Imagine if your assets under management went from $721 million to $50 million….

Would you have the courage to stick with your system?

Our next guest was able to weather that storm and come out even stronger. In fact, he gives credit to the fall in assets because it was an important component to improving their processes and efficiency today.

We’re excite to share with you, the second part of my interview with CEO of Systematic Alpha Management, Peter Kambolin.

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EXCEPTIONAL RESOURCE: Find Out How to Build a Safer & Better Performing Portfolio using this FREE NEW Portfolio Builder Tool

In This Episode, You’ll Learn:

• How many markets Peter trades and the number of different spreads
• The three points during a day in which volatility is elevated
• What triggers an exit from a trade when profit levels haven’t been reached
• How Systematic Alpha Management makes decisions relating to sizing market positions
• The number of daily trades Systematic Alpha implements
• How much of the P/L comes from the hedge component of spread decisions
• What kind of Risk Budgets that Systematic Alpha Management runs
• How to drawdown profile has changed over the last few years
• Estimating and predicting Black Swan events
• How Peter personally balances the challenging feelings of managing a portfolio in drawdown
• Exploring mean reversion and how the hedge ratios change daily
• On the value of being located in the heart of New York
• The biggest challenge for Peter in running Systematic Alpha Management
• Peter’s opinion on why success in the CTA industry has shifted from the United States of America to Europe
• Why individuality is critical in success in the CTA industry
• Peter Kambilin’s biggest failure and what he learned from it
• Some fun facts about Peter that you probably would never have guessed

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Follow Niels on Twitter, LinkedIn, YouTube or via the TTU website.

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Send your questions to info@toptradersunplugged.com

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Niels

Fascinating. Tell me Peter, how many markets do you trade all together, and how many combinations of spreads to you have in your portfolio?

Peter

Yes, well, we trade approximately 20 to 25 different markets that include major global equity indices, major currencies, and we just use three commodities for hedging. We trade about 20 to 30 different spread combinations, but each spread we trade in a variety of different sub markets up to maybe 20 actually. What that means is that, let's say you have a spread that fluctuates - goes up and down, etcetera. We apply different logic, different rules when we place trades, because we don't know... the sign wave that a spread could experience, moving up and down, is not always the same. The amplitude of the move would be different, the time it takes could be different, etcetera, so, we have models that on average would hold positions, say 3 hours. Some other models will have holding times of say 10 hours, and others will hold somewhat longer.

We try to exploit short term mean-reverting moves in the spreads and longer term mean-reverting moves in the spreads, all within a day and a half, two days. What's interesting is that by diversifying our holding time, the returns that are generated they are often uncorrelated to one another. So, let's say we could be trading S&P, FTSE, and British pounds spread and hold for 3 hours, and it will have almost zero percent correlation to the same spread that actually is the same, but which we would trade using a different holding time model. So this is one way to diversify.

Niels

Excellent. Now, from what you have explained, it appears to me, at least, that part of the way you are getting out of a trade is based on your target being reached or the spread coming back to the expected level. But you also talk about the average holding periods of 3 hours, or 6 hours, so on and so forth, what triggers the exit, if you haven't reached your profit level and you haven't been stopped out? Is there a time exit?

Peter

We don't have a time stop. Imagine a moving average, or mean of the spread and you can... if you're lookback window for the moving average is long, that moving average will be changing very slowly, every minute, but if your lookback window is very short - let's say it's 1 hour, or 3 hours, it will be moving with the spread very rapidly, so if the spread goes up the moving average will go up as well. So our so called fast models, the ones that hold only 3 hours on average, they have a very short lookback window for estimating the mean or moving average of the spread, which means if the spread goes up and there's a small reversal, it will touch the trigger point. That's how it's done. So we don't have a particular time stop. We tested that idea and it doesn't work as well as trying to come up with a different moving average lookback window to estimate your fair value of the spread itself.

Niels

Sure. Now, staying just again with the trade and the model and so on and so forth, I wanted to ask you about how do you size your position, how do you work out how much to put on in terms of these signals?

Peter

The way it works is from the top to bottom. We know our overall assets under management. We also know what is the maximum exposure we would like to have if, let's say, all the models hit the trade in the same direction. This is our...some target that we have that we will not reach. That defines how much risk we would like to trade overall. Then we'll look at three geographical regions, I mentioned before we trade Asian to US, Europe against US, and US against US, or Canada as part of North America, so we would break our risk among the three geographical regions, and that is done based on historical returns, our expectation of returns, the quality of the returns, and for historical reasons I would say 55% to 70% has been allocated to European spreads, anywhere from 0% to 10% to Asia, and the balance is North America. Once we determine that, and that review is done roughly every 3 months, we assign individual risk level to each country that would trade within a particular zone. Let's say in Europe we currently trade UK, Switzerland, France, Germany and EuroStoxx50, so 5 markets. Risk is assigned to each one, maximum risk again. Depending on our historical P&L, our back tests and various other tools that we use, and then within each country we have a number of different signal spreads, as I described before - there could be up to 20 to 30 for each country, and then risk and longs - these individual signals is allocated using an optimizer that we use that looks at 1 minute real return of these spreads for the last 4 or 5 years and it tries to assign more risk towards those models that, not only produce the best returns, but also that are uncorrelated to the other models in the same type of portfolio within same country. So we do not have even risk allocation, to answer the question, we have certain preferences in terms of the geographical zones, in terms of the particular countries. For historical reasons we like US, UK spreads the most because they are the most stable and the most highly correlated. And then within each country, we allocate risk based on our optimizer that we have built proprietarily.

Niels

How many trades do you end up doing in a day on average, with all these models?

Peter

Yes, so out of 200 signals maybe, depending on the volatility, on average we would have maybe 20 trades a day. Most of the models actually stay in cash, so what that means is that, if say S&P and FTSE are fairly priced in relation to one another, and they are moving exactly or more or less the same up and down, there's no opportunity for us to trade at all. We'll just stay out. We will not have any positions at all while we could be detecting a lot of positions or trades, let's say in Swiss SMI, the Swiss frank, S&P trade, so if you look at our portfolio, day after day, it's not stable, it's changing all the time. We are not invested in all these markets all the time. We are arbitrageurs, so if we detect a mispricing we will come in and provide liquidity.

Niels

Sure. And you gave a good example before where you had the FTSE, the S&P, and then you had the currency side to things, which you mentioned was kind of a hedge component. Is there always this hedge component in the models, and if so, when you look at the P&L over all, how much of the P&L of return stream actually comes from the hedge component of the spread, if I can put it that way?

Peter

When we look at the P&L, we look at the P&L for the full spread, we do not try to understand, or we don't care if the P&L came from the equity market or the currency market. For example, we could be losing on the currency leg, but that currency leg will generate extra return via the index leg, so we don't dissect the returns coming from all three legs of the spread. We'll look at the spread itself.

Niels

OK. In terms of open risk, I mean, I don't know whether it's possible to give an indication, but if you operate stops on all your positions, which is my understanding, can you say something to the point about what is kind of the daily open risk budget, because you might used valued risk, I don't know, as kind of something that you look at, but my experience is that valued risk works great until the point where it doesn't work, and it usually is when the markets get very volatile and there's a crisis. So can you talk about how much open risk, meaning if everything got stopped out in a day, what kind of risk budget do you run?

Peter

Niels

Sure, sure. Now I wanted to shift gears a little bit by staying on the point about risk. I want to touch upon drawdowns, because perhaps a lot of people are not aware of it, but CTAs in particular spend most of their time in some kind of a drawdown, and probably only 20% of the time reaching new equity highs, so I wanted to understand a little bit about the drawdowns that you've seen, that you've experienced, what you've learned from them, I know you mentioned earlier that you made some changes after one of the drawdowns, and what you've learned from them? And also, whether you thing the drawdown profile of the program has changed with the changing of the environment that we've seen in the last few years?

Peter

Niels

Sure, sure.

Peter

Niels

Yeah, absolutely, and the re-leveraging, going back to normal leverage, is that also a fully automated process, or do you have to have a little bit of a role in setting the leverage, because you said that you are looking for some improvements?

Peter

I would say it's more art than science. We would look at which countries, which spreads are behaving back to normal, which ones are generating positive returns, and we would re-leverage those first, and then if we see a recovery across the board, we would put risk back to all the models. It's very difficult to fully systematize it, although we try to use as much data, as much tests and allowances as we possibly can.

Niels

Peter

Niels

Peter

Niels

Definitely, definitely, and obviously part of your insight, part of the reason why you have this strong belief in the strategy is down to research, and research is actually the next thing I wanted to touch upon. Now research is an interesting thing because investors, they want managers to continue to innovate, but they don't want managers to change, so how do you balance these two things, and how does research really work inside your firm?

Peter

We're doing something that very few managers, I believe are doing, we are estimating our parameters, not necessarily on in-sample data, but we try to use walk-forward out-of-sample tests, and scenarios to test how robust our parameters are. The biggest criticism of quants is that they tend to over optimize their parameters that will look excellent on paper, and then they start trading it and the return is very different. So in order to avoid that we are using different tools that we developed in house here to make sure that our parameters that we choose are not just some over picked results, they are based on a lot more fundamental reasons why this should continue working.

So this is the main area for us, to make sure that the models are robust, to make sure that mean reverting statistical tests that we do are still looking good, and we'll look at each country individually. We'll look at how these mean reversion tests change over time, for example for the full say 10 year history, or the last three years, or the last 6 months, and what we ideally want to see, we want to see no deterioration in the mean reversion tests, because for us mean reversion is the key to the game, and that's what we've seen. If we are seeing some signs that things are changing, that's when we would potentially deleverage our allocation to a particular country. That's why these once in two, three months rebalancing our risk is so important, because once in awhile we have to intervene and make certain adjustments.

Niels

Now I'm certainly no expert in mean reversion as a strategy, so help me understand, how quickly can these kind of relationships change, and how easy is it to...or difficult is it to realize that something has changed which is a little bit more structural or fundamental, however you put it, than just something that has gone a little bit differently for a short period of time?

Peter

Well, when we estimate hedge ratios. Again I think I mentioned this before. We have a certain lookback window. If the hedge ratios...and by the way, we are recalculating hedge ratios daily...if the hedge ratios are changing rapidly in a certain direction, that means that markets are no longer correlating, or break down in the relationship between the two. So on one hand, by estimating hedge ratios daily and adjusting them we are making sure that we are trading the most recent relationships between the markets, on one hand. but on the other hand, it could be an indication for us to move away from that market all together. I'll give you an example: for a long time we traded NIKKEI, Japanese yen, S&P relationship. It was one of our best relationships in the first 10 years of our existence. Over the last almost 2 years now, we noticed that correlation to NIKKEI and the rest of the world really disappeared after the new economic policies were introduced in Japan. So, instead of waiting to lose money before we cut the risk, we actually did it before that happened. We noticed that correlations were weakening, the spreads are no longer stable, or another way to explain it, hedging NIKKEI with S&P no longer works. We stopped trading that relationship, although, overall it produced, before that we had strong returns for us. So on one hand we try to be dynamic in how we hedge as we trade, based on the most recent relationships, on the other hand if these changes are too strong we will ultimately cut the risk and stop trading.

Niels

Sure, and just one question to that example that you just mentioned, now clearly you would have noticed in the data that the relationship between the NEIKAI and the S&P was changing, but in order for you to stop trading that relationship, do you have to go and look for the fundamental reason why it stopped working, and in this case looking at economics as the cause?

Peter

Often we would look at the data first, and then we would try to explain to ourselves looking at the fundamental analysis. It's rarely the other way around, because it's often the mental analysis that tells you one thing, but data is continuing to tell you something totally different, we would believe the data, we would not believe the fundamental analysis. So data is number one, and then of course we would try to explain it to ourselves, what's the meaning of all of this, but we trust the data first.

Niels

Yeah, yeah, now just looking on the business side of things. Clearly you and your partner are crucial to this, but do you consider yourself as a firm to have a key manned risk, or is it all so automated, that actually, to a large degree the company could continue without one or both of you?

Peter

I would say for six months or so you wouldn't notice a change if either one of us disappears (laugh), but ultimately clients have liquidity, our clients have weekly liquidity, managed accounts have daily liquidity, so they can very easily take their money away from us. Yeah, everything is automated, everything has certain systems in check, how to do the research, how to do the marketing, etc. so longer term, of course, you will feel an impact, but not in the first three to six months.

Niels

Now, what's interesting...I wouldn't say it's becoming the norm, but certainly a lot of managers have chosen to set up their business a little bit outside the financial hubs, but you are right there, you're located in the middle of New York. Do you think being right in the center of the financial world helps you in any way, or does it not really matter where you would be going to the office every day.

Peter

I think it helps. It's easier for clients to come see us when they are in New York. We do have a lot of meetings in the office. Plus the overall energy of the city, the competitive spirit, you work harder every day. Our lease, for example expires in May of next year, and we plan to stay in New York although it will be cheaper to go to Jersey for example, where we do have, actually, a secondary office as a backup facility, but I believe staying in New York is very important.

Niels

I think I may know the answer to the next question, but I want to ask it anyway because I think, again, it's important for people to better understand, and that's really the challenges that you face as a business owner and as a manager, and what would you say the biggest challenge has been in the last 10, 14 years for you and how did you overcome that?

Peter

Well, the biggest challenge is, I would say, to first convince clients that what we are doing is very, very beneficial to their portfolios, and it's quite upsetting to see them leave sometimes, after a drawdown because if they believe in the story, if they believe in the long track record, and they believe in our uncorrelated properties, they should expect us to have sometimes negative months when there are other managers doing fine. So what we've noticed is that they like the uncorrelated property of your program when you make them money and everyone else is losing money, but when everyone else is making money and you're flat to negative, all of a sudden they don't like it any more. I guess it's human nature, but we highly, highly appreciate those investors that are in for the long haul, and we hope that in the future we will get more of those managers, especially given the fact that we have 10 years of audited track record in the fund, I think smart institutional investors will recognize it and will have a better understanding of our turns going forward.

Niels

Yeah, I think on that note, which is quite interesting. I think, as an industry, maybe we haven't been good enough at explaining to investors why they should invest with us, because it's been the same argument that has been used, and clearly they're not strong enough because we know that money has been flowing out, and I think actually today, in our conversation, what you've done so far is quite important because in my experience, at least, a lot of people, a lot of managers are very good at explaining how they make money and what they do, but they never really explain why they do it. I think that's actually one of the challenges for the CTA industry is to become better at explaining the why. I think if people understand why you do things, and agree with them, they are more likely to stay through the good times and the bad times because they have something that they truly understand as to why people do what they do. But anyway, that's just my own observation. I wanted to ask you a slightly different question and that is, this industry started as a very US dominated industry and certainly most of the famous managers 10, 15 years ago were predominately based in the US. It seems to me that the last 10 years European managers have actually created much bigger firms than many of the US legends have. Do you have any observation as to why the European managers have become more favored, or have been able to grow their businesses much better than US based managers?

Peter

Niels

(laugh) Sure, sure, now I've got a couple of more questions in this section and then I wanted just to go on to the final area of my questions, but I wanted to ask you firstly: you know the CTA industry well, I accept that you do things in a different space compared to many other CTAs, but if you were going to ask a question of my next guest here at Top Traders Unplugged, about their strategy, or their firm, what would you ask them?

Peter

Niels

Sure, true. Now I also wanted to ask you another question, which I think is really, really important, and that is you've been in hundreds of due diligence meetings, and you've probably had as many conference calls and so on and so forth with investors and potential investors answering thousands of questions, but I want to ask you, what is the question, in your mind that investors should ask you, but they never do? And this is in a sense to help them better understand your strategy, is there something they're missing, because part of why we're having this conversation today is trying to ask different questions than the typical questions that you get.

Peter

Even investors are too focused and too concerned about so called headline risk. If they invest with Blue Chips they know that if they lose money with Blue Chips then no one will say a word because, well, a big firm lost their money...no...things happen. If they lose money with a smaller manager it could be a problem, because people around them might say, well, why did you allocate to this manager, and why did you lose money with that manager? So I think investors should first be concerned about how liquid that investment is. Are they controlling the money? Let's say it's a managed account, they clearly control the money. They invest via the platform, let's say at Deutsche Bank, they clearly are safe. Even if they invest in the offshore fund, or a domestic fund, if the third parties involved in this fund are very reputable institutions like KPMG the auditor, or SS&C the administrator, and the custodians are Bank of America and Wells Fargo and Newedge, clearly they have very limited risk in term of some kind of fraud or ability to get their money back. So they should not be, I believe (it's my opinion) as concerned about the so called reputational risk, they should be more concerned about how to build their portfolios and partially the reason the fund of funds business model failed is because unfortunately the managers that were running the fund of funds, they were not building the right portfolios. They were either too much concentrated on similar means that have 60% or 70% correlation to one another, or for other reasons. If they were doing a good job, if they were really building portfolios that would stand difficult periods for different managers. I think the whole concept is a good concept, just it was not applied properly. I would say if investors are convinced that their money is safe, they should be more concentrated and concerned about the particular strategy and how it performs and how it adds to their portfolio rather than looking at some potential headline risk that might never be realized. At the end of the day they could be suffering in terms of the real returns for their investors, that's a pity I believe.

Niels

Sure, sure. Now the final section that I have is something I call general and fun, so a little bit outside the norm and not specifically related to a model or trading program, but I just want to ask you a couple of things that might be useful for people to understand, and one of the things I wanted to ask you is just for the benefit of people who are listening to this and hoping to become the next Systematic Alpha, and that is what does it take to become a great trader or great CTA in your opinion?

Peter

I think you have to have an edge of some sort. In our case we are occupying a certain niche - a certain trading model that we believe is sustainable, but I'm sure there could be other interesting niche ideas that are not exploited at the moment. So for new people that are entering this area, if you have the right idea, and if you believe that you are better at that idea than others, and you work extremely hard, ultimately you will become successful. The road is not easy, by any means, but if you are different from others that's the only way I believe to succeed.

Niels

Sure, sure, and since, as I said in the very beginning, this is also about getting to know you as a person to the people listening, so I wanted to ask you a sort of different question, and that is, do you have any sort of personal habits that you think have helped you become successful in this business over the years?

Peter

Well just try to keep my head clear. As I said before, Alexei and I have very different skills. I do not have quantitative skills at all, even though I talked about our research and other things, but I'm scratching the surface, Alexei is the real quant. My biggest strength is, I mentioned it, so called common sense trying to understand what is good what is not good, what makes sense, what doesn't make sense, and sometimes I am involved in our research process by simply directing our research where to look at, or what kind of ideas to possibly exploit. I personally cannot back test them myself. I don't have the skills, but I have this ability to see things and to challenge certain things that we do and to pinpoint some other areas that we could be overlooking or should improve. This is my contribution to the research.

Niels

Sure, sure, and as a business person, if we look at it that way, but also as an entrepreneur, which is obviously a part of the journey you have been through, what do you think has been your biggest failure? I know we talk a lot about successes and people celebrate that, but often failures are the ones where we learn the most. If you look back on your path, what would you say was the biggest failure and what would you have done differently today?

Peter

Niels

Absolutely, and in order to end on a high note, my last question to you where I've had some interesting answers, let's put it that way, from other guests, I wanted to ask if you could tell me a funny fact, or a fun fact about yourself that most people don't know about you? And I can reveal that some people have told me that they have been in movies, or they do impersonations, so it's been very varied, but if there's something out there where you say, "this is something that most people wouldn't know about me." Is there anything that you can share?

Peter

Niels

(laugh) That's for our next pod cast. Peter, I wanted to, before we finish, I wanted to ask if you could tell the listeners what's the best place to reach out to you and learn more about your firm and, of course, the new offering that you are coming out with in terms of the UCITS fund?

Peter

Niels

Sure, fantastic, Peter. Thanks ever so much for your time today, and also thanks for I think a great conversation. I really appreciate that you've been very open and willing to share your insights and your views on the evolution of your firm and your strategy as well as the industry as a whole. I think that is so important, so I appreciate that and I hope that our listeners will find a way to thank you as well, whether it is social media, or by contacting you directly, and of course the listeners can find a lot of details about our discussion today in the show notes, on the website TOPTRADERSUNPLUGGED.COM and I hope we can connect at a later date and see where you are in all the great work that you do.

Peter

Sounds excellent, thank you.

Niels

Thank you so much, take care Peter.

Ending

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