Setting the record straight on systematic investing

May 3, 2023 | Education

After the challenging start to the year for global equities and bonds, investors are rightly re-evaluating their asset allocations. As global interest rates rise in response to significant levels of inflation, sophisticated investors are considering an updated opportunity set for the best inflation hedge strategies available. Alternative investments such as systematic trading rightly form part of this conversation, yet are often met with a number of outdated and ill-informed misconceptions. In this short piece we attempt to refute some of these myths to help investors make a more balanced appraisal of their portfolio.

Successfully targeting levels of volatility

Systematic strategies are often all incorrectly labelled as highly volatile. In fact, the level of standard deviation – a common measure of volatility – is typically the starting point for most systematic managers. Exposures in their strategies are sized to target a particular level of volatility, something they have historically been successful at doing. Sophisticated investors understand how beneficial volatility targeting can be when constructing their own portfolio and as a result have been demanding lower and lower volatility classes, driving down the historical standard deviation of systematic managers over time. Even so, the rolling volatility of systematic managers has been significantly lower than global equities – a mainstay of most traditional portfolios, particularly during times of market stress. Figures 1 and 2 below demonstrate precisely these two points [1].

A strong focus on downside risk

The riskiness of a strategy can be considered in many different ways, beyond simply the level of volatility it generates. Drawdown is another useful metric that measures the historical cumulative losses from ‘peak-to-trough’. This captures the potential for downside risk, important when one considers the investment horizon of an actively managed asset. As shown in Figures 3 and 4 [2], systematic managers historically experience shallower drawdowns than global equities. There are a number of reasons for this, but it cannot be denied that a strong focus on risk mitigation (including additional risk overlays such as limit orders) and deliberately investing into highly liquid underlying assets are helpful contributing factors.

Designed and built by human researchers

There is also a degree of confusion over the level of human involvement in systematic strategies. Some less familiar with the sector are often unaware of how trading decisions are actually made. In fact, strategies must be designed and built somehow, often by entire teams of researchers. In practice, this means creating the rules and specifying in detail the decisions that the strategy should make, given market movements. In which case, this can only ever be implemented by human researchers. These processes are not designed to replace humans, merely assist them to trade as efficiently as possible, across a wide number of markets and in speed if need be, without falling into the traps of cognitive bias associated with discretionary trading.

Clearly identifiable strategy

This is closely related to the misconception that systematic strategies are black boxes and it cannot be explained what they are doing. In reality, not only can most systematic strategies be clearly explained, they can also actually identify the specific trading opportunity they are targeting. For example, systematic trend-followers are studying markets to look for the time series momentum premia, based upon the observed phenomenon that prices tend to exhibit ‘trends’ over time. Managers might also target several different premia at once across multiple asset classes. This level of sophistication also often extends to performance reporting, where systematic managers can attribute profit and loss to individual factors. This helps to contextualise performance and demonstrate whether a strategy is delivering (or not) on its objective.

Liquid markets with implicit leverage

Finally, how systematic managers implement leverage into their trading strategies is commonly misunderstood. To begin with, they prioritise highly liquid underlying investments in markets that have the infrastructure to trade electronically, like futures or CFDs. Both of which trade with implicit leverage in the form of notional funding. This means that managers only need to post a margin in order to gain access to the full value of a contract. This is similar to buying a house where you only put down a deposit and if the property increases in value, you have access to the entire change in price, after accounting for fees. However, unlike buying a house, futures and CFDs are highly liquid and therefore one can exit a position quickly if need be.

It therefore makes little sense to judge how risky most systematic managers are by calculating the notional value of all their positions in isolation. Instead, one should take a more holistic view and try to understand how managers are positioning their strategies to deliver on volatility targets yet minimise drawdowns. After all, this is typically the starting point for most systematic managers.

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[1] Global equities are represented by the MSCI AC World Index and systematic strategies by the BarclayHedge BTOP 50 for the period January 2000 – July 2022 inclusive. Source: Bloomberg.

[2] Global equities are represented by the MSCI AC World Index and systematic strategies by the BarclayHedge BTOP 50 for the period January 2000 – July 2022 inclusive. Source: Bloomberg.