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One strategy for all seasons (including inflation) | Pro Club Bd

Investors around the world are focused on the likelihood that inflation will last a little longer than the “temporary” period suggests. As investors ponder what might be best for their portfolios in an inflationary regime, a venerable systematic strategy deserves scrutiny. Known as Discus and developed by Capital Fund Management (CFM), since its inception 30 years ago it has evolved into a remarkably sophisticated and difficult to replicate alpha-generating strategy. Inflation is among the myriad scenarios it evaluates with its models, which include nearly 200 predictors across asset classes.

Inflation is one of many things we try to anticipate,” says Yves Lemperiere, Head of Research, Alpha Strategies, at CFM. “We have many different ways of forecasting it – backward looking, forward looking, searching the web, using market products. The sheer breadth of data we look at in Discus makes it much more of an all-weather product than a standard trend follower.”

In addition to being resilient in different market regimes, Discus is far more nimble than a typical CTA. When it first hatched, Discus was essentially a trend-following strategy. Had it stayed that way, it would likely function like most CTAs, taking a long or short position across an entire sector. But Discus transformed. Despite its roots, it has greatly reduced its reliance on trending models. Rather than being overly directional, Discus involves relative value in significant measure.

“Because our predictors and portfolio construction are fairly specific, we can take a relative value position. For example, within each sector, we moderate the net long position on a short basis using relative value with two indices,” says Lemperiere.

According to Lemperiere, what this could look like in concrete terms can be seen in market-neutral equity strategies that compare indices with each other. “The CAC 40 [French] and DAX40 [German] may correlate, but clearly CAC minus DAX is something fairly new. This is a model that takes advantage of the difference between two countries, focuses on the idiosyncrasies of the two countries, and hedges against other similar stocks. It could be Europe vs USA, it could be anything. Because we have such a wide range of predictors, and some predictors focus on relative value components, it turns out that about 30% of our risk is due to relative value modes. And to play relative value requires much larger positions to take some risk than if you are fully directional.”

Decorrelation at the heart of Discus

In challenging environments such as those driven by inflation, investors are becoming more aware of over-correlation within strategies and across their portfolios. When Discus came out 30 years ago, global stock indices were not overly correlated. However, the coupling between markets in different countries strengthened from the 1990s, peaking in 2008 with the global financial crisis, until by and large most economies and interest rates converged.

Combine the large number of models and predictors in Discus, and the vast amount of data that feeds what Lemperiere affectionately calls “the beast,” and you’re working with a low-correlation recipe.

“When we say that Discus provides strong decorrelation, it’s not just talk,” says Lemperiere. “Not only does it have a low correlation between traditional risk premia and the major asset classes – i.e. bonds, indices, etc. – it also has a relatively low correlation with trend-following strategies. And we are also decorrelated in the tail. Many investors are long stocks and really want to know how we perform when the market falls. So we did several case studies and it turned out that Discus has a very low correlation. It shows slightly positive performance during extremely negative events in the market. Overall, they are only slightly correlated with the trend.”

There’s a lot under the hood of Discus. The constant focus on making sure the strategy is more dynamically adaptive than any other creates a mix of technicals and fundamentals that might be a little off-putting to some investors — but for the same reasons, it’s a portfolio differentiator, says Lemperiere.

Yves Lemperiere

Vigilance around cost efficiency

Discus – and all strategies at CFM – are built on three pillars: Research, Technology Implementation and Trade Execution. Minimizing transaction costs is becoming increasingly important not only for investors, but also for the success of investment strategies.

“We put a lot of effort into research because you can find wonderful alpha, but you can blow it up in execution,” says Lemperiere. “Transaction costs can noticeably change the performance of a program, especially for something like Discus, which is a faster, mid-frequency program with a hold period of around 20 to 25 days. We have a team of researchers dedicated to implementing algorithms to execute orders and then analyzing the results to help us model transaction costs.”

The process described by Lemperiere has led to a better understanding of how the trades themselves affect transaction costs. “For large trades, not only are you paying your fraction of the spread, you are also increasing the price when you buy. The more you buy, the more the price goes up and the higher your average price will be. We call that impact and we spent a lot of time modeling it.”

Similarly, the knock-on effects of the effects described by Lemperiere have both permanent and transient qualities, the latter of which will return once buying stops and the price is no longer depressed. “Execution cost modeling is an important part of portfolio construction at CFM,” he says. “We can do it because we understand the costs and have invested a lot of time studying it. We model everything we can. For example, when you trade one asset, it affects another asset. We call this cross impact. Transaction cost modeling is very complex – in short, it’s naïve to say it’s a quarter or a half of the spread. If you want to follow a trading strategy with relatively high or medium frequency, you need a more sophisticated model.”

research driven

A big part of the success of Discus – which recently won the bid The Hedge Fund Journal CTA Performance Award for Best Risk-Adjusted Returns over 5 Years in the Systematic Short-Term Traders Category – Can be attributed to the research team and process at CFM. Autonomy is widespread. When a researcher stumbles upon a topic they find interesting, or stumbles across a time series or data product that might prove useful, they are given time to follow their instincts.

In the complex and highly nuanced strategies of Discus, conducting the supporting research and ensuring the data is available at the right time every day is no easy task. The CFM research team consists of three peer groups: a predictor team, a portfolio construction team, and an execution team.

“It’s important that we maintain a relaxed and collaborative culture,” says Lemperiere. “We want the team to interact and challenge each other, point out possible mistakes and find solutions together.”

Lemperiere says the next big turning point for Discus is alternative dates – not that they’re entirely new to the strategy.

“What has changed is the coverage we get from alternative data providers,” he says. “Five or six years ago, we realized that the data quality on futures was not as high as we would have liked. It took a few years to find the right data suppliers – this is not low hanging fruit. Today the quality has greatly improved. I am sure that brokers will also recognize this and reposition themselves as data providers. You have data catalogs with operational insights, analyst reports and so on.

“It takes some skill to get value out of it,” he continues. “Discus is well positioned to be very additive.”


Disclaimer

Any description or information relating to the investment process or allocations is provided for illustrative purposes only. There can be no assurance that these statements are or will be in any way accurate or complete. All figures are unaudited. This article does not constitute an offer or an invitation to subscribe for securities or interest.

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