whole cascade of trading horizons that we cover. So if we think the markets are turning or our portfolio is vulnerable to reversals we will allocate more to the short-term trading and the hybrid trend following space and less to the standard trend following managers.

Adam:00:19:00Okay. So that speaks to your active role that RPM plays in the management of the portfolio. So, why don’t you go into that in more detail because I think that actually is a very unusual dimension of RPM’s business where you’re very active in allocating risk between managers and in managing overall portfolio risk?

Managing Portfolio Risk

Alexander:00:19:27I want to walk you through three trading examples which are all taken from the great Corona crisis because that’s the last major crisis and again a crisis where people ask “where is my crisis alpha”, typically and the first example is going to be more complicated. Therefore, I have to take a little detour and explain some of RPMs indicators that we use, and the other two examples are simple position management where we think something is out of the ordinary, not acceptable in terms of portfolio concentration risk or in terms of aggregate exposure. So, we have several indicators but one of the most important indicators that we use is the so-called coordinated market sell-off indicator and here in this graph what do I mean by coordinated and market sell-off, reversals are a regular characteristic of financial markets as they move along from one equilibrium to another, but what we call a coordinated market sell-off you might also call VIX or correlation spikes. We define the coordinated market sell-off as a day where RPM has a major down day so we lose more than two standard deviations and at the same time approximately one-fifth of all financial markets that we monitor also have a volatility spike of more than two standard deviations. It’s a real correlation and volatility spike that hurts our performance and we started noticing or started the research at the first sell of here China sell-off on February 27, 2007 if anyone remembers that one. Then we had the onset of the sub-prime crisis here and the quant sell-off in August 16th. Our indicator was up and running by mid-2008 protecting us a little bit from the oil sell-off of 2008 on July 17th and so forth.

Normally, these sell-offs or these spikes performance recovers quite quickly but we try to…If we can cushion our performance during these sell-off days or make it less hurt then we can add a lot of value on top of our portfolio. And the indicator itself is quite simple, we do a daily profit regression analysis and then we mix a lot of data with a lot of different data frequencies, so the monthly and weekly data doesn’t change on a daily basis obviously. So we have macro data in there like macroeconomic activity or central bank activity and the idea is the more the fundamental variables change, the less likely there is a coordinated market sell-off. Because when fundamentals change, then markets have to adapt to the new market environment and we will be moving to a new equilibrium. If there is no fundamental information then there is more room for speculative and fast money flows in and out which are more likely to occur during these volatility spikes. We also have market data in there, for example, we measure all the CFTC’s futures data, they have a categorization for commercial and non-commercial positions there and the non-commercial players in the futures markets normally are banks or hedge funds and it’s basically the same idea there. If there’s more speculative non-commercial money flowing around in the futures markets, then it’s more likely that we have these kind of sudden sell-offs than if all only Shell and Cargill are trading.

Adam:00:23:26How are you measuring that using the CFTC data for example?

Alexander:00:23:31Well, you can just download it from their server. The positioning and then you can net it out and then you have net position that’s back.

Adam:00:23:38Across many markets or-

Alexander:00:23:40All markets. All markets that are on the CFTC. Then we have daily proprietary data which we can only have due to our usage of managed accounts and there we have different kind of concentration risk measures, for example, measuring the correlation between our trend following bucket and our diversifying strategy bucket or, for example, measuring the similarity of positions between different trend following managers. Again, the idea is there, if everybody is doing the same thing, if short-term traders and VIX traders and trend follow managers are profiting all from the same sector or at the same time then we don’t have enough diversification as before so this is dangerous. We do this on a daily basis and we define a risk above 20 as high and the graph is the last five years here. So the orange is our daily out of sample estimate of a coordinated market sell-off risk and the vertical…I would call them pink lines are when we have actually seen these events, and as you can see we don’t get them all but we get some and we act on them. Normally we reduce our risk by 20% if we have high Coma C a risk above 20%.

Adam:00:25:06That is generally the threshold. So 20% in either direction. If I recall you can be 120% of risk?

Alexander:00:25:15No. The output from a probabilisation can only be between zero and one.

Adam:00:25:23I see okay. There is some model that you use to be able to increase your risk above 100 percent, right? But it must not be this indicator.

Alexander:00:25:34Thank you very much for doing the introduction to my next slide.

Adam:00:25:39Pleasure. This is what happens when you do your homework? You get ahead of the guest.

Alexander:00:25:44No problem. The other indicator that we use is called the market divergence indicator or index. It has been in use since the mid-90s in different versions. So it’s been updated regularly and extended and researched over and over again but in a nutshell it’s basically our way of measuring time series momentum across futures markets. Time series momentum is the term coined by Moscowitz in their seminal paper from 2012 and to set it apart from cross-sectional momentum. Basically what we do is we relate the daily absolute price changes to the underlying volatility and we do that for many different markets and across many different time horizons. So, we basically, for example, we have the absolute price change over a five day look back period, and then the underlying price fluctuation for these five days periods, we do that across all futures markets, and we go all the way to 250 days look back period. And as you can see when this indicator is moving up, then we have time series momentum in the marketplace, we have trends across different markets, we have trends across different time horizons. And as you can see in this graphic we have plotted there the sub … index that is normally when the CTA universe profits, when these time series momentum is increasing. What goes up must come down so once we have seen a trending environment, what to expect going forward is that these trends will reverse or disappear. That is not normally not a good environment for trend following managers and so we use this indicator, we call it vice versa.

So if this indicator is very low we see it as an opportunity so we normally consider increasing risk, something that we actually did now since August and if this indicator has reached a local maximum, a peak then we say this current trend period is over, we have to reduce risk and what normally happens is that this coordinated market selloff indicator and the MDI indicator signal a risky environment at the same time or around at the same time that would make us reduce risk significantly in the portfolio.
So this is our interactive website for our clients, we can see daily fact sheets and positions they can do all kinds of scenario analysis where we post our research but we also have a page for our indicators, for example, the coordinated mark itself indicator which we call Coma C and if I go back to February of this year you can see how it is picking up and you can see on February 12th that reaches the 20% threshold here. So on February 12th we decided to decrease risk across the portfolio by 10% but especially by reducing the allocation to trend following managers. That was maybe a week early but as I remember correctly this sell-off started on February 21st, because that was my birthday and I was at the carnival in Cologne.

Adam:00:29:19Your birthday is February 21st, my birthday is February 21st.

Alexander:00:29:20All right, cool.

Adam:00:29:26That is wild.

Alexander:00:29:27All right. So, that’s where we initially started reducing risk across the portfolio, now let me walk you to…here you have the MDI and let me take you back, I think it was mid-March, I think the 10th here, and you see in the second week of March 10th you can see a major spike in the MDI index here, the orange line just jumping up there was the fastest increase in time series momentum that we have on our records that was the week after Trump banned travel from the Europe and the equity markets just fell off a cliff. These two indicators made us reduce risk even more. So we had 80% target risk on trend following, was significantly below its long-term average levels and then we had the bounce back in late March obviously. But now let’s fast forward here to this index to mid-April. In the comments here you see we had two of these sell-offs obviously which were correctly forecasted and now you can see that the coordinate mark sell off risk has dropped down significantly below its 20% threshold. At the same time if we fast forward also to mid-April here you can see that also the times serious momentum indicated the MDI has come down to long-term average levels and sounding all clear both indicators. So we took back risk to normal levels officially on April 23rd. Over all this risk reduction, this tactical risk reduction had added 1.4% to overall performance. Otherwise our portfolio would have been down more than it actually was. That was quite a successful intervention by us I would say, and the same thing before VIXmageddon I think ,it’s called in February 2018 and so forth.

Adam:00:31:52Love it. I’m sure people are going to be curious where are we today with those indicators, are you able to share?

Alexander:00:31:59All right. Indicators.

Adam:00:32:03It’s a great tool. Did you build that internally or did you-?

Alexander:00:32:06Yeah of course. That’s before you got those solutions just to buy them.

Adam:00:32:11What did you build it in?

Alexander:00:32:12I think we have the first version of this 12 years ago, 15 years ago. Currently the MDI is at its long-term average just around one, has been ticking up this month, this month is positive across portfolios and almost also across managers here. So there are some trends but it’s not a major trend environment yet. Actually we believe we had a mail out two weeks ago, we believe that in election years normally. Okay rewind. Normally the best period for CTAs is the fourth quarter but it’s significantly different during election years. In election years you have all the trend environment that you see normally in October, November, December concentrating to after the election is over. So we expect trends in either direction to pick up significantly after November 3rd or some point at November.

Adam:00:33:17Okay. Now that makes sense.

Alexander:00:33:20Coordinated market sell-off risk here is ultra-low and that is because…you can’t see it here, but I can tell you is that we are very diversified across managers and sub advisors, we basically have no net US dollar exposure, we are long bonds but there are managers with significantly short bonds exposure as well. So it’s diversified away so to speak, the risk here, sell off risk.

Adam:00:33:52Got you. What else are you working on? Have you added any indicators in the last little while or have those been in place for many years and they are sufficient and you’re not really seeing any need for new ways to view markets given the changes in behavior?

Alexander:00:34:10Actually. Thank you for asking. Actually if you remember the coordinated market sell-off indicator picture which I just shared it shows you that we missed two sell-offs in October 2018.

Adam:00:34:23I did notice that.

Alexander:00:34:25All right. That triggered a reevaluation and an update of the indicator and we found a better input factor, we added a new input factor and basically we measure the portfolio’s US dollar bond position versus is its US dollar equity position.

Adam:00:34:51So when they’re both high, or how does that work?

Alexander:00:34:53Beingshort bonds and equities at the same time is not a good thing.

Adam:00:34:57When you’ve got high exposure to equities and bonds at the same time you say?

Alexander:00:35:02No. Short bonds and short stocks that’s not good.

Adam:00:35:05I see. I got you.

Alexander:00:35:07So that’s been added. It’s not added to our website but we run it internally and the indicator behaves very different from the existing one so we are still evaluating. The new one would have missed the February selloff, for example, but would have taken the one in October so we are thinking about a combination of the two but we are not there yet. We have to evaluate-

Adam:00:35:36Yeah. Well you want diversity of signals. Some of them are going to pick up on different types of coordinated market sell-off environments and others will pick up on different ones. That’s kind of ideal. What’s changed in terms of your manager identification and selection process over the years? Are you doing things the same way right now as you did five years ago or how do you think about identifying new managers? What are you looking for when you’re monitoring them for a while? What causes you to pull the trigger?

Selecting Managers

Alexander:00:36:08Well, we have to differentiate between pre and post Corona obviously. The monitoring process is still the same. We have on a weekly basis I get an email from our database telling me if there’s a new addition to the Barclay Hedge Database, that’s about the CDA database, that’s where most managers report to, and if there’s a new entry I normally read the trading strategy description, I normally do some rough correlation analysis and then I classify the manager by one of 20 sub-strategy categories that we have.

Adam:00:36:49Is that qualitative based on how they describe their strategy or are you running- I guess you don’t have much data.

Alexander:00:36:57No. But if you’re a trend following manager and you are down in certain months when everybody else goes up then something’s wrong obviously, but normally I go with a description there. But sometimes for example we have more categories there, for example, if a manager which I’ve never met is saying something, they’re doing something systematic in currencies, I don’t know if this is trend or total trading so they get the category systematic FX trader for example.

Adam:00:37:31Okay.

Alexander:00:37:32The second step that we do is we get a ranking on a monthly basis, the top 20 performing managers and 19 of the 20 we know have been invested in or are invested in or decided not to invest in for several reasons, but if there is a name that we have never heard of then obviously it’s my turn to pick up the phone and call that manager and get to know them and put them on a watch list. So that’s the second part of the monitoring process. And once we have the managers on the watch list we do the full diligence always in groups because we also…I forgot to mention the beginning, we focus on the smaller and younger managers so what we call evolving or emerging managers and our experience has shown that we cannot afford to do one due diligence process per manager, we always cluster them together in groups of four or five managers and then we do the whole due diligence process because those managers sometimes cannot deliver all the data that we need or not in the time that we need.

Once the watch list is filled up with let’s say five to eight names I make a presentation to the investment committee and we discuss each manager in length and, of course I have to have a conference call with them before and tell them about my experience with the manager or I’ve met them in person and then they decide the four names which to do the full due diligence on. Pre Corona there was always also conferences like the MFA or Alphametrics, a long time ago where you actually met people and sometimes you met managers that did not even show up in the database because they never, they have not started reporting or anything like that. These kind of events have totally stopped. It’s going to be hard for us to find new managers if they don’t start reporting. We have some contacts at our brokers, SubGen for example, or other cap intro teams that make suggestions to us because they know what we’re looking for but, I think we’re going to miss those conferences in the long run going forward.

Adam:00:39:54Yeah. Just to be able to be introduced to managers that are a little bit off the beaten path and not reporting to the typical databases and stuff. That makes sense. Obviously, what goes into the operational due diligence? You’ve got the basic boxes you’ve got to tick I guess, but then for the managers that tick all the general boxes in terms of operational integrity and approvals and multiple custodians and all of the operational and compliance things, what else are you looking for that differentiates a manager that says this is somebody that I want to look more closely at?

Alexander:00:40:35Well, that takes us back to the investment due diligence because we have two different processes. The operational due diligence is only to tick the boxes as you said, do reference calls. On-site visits, now we’re going to do Zoom or MST, on site visit obviously, verifying the track record stuff like that. That’s only to tick the boxes and we are as we only invest through our managed accounts we are, the operational risk is quite limited actually in the investments that we make. From the investment part what we are looking for in a manager is performance, diversification and uniqueness. That would be my three words in a nutshell. Obviously we want absolute performance but if you have a track record that has no down months then something’s wrong obviously so we have to understand where the performance comes from and we have to understand the weaknesses also, and that’s also why we only invest in systematic strategies because we want these strengths and weaknesses to be repeatable and reliable, so we as a allocator can add value on top of that.

Adam:00:41:47How do you overcome the issue of a manager who is truly do-? It’s a strange relationship because if…for much of our evolution, for example, we really were not doing anything that was really truly novel. Like you could look through our performance and see, they’ve got allocation to trends at these tenors and they’ve got allocation to carry and if you’ve got some more esoteric factors that you can perform some style analysis on you might also observe that we’ve got some skewness exposure or some seasonality that kind of stuff in there. But we were very open about it. You’ve been through our deck, you see we’re very open about what we’re doing but as you get into managers who are doing something different it’s a different kind of conversation, the manager doesn’t want to disclose and the performance itself is not enough to give you any real confidence and significance. How do you overcome that potential challenge?

Alexander:00:42:52Okay. Let me rephrase here. Uniqueness, for example, what you just described, we have over 100 manager contacts per year. What you described is pretty unique in the managing universe that we meet, the broadness of your approach is a unique factor in itself. So that puts you apart from other managers, multi-strat managers I have come across for example. It can be other factors for a trend following manager, can be, for example, a manager…I don’t know names here, but their first position is the strongest trend signal obviously, that’s the largest position but the second position is not the second strongest signal but the second position is the one that is most diversifying to the first one. It doesn’t have anything to do with any trend signals and hearing that makes total sense intuitively but why not of course?  Then this is basically cross-sectional hedging within your trend following system, doesn’t sound like rocket science to me but at the time when I met that manager that was over four or five years ago, that’s the first time I’ve ever heard that from a manager, describing it that clearly and that plainly. That was a unique factor for example. It doesn’t have to be any rocket science or anything like that, it’s just-

Adam:00:44:27But it’s different.

Alexander:00:44:28Yeah. It’s different.

Adam:00:44:31It’s sort of analogous, it’s sort of a heuristic way to maximize exposure to trend while also simultaneously maximizing diversification in the portfolio and not getting overly concentrated. I like it. I guess what I’m getting at is-

Alexander:00:44:47Can I make another example for example if you want?

Adam:00:44:48 Sure. Great.

Alexander:00:44:51Another long-term trend following manager has like okay, which basically we try not to get whipsawed, because that’s why we use long-term trend falling for entry signals. Fair enough. Heard that before. But at the same time we create some asymmetry for getting out, so there we have a 99 times 99 matrix over the different trading horizons and if this metric says more than 51% telling us to get out then we close the position. So basically they’re faster on the way out than they are on the way in.

Adam:00:45:24Nice.

Alexander:00:45:25Has its strengths, has its weaknesses but it’s definitely a unique setup.

Adam:00:45:30Got it. So you want them to have to be doing something a little bit different and then you’re observing the performance and this is always the tricky thing for me because, it’s easier to identify managers who are doing something wrong, but I think it’s much harder to identify or to distinguish between managers who are doing something different and managers who are just luckily exposed to some systematic risk that they’re not consciously aware of but that can change at any moment and render their strategy ineffective. This is the challenge with the returns based selection criteria and I’m just wondering what your thoughts are.

Alexander:00:46:30Well, we have managed accounts again. We have a real-time performance system here as well so we can…Well during the Corona crisis we checked every quarter but normally we check every maybe three times a day or something, we update the real-time performance so we see on a daily basis if what the managers are doing and what contracts they are profiting from and…of course we are not perfect and there’s nothing, there are no guarantees but if there’s anything out of the ordinary or if we observe a style drift or we are, we question why the manager has performed the way they have. We schedule a conference call, get an update or we do some re-analysis or in the most simple terms, if something seems off we just set the allocation to zero, that has happened this year three times actually already. Then it’s about intervening quickly to protect the whole portfolio.

Adam:00:47:30Yeah, right. I like it but I wasn’t really referring to that. I was more so just as you are deciding on managers to allocate to, you’re observing performance and as you’re observing performance if there are major outliers, now you’ve got reasons to ask questions, negative outliers pause both outliers I think are reasons to ask questions. But if you just have a manager that looks like it is performing well there are no major outliers, how do you think about distinguishing between skill and luck?

Alexander:00:48:10Well, we actually also have position data on a daily basis. So we actually react on that too if you have outliers there. I could give you an example-

Adam:00:48:20In terms of excess concentration or they’re only making money in one market really or that kind of stuff?

Alexander:00:48:27Yes. Then we would intervene as well. I can just…Do we have some time I share?

Adam:00:48:33Of course, please.

Alexander:00:48:35This graph is less complicated than it looks. So, that’s our position data for the different managers in one of our portfolios on March 25th and there you have the different sectors FX US, FXAsia, commodity managers, commodity softs and so forth. You have the overall risk measured in the red line there and it is always compared to the green line which is the long-term average sector exposure and what you can see there is that the risk in metals is sticking out and very much so. Then you have the columns there and this is how much the underlying managers contribute to the overall risk in each sector. It also helps you to see where you can find diversification or if the portfolio is very concentrated but on that day, the main thing that we were concerned with was that it is one manager who’s basically driving the overall metrics exposure.

Adam:00:49:50So did you inquire with that manager? Was that a cause to reach out?

Alexander:00:49:53There was of course a cause to reach out. There was also a cause to reduce the allocation. It was actually, the manager profited actually from that move. But from our from our risk management perspective from a manager of managers this allocation was prudent to reduce risk in this sector.

Adam:00:50:19Okay. So who’s a typical client of yours and what are they looking for?

Alexander:00:50:21That has changed dramatically since I started. When I started 15 years ago we basically did white labeling CTA solutions for Japanese clients for their structured products, could be banks or corporate pension funds, since this kind of investment vehicle has, due to the low interest rate environment, has not any, there’s no demand for that anymore. So since 2010, 2013 two different portfolios we’ve launched our own flagship funds where actually our name is on there. So the RPM Galaxy CTA Fund and the RPM Evolving CTA Fund and their clients are mostly from Europe, Sweden, German speaking Europe, Netherlands and there we have family offices, private banks. Here in Sweden also some corporate pension funds.

Adam:00:51:14What’s the difference between the two funds?

Alexander:00:51:20RPM Evolving is aiming at smaller younger managers, we find that these managers have possibly some outperformance but they’re even more diversified among themselves than mentors of different sub strategies if they are big, and Galaxy is a portfolio of big managers. So your typical CTA names.

Adam:00:51:39What are clients looking for? Have the needs of clients changed over the last little while? Has the COVID crisis changed people’s expectations or-

Alexander:00:51:51Well, that’s something that…We’re always happy if the CTA industry measure as the Barclay B Top 50 or the separate CTA is doing well because that means the whole industry is doing well and most of the money is unfortunately in the big names, otherwise they wouldn’t be the big names. But what we have noticed since at least the last three years is that the smaller managers significantly outperform the larger managers which basically means the people that are interested in our portfolio solutions are looking, they have already CTA allocations in Sweden, there are three names basically and they’re looking for something else to diversify from this one manager that has disappointed them in the last three or four sell-offs.

Emerging Managers

Adam:00:52:43What do you think it is about emerging managers that allow them to maybe generate a little bit more excess alpha?

Alexander:00:52:55Well, I would say 20% of the new managers are the future stars, there’s new tenant out there, they try new ideas which maybe if they had worked at I don’t know, AHL before they were all their research ideas going into this institutional process of approving or not approving and takes forever, they get frustrated, start their own shop. For example we were invested in ADG until they were up to one billion from 120 million until they had one billion. We were invested in John Street as I said when they had below 100 million actually until they now I have become too big. There are future stars or future big names out there that we are looking for. I don’t know if it’s virtual or coming with the fact that there’s only often two or three people running the show there is that their strategy are more pure. They’re exploiting more like one risk factor not trying to exploit all of them. So that can also be an advantage from a portfolio’s perspective. They run at a higher volatility which makes more sense from us combining we have currently 30 managers in the portfolio and we have a target volatility of 15% and it’s actually quite hard to get up to the target volatility if you have managers that are so diversified among themselves. So the good thing is if they have high incoming volatility and some of those managers that we have we would never invest on it’s own basis, given if you have 30% or more volatility, that’s nothing you want as an end investor so to speak.

Adam:00:54:43I was wondering if it maybe also is due to the fact that they can trade faster signals and they could trade in more frontier markets and less liquid markets, trade a little further out the term structure, they’re able to take advantage of things because they don’t need the same amount of liquidity that larger funds do.

Alexander:00:55:01That’s true for most larger managers versus smaller managers but not for all. For example a manager called Icem, they make a thing out of it to really be diversified and have really high commodity exposure and go to the what we would call niche commodity markets as well. So you have the big guys doing that as well. I can imagine that it is an advantage if you are in those markets and you are a smaller player that you don’t leave a footprint or so and that you can be faster in and out with less slippage and stuff like that.

Adam:00:55:34Excellent. Well look, we’re coming up on an hour and we covered a lot of ground, did I miss anything that you wanted to make sure that you had a chance to talk about?

Alexander:00:55:44No. I’m fine I think. I’m good, talked a lot.

Adam:00:55:49Now that was great. All right. I appreciate it you sharing your process and a little bit about RPM and I’m sure we’ll have a chance to connect on similar topics in the future. What time is it there now? Sort of you’re into the evening right? It’s quarter to five in the afternoon, it’s getting dark here.

Adam:00:56:08It’s time for a pint. All right well.

Alexander:00:56:12Well, it’s a Tuesday so no.  I’m gonna wait until Thursday.

Adam:00:56:17All right, got it. I wasn’t aware of your schedule but that sounds prudent. Well look, Alex thanks so much for sharing your insights and for spending some time with us this evening and I’m sure we’ll chat with you soon.

Alexander:00:56:30Yes. Thank you very much. Thank you for having me.

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