Our next guest worked for the European Commission before starting his own firm. In an unusual career twist, he sold his company to a larger firm only to buy it back from them a few years later and had to start from scratch. Learn about his aversion to risk, his short term trading strategies, and his interesting past as one of the fastest readers in the world.

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In This Episode, You’ll Learn:

• About Luc’s time working for the treasuring of the European Commission starting in 1985.
• How he learned about Options trading before many people were doing.
• About his years working for Bankers Trust in London and Morgan Stanley as a trader and how those experiences influenced his career later.
• How he started Analytic Investment Management (AIM), doing options trading.
• How he acquired his first clients.
• Why he got started trading currencies.
• About the early days of trading and the physically demanding work before computers took over.
• How his attendance at conferences, getting invited to speak on panels, and other speaking engagement led to the sale of his company.
• About the selling of AIM to Trobico in 2006 and why trobico bought his firm.
• How he ended up buying his company back from Trobico in 2010 after management changes caused them to shut down everything in the alternative investment space.
• About the different products that Capital Hedge provides.
• How he had to start from scratch, getting all new investments after buying his firm back.
• Where he is now – advising $200 Million US dollars, mainly in his DPI program.
• How he is one of the fasted readers in the world, and how he learned to speed-read from a class he took in the Netherlands.
• How he convinces institutional investors that a 2-3 person company is enough to manage the investments they have, and how technology has changed the game from needing a staff of 25 to needing just 2.
• How small managers need to describe what they do, and why they might not want a multibillion-under-management hedge fund.
• How investors should look at a track record of a firm and why that doesn’t necessarily mean good returns in the future.
• Why investors should see the latest test of what the firm is currently running rather than worry too much about the historic model results.
• How Luc trades and develops his systems, and how he looks for patters in the market.
• How to avoid model decay and avoid the risk when the model will stop working in the future.

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Resources & Links Mentioned in this Episode:

• Learn about the European Commission.
• More about Bankers Trust.

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

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Niels

Luc, thank you so much for being with us today, I really appreciate your time.

Luc

Thank you, Niels, it's a pleasure being with you here.

Niels

Great stuff. Now as I was preparing for our conversation I noticed a few interesting things that I'm sure we'll have a chance to discuss today, but I'll give you some of my initial observations.

Luc

OK.

Niels

You can hear that I am excited about all the possibly topics that we can talk about today, but of course before we go into all of those details and where you are today, I really would like for you to take us all the way back to the beginning and tell us your story and what led you to take this path in life. Feel free to go back as far as you want really, Luc.

Luc

Of course, at a certain point in time, the person who was in charge of the treasury - the treasurer of the European Commission - he said, well, could we not get a little bit more return out of this and still keep the level of risk, which, of course, is a very tough thing to do. The big advantage of working for such an institution is that we had the luxury of being provided with an immense amount of ideas, and ideas that came from the investment banks. The reason was pretty straight forward: being a very important client to them - I think at one point in time we were, after the World Bank, the biggest issuer of Euro bonds on the globe, so we had a lot of contacts with the issuing banks, with elite managers from banking syndicates, and so on. So we got a lot of trading ideas from the Goldman Sachs, the Morgan Stanley’s, the Deutsche Banks of this world, but also from Japanese banks, from the French banks, and everyone wanted to do business with us because of this very big and large treasury - over 2 billion. We, of course, were obliged to write some serious tickets. If we did like 5 million transactions, it would mean nothing on the portfolio. So these were very substantial tickets, and, as a result, all the banks were eager and keen to do trading with us.

In order to get our attention, they would try to present some of their latest, most novel trading ideas. More and more these things turned out to be oriented towards the so call derivatives world, which was trying to extract some more value, trying to limit the risks, but still get away with the decent returns, slightly above market and so on. I became more or less interested in these ideas which had to do with swaps, which had to do with options, with futures: so the typical derivative instruments of those days. Of course, when my colleagues and people that I had to report to said, why should we do that, and why do you think it's a good idea? Of course, it is important that you can clearly demonstrate and clarify why this idea of doing a certain trade makes a lot of sense. So what you have to do in order to convince people in the trading world, if someone says I'm interested in a trading idea, but how do I know if this works? How do I know if this is indeed a very good risk-adjusted return proposition? Then, of course, you have to deliver some kind of proof and actually demonstrate that this is the good way to go and that is how you can determine the maximum amount of risk and so on. So basically it boils down to that you have to provide them with substantial research that actually can help in convincing them that this is the way to go and that this is the way you need to treat these kinds of investment puzzles.

Niels

Do you remember what kind of ideas that you had back then, and also how you would go about testing them, because obviously you didn't have the same technology as we have today?

Luc

Exactly. So it was, in those days, mostly a question of trying to quantify it: put it into a model type spreadsheet where we are saying, let's do a scenario analysis. If this and this happens, what could go wrong? What would we end up with? This is more like options with different outcomes where we would say, well, if you do this transaction, and we sell, for example, an option on this bond, what could happen? Well, we could be called away. We will be receiving some premium. What is this going to do compare to doing nothing and just keeping the bonds in the portfolio as we are currently doing? Basically trying to convince them that it is a way of shifting the return and the risk equation slightly away from the traditional buy and hold, and what would be the advantage of doing that.

Niels

If I may interrupt you here and just ask where had you learned about options? Where did that come from?

Luc

That's a good point. Actually options, I learned it at University. I took some econometrics classes in statistics, and one of my professors at Brussels University was quite interested in derivative instruments, futures, swaps, options. Back in those days in Europe, the options markets were not that developed yet with one big exception the European options exchange, which was in Amsterdam. They were very keen in doing different things with portfolios, with employing options either to leverage certain positions or to, of course, limit the risks. So that's how I learned, and I followed a couple of courses, read some books, and that's how my interest got peaked. I think it's also a nice way to combine the pure economics, the financial side with the more quantitative mathematical or statistical combination. So you end up with something which is pretty neatly described, where you can say, well, if you do this, if you do that, we can have a pretty accurate idea of what can go wrong and what we can expect to make. That's where options, of course, fit in perfectly.

Niels

Sure, sure.

Luc

Actually, in that period of time that I started to learn more about it, the options market was still relatively underdeveloped, I should say. As you remember, only in the early 70s they started with the CBOE, they started with... Black Scrolls came out, so it's 10, 15 years after the very start. Options were something very new. For some people, it was not very known. It was considered maybe a dangerous animal, for some people, to stay away from. That's one more reason to do a lot of research to find out potential hiccups if you start trading such an instrument.

Niels

What did your colleagues feel when you presented that kind of evidence? Were they jumping up and down, even at that time, saying this is great Luc let's do it, or were they skeptical?

Luc

No. It was rather the skeptical approach first, when they said well, how can we be sure? Are there no errors in the spreadsheet? How do we know they are going to deliver on the contract if we sell out these options, and we receive the premium, but what will happen if there's an event? So they were in the beginning a little bit skeptical, and then we decided to give it a try with a small portion of the portfolio. As we saw, gradually that this was working out well, we did more and more of these trades.

Niels

And it was basically - I say basically, but it was in the realm of selling out of the money options, essentially.

Luc

Yes, exactly. So the equivalent of what we call now-a-days covered call writing, married put combinations, so that you have an underlying instrument - let's assume you have the bond, and then you buy a put to protect the price from falling, or you have the bond and you sell some call options against it to get some more income. So a very basic option trading strategy in those days.

Niels

So you did that for a period of time. What led you to then start thinking about, hmmm maybe I should do this on my own?

Luc

Niels

How long did you stay with them before you...?

Luc

For a couple of years. In the early 90s I then sent up my company AIM, Analytic Investment Management, which was doing a very similar thing as what I had been doing earlier at Morgan Stanley and Banker's Trust, which was actually developing trading systems using derivatives, and of course, that's where my interest in short term trading started to develop.

Niels

So the options side obviously continued. The short term trading, was that directional short term models that you were thinking out at that time?

Luc

Actually the two, because the short term trading was actually was one of my main interests, so it had become one of my main interests of research for the simple reason that I found out that if I want to test something out; if a certain strategy or approach works, I should try to see how it has done in the past. Let's look at the last couple of weeks, the last couple of months and even if I had a trading system, which would only trade now and then; let's say 10, 12, 15 times a year, I would have to go back in time quite a long period, so I wouldn't be able to collect a lot of data to validate if the assumption that this trading program is a good one would be good or bad.

I ended up trying to shorten the timeframe and actually improve and increase the number of trades that were generated by the trading system so that I could have a better idea, a better feel for how this trading approach, this method works if we test it out and we see hundreds if not thousands of trades over the last so many years. Then of course it becomes obvious that as soon as you have a very big sample, a very big data set of trades that you have done in the past and that you have back tested at that point in the past you can see, well these are the weak point of the strategy. Here we go in a different market environment, and that is obviously where this strategy has a good time, or flourishes and this is a more difficult environment for this trading approach. So we can get a better idea of what works and especially when it doesn't work - for what reasons it doesn't work.

Niels

Luc

Niels

So no currencies at this time?

Luc

I didn't know a lot about the FOREX market. I traded some currency futures and some currency options, but nothing on the inter-bank market, which was a totally different world. It was very much a world of being informed. Knowing where the flows are, where the stops are, what big tickets were being basically shuffled at what prices, so it was really getting some market insight, which was really concentrated at the very big banks. So as an outside trader, I think it's a pretty difficult thing to do to do some longer term directional trading in the FOREX. So this client said, why don't you look into the possibility of converting your current system into a currency system. In other words, let's try and apply the same algorithms, the same programs, the same techniques and see to what extent they would work in terms of trading in the dollar against the Deutsche mark, the dollar against the French franc, the pound sterling against the Deutsche mark, and the yen against the dollar, these kind of main currencies which were extremely liquid comparable to today's liquidity on Euro/dollar and dollar/yen. Of course, you would have the big advantage of having never an issue in term of being able to get in and get out at a very decent price. There would always be a market and people would make your market for 5 million dollars at all times, so it's never an issue, and as we didn't trade a huge size, it would be a very different story than trading, or scalping S&Ps and trying to get away with 100 lots when the daily volume was something like a thousand times bigger. It is a much different environment trading the FOREX market compared to, of course, the futures pit.

Niels

Before we dive into all of the details, I want to just finish the story of AIM, what happened, you got bought up by Robeco and then so on, and so forth. So if we can finish that story, then we'll dive into more details as well.

Luc

Niels

How big was AIM at the time?

Luc

Well, we managed about 250 million, which was sizable, but not too big and there is a very good reason that it never got too big and never stayed too small because there is some kind of a sweet spot for the strategies that we trade, which of course we can cover later on. But Robeco was also smart enough, I think, to say, well, we're not going to focus on these companies which are already several billion dollars, because it would be a very expensive price for them to pay, nor would they invest in really tiny boutique firms with say 3 million dollars under management. You should be able to provide a decent track record. I think that they had a criteria that you had to have at least 10 years of track record, at least 100 million under management, but not more than 500 million or something. So a good balance of not being a start-up derivatives firm, but not having grown to a multi-billion company, because then it would be too expensive for them.

Niels

I'm a bit curious here to take us back to that time. How big did you think, and in your discussions with Robeco, how big did you think AIM could become in terms of capacity? I'm assuming that they buy you because they think you can grow.

Luc

They were looking, actually, for alternative companies or people with would deliver some alpha, would deliver something using different instruments, different techniques than the traditional. So that was one reason - so it's diversification reason for them. Then, of course, definitely they would buy it only if they think if they take stake in that company and ultimately acquire it completely and totally that they can grow the business. They recognize the fact that this relatively tiny boutique firm, which has less than 500 million under management under all cases, and in our case it was 250 million, with their name and support behind it, and their sales and marketing organization behind it, they would probably be able to make it grow significantly.

Niels

Sure, but you mentioned that there was... this is why I was asking before - you mentioned that there was a sweet spot for your strategy in size, and I'm just curious what you thought that sweet spot was at the time?

Luc

Well, we made various estimate of course, and the numbers always came back, and actually what was an even better estimate was the estimates from the clients, because some of the clients were really quite good at comparing. They were in a better spot or better position to see what we were doing compared to what other people were doing, and they could say, well, if these guys continue to do this, they will probably start to run into trouble if they would grow this big. So what we got as feedback from the clients, and what we thought ourselves was always a number between say 250 and 800 million, but capping out definitely at 1 billion, with the then current strategies. Obviously the idea was that if we would grow we would probably hire some more people. We would maybe expand into other areas -maybe into equities; maybe into bonds, something that we didn't do, instead of just limiting ourselves to mainly FOREX and futures and options trading. For the then current portfolio of systems that we were trading, probably we could do it times 3, maybe times 4. That was probably the idea.

Niels

Exactly. They had a five year option to buy the rest, but what happened?

Luc

Niels

Was it difficult to agree upon a price to buy it back?

Luc

It was. It was very difficult. It took us about a year. So I think it was a good thing for both of us that we then could focus again on what we wanted to do which was actually research and trading. Bottom line is we are more a research company than a pure trading firm. Trading is nearly like a byproduct of what we do in terms of research. So it was a good thing, and it was good working together with them for these five years, but then at the same time, when they're orientation and objectives changed, so it was also good for us to go back to the original configuration.

Niels

Luc

Niels

Luc

Niels

Yeah, sure. How much of the assets could you keep, when you then started your current firm?

Luc

We started back from scratch. That was the drawback of that. But then again we had the intellectual property which be basically required and acquired again, so it was a question of prospecting again and showing to the world that what you were doing before was very similar to what you were going to do in the near future.

Niels

Was that a difficult process, at the time to raise enough money to start trading again?

Luc

It was. It was not easy because, OK, when you are used to trading to a certain size and there have been days that we have been, especially in terms of trading; we have had very big trading days. I remember trading this when we traded over 1 billion in a single day, which was on the currency markets not huge, but still, for us as a relatively small firm, was a significant amount. Now if you didn't have to scale back down and say, well let's do 1 million here, and 2 million there instead of 5 million and 10 million, it is different, and it has an impact on the trading as well. Then again, we knew a lot of people on the institutional side. We never had a lot of marketing in the private investors world, so we had a very strict focus on large institution clients and so the story was, and I think it's still pretty convincing and returns have been pretty steady and that is actually what institutional investors prefer most of all: this recurrence in the return stream, this steadiness, and what we call robustness of the program.

Niels

Without naming names, what kind of investors did you get on board to begin with? Who bought into the story and the comeback of you as an independent manager?

Luc

In the very beginning, it was mainly what we call now-a-days family offices. So bigger family offices and some pension funds. So pension funds which we went to see, and told the story, and had experience with back in the day from Bankers Trust and Morgan Stanley, and were familiar with the derivatives trading that I have done there. They were interested in the concept and mainly people from Switzerland, where there was a little bit more... I should say they were more exposed and more advanced in terms of using hedge funds, using derivatives compared to say the average bank in Belgium or in France, which has less exposure to derivative instruments.

Niels

Luc

Definitely there was not a good environment for CTA strategies to be marketed, but then again, as we were able to differentiate ourselves, because we were trading very short term, and with very controlled risk, that is something which was very appealing to many people. If you can really control the risk at all times in a very precise fashion, that, of course, helps.

Niels

Now 3 years later, where to you stand now? I know that you have two programs, but just out of curiosity and for the listeners to benefit, where are you now in the two strategies in terms of AUM?

Luc

Well, actually we are around to advising some nearly 200 million U.S. dollars, which is mainly in the DPI program. Kairos is relatively recent, so there is a DPI program that is the downside protection on income program and on the other end we have Kairos which is a cross asset class solution where we work mainly with position sizing algorithms and dynamic risk protection, as this is called, so that has a shorter track record - nearly two years now. That is still growing. The reason why we came up with a second program is that we saw that in DPI, it is, and I think we hinted to this earlier on during our talk that some of these trading strategies can work very well, but they are very difficult to scale. So when you ask me what do you think, or what did Robeco back in those years think in terms of assets under management with those kinds of trading strategies, definitely not more than a billion. We could maybe trade without too much trouble 500 million, but go twice as big as that would be difficult. Now this new one, the Kairos program that I've developed over the last couple of years is something that we have been working on for many years, but it is like a very difficult thing to do, and it was especially challenging in terms of taking away some of the constraints. What we have, and I don't know if this is maybe a good time at this point of time...

Niels

Luc

Well, it's actually quite a funny story. It is something which I did not intend to do. I've always been an avid reader. I started reading I think at the age of 3 or 4, so relatively young. I've been reading quite a lot. I was reading fast, but I didn't know to what extent some really good techniques could improve that dramatically. I think it was in the early 90s I got in touch with a couple of researchers who were doing something which has to do with how the brain works and how we can improve the efficiency of our brain and having read about it I said well, this is potentially an interesting subject. This person who was teaching the class, and organized the program, he was a remarkable person there, Silva I think, he was by himself he was really, really very bright, but he also had this incredible memory and I was really impressed and I remember that one of the tricks that he did (it was not really a trick it was showing off how good his memory was) so he was an American person, so he didn't speak any Dutch, and I visited with him in Antwerp and he said, show me a book of which you are sure I have never seen it before.

So we were in this library and I took out a book of Dutch painters, and these were painters of like the 17th and 18th centuries and there was the picture of the painting, could be a Vermeer, or could be a Rubens, or could be whatever, with an inscription in Dutch of the painting, what's on it, the title, when it was painted by whom and so on, and of course he'd never seen it. He might have seen some of the pictures of the paintings. That's probably where it ended. So I said well, you can do a little experiment if you want. We had this course organized, I think, over 5 or 6 week period, so every week there was a new chapter to this training in speed reading as he called it, and he said well, at the end of today's class, and it was a day long class, he said you can take any book, that book or another one and we'll just go through the pages about 1 second at a time. I said well, fine, so we did that. So we took the book one second per page. So it was like 200 seconds we went through the book, closed the book and put it away. The next week we showed him the pictures of the paintings and he gave the titles and who painted it, and what year it was painted and even some of the names. It was totally amazing. He said it was not only a question of reading fast, because you have to absorb the information in like one second, but also of course memorize it. So then during that course we were trained in some techniques to improve the speed of reading and some people were average or even below average. I remember that there was a mathematician in the group, and she was really slow in reading because she was used to reading these mathematical formulas and studying them for minutes before moving to the next page. She was really slow in reading, well she also more than tripled her speed after this 6 week class and in my case it also improved dramatically. He said you should participate in this world contest, which I was not very intrigued about, but he tried to talk me into it, and it was a fun experience.

Niels

Amazing...excellent. Now, the next topic that I want to talk about is here we have someone like yourself, you're running a short term trading program, you've got almost 200 million dollars under management, yet I sense that you have a very lean organization. So I want you to tell our audience how do you do that? What do you do in-house? What can you outsource? Let's start with that, I have one more follow-up question, but let's start with that.

Luc

Now I can run the exact same system in probably less than an hour - probably in 3/4 of an hour, and that will do everything. It will make all the calculations and the calculations have actually evolved to the extent that they have become more complex and there are more difficult items to calculate than there were say 15 years ago and still with this technology it's now possible. So now if you have a group of say 2, 3 people, and we focus as we did before on just two things and these two things are research, on the one hand, and then what we call the byproduct - the trading, which is actually the implementation of the research, we can do that with a couple of people only. So if we have 2, 3 people here in the office, it's more than sufficient to be able to do everything we want and make sure that everything is double checked as it should be, while before, we would have at least 3 traders, because we had to phone in the orders in. We had to adjust the stops. We had to trade all the stops, change the size, take profits, and it's always a phone call and double check and get a confirmation and write it down, and now it's all electronic. We see it on the screen. If the trade is filled or partially filled, that comprises a perfect audit trail. Before there was a middle office, back office and front office, so it was much more in terms of human resources we needed to do the exact same thing.

Niels

Sure. I think this is critical to some extent because I think for people to understand that someone like yourself, running that amount of money can do it with a team of a total of 2 to 3 people yet competing, and I may add here because I have seen your track record, certainly competing with the best of the best in the world, that's extraordinary. My next question, I think, is really critical. How do you convince institutional investors that two or three people is a big enough team when some of your competitors are maybe 25 people?

Luc

That's indeed a very good question, and I think the way to convince them is to show them. We are way past the time where hedge funds were telling people, well trust me; this is how we do it, and you'll see how it will be OK. Now we are during the period, and I think since at least 5 years, it's no longer the "trust me" philosophy but the "show me" philosophy. We have the demonstrate to them, and we have no problem talking really in great detail about how we trade and why we trade what we trade, and how we trade what we trade. It's only by letting people see what we do and how we do it that, of course, they get convinced that there is some value in it. Of course, this has to do with the fact that we are extremely focused on the various specific trading strategies. So you may say, well, what stocks should we buy because I'm a value investor, well, we don't know. What bonds should we buy in Europe if I want this kind of modified duration? We don't know. It's not our niche strategy. We are very much focused on volatility trading using options, risk control, directional trading in the FOREX, and that's about it. So it's not like, OK we have a total, complete, broad program which is using fundamental news; which is using order flow; which is using investor sentiment; all these things which I think require a lot of inputs and activity.

Niels

I take that onboard, Luc. I agree with that, yet, and I think this has an interest for a lot of people because there are more small managers than there are big managers, let's put it that way, so this is a challenge that many people are faced with. I also take onboard the fact that you say, OK, but we'll show them. Still, I would argue that a lot of people would shy away from a small team because of the career risk that they may run. It's easier to buy, and we all use the large managers, we all know as 100 PhDs and all of these things as they are sort of the benchmark which obviously is not entirely fair, so I'm interested in whether you have some good tips or advice for all the other small managers out there that are facing the same situation that you are, except that they don't have 200 million under management, maybe, but with a small team, with a fully systematic approach and a good track record, how do you think you've been able to convince them? Because just showing them, OK that's one thing, but is there anything else that you think other people could learn from, from your experience?

Luc

I think what is most important in trying to bring the message across is very clearly describing what you do, what are the advantages and what are the risks. If, to a certain extent, you can very neatly and precisely describe what they are going to buy if they subscribe to your program, then it's a big step forward. If you say, well, I'm the best trend follower on the planet. I am from a small company in Abu Dhabi, and I've never given a presentation to a pension fund, but I'm definitely one of the best trend followers on the planet because my strategy is so good, no one else comes even close to it. It's a very tough sale. If you say, well, I've been doing this for 25 years, this is the track record, this is what I've been doing, these are my credentials, obviously that helps, but you have to be very open and honest about it, it remains a fact that some pension funds, some large institutions, they will still shy away from investing in the program because they have some criteria. We've run into that multiple times where a bank says, well, this is really what we like, I like your strategy, I like what you've told us, I've seen the track records, everything is nice, however, we are a big company and we never would invest less than 50 million dollars in the program, however we cannot be more than X percent off your program.

So you have this chicken and egg situation. We say well, I remember one client in particular said, well, we would never invest less than 50 million (it was exactly that number) however we cannot have more than 10% off a manager when we invest with them, which means of course that you need to have at least 500 million, if not you would be more than 10% off your total assets under management. So he said, well, do you have a bigger fund. No, we don't. So it becomes tough to grow, and then it becomes a question of, of course you have generic growth so to speak, but that would take years, unless you are compounding at an incredible return, which very few people can do, especially for a longer time period, but then it becomes do you really need this huge assets under management. Do you really want to have 1 billion, and frankly, in our strategy especially the DPI program, we know that it wouldn't work. It would even become sort of destructive. So it can be a blessing that you have a strategy which works fairly well and that you are happy with, and you know that I can easily trade 5 million, 10 million, 100 million, 200 million but probably not 500 million with this strategy. So I know the constraints. I will try to optimize it for that kind of number, for that kind of money under management, and I know that I can't become bigger than that because it will have a bad impact because of slippage and so on.

So it's one thing to say be happy with the configuration that you have. It's another thing to say, well I want to grow this into a multi-billion business, which is not exactly what we have in mind. Now the second program that we have would allow the program or the assets under management to grow pretty significantly because there are much less constraints in terms of doing this in a bigger environment; doing this with more money under management. The DPI program, which we have been trading for a long time - more than 15 years, well that one definitely can't be traded on a much bigger scale, and people would argue, then would say that's hard to believe you're trading G10 currencies, these are the most liquid markets on the planet. That's true, but if you try to move say, 30 million Swiss francs at this point of the day on a Friday afternoon it would be virtually impossible unless you are happy with a spread of 10 pips. If you do that say on a Tuesday afternoon, or a Tuesday morning, the spread could be 1 or 1.5 pips, so if you don't know that, and you suddenly make every Tuesday morning into a Friday afternoon you're going to create some serious problems. You have to be realistic in terms of what strategy can be scalable and to what extent. If you are a trend follower, then of course you trade some very big markets and longer term and are used to the swings and it's scalable to a very large extent, but in our type of quantitative short term trading strategies, it's much more difficult to have a very scalable approach, so it's heavily related to what you do and what markets you are trading.

Niels

Sure. I think that you bring up a couple of very interesting points and I would just add one thing to that and that is for many managers who want to grow their business and they go out and they would talk to investors, I think one thing that perhaps I would describe as a small mistake in marketing is really that people often say, oh but my strategy can manage billions, and that may be true, but actually I don't think that that necessarily entices people to invest here and now. I think that might entice them to say, OK, if you have so much capacity we'll wait another year, and we can still be back, rather than say, we may be able to manage a few billion at this strategy but in fact, we are going to stop at 400 million, we're going to see how it is. You create that kind of scarcity which is, in fact, a mental trick in the mind which I think might be a better approach.

Luc

I fully agree with that because it's exactly what people tend to make as a mistake and say well, we have this program which we can grow to 10 billion so what's the advantage for the investor? If he's late in the game, he can still join in while if you have this limited capacity, so to speak, and you know it's something valuable. It's only there now, and maybe longer it will be there in two years, you create an additional incentive, I fully agree.

Niels

Just one final thing before we jump to the next section. You mentioned that showing what you do to investors helps you convince them, but I have a feeling that what you do could also often be described as some kind of black box, because there are some technicalities, algorithms happening, and so on, and so forth. How do you bridge that gap? One thing is to show them that we press five buttons and that runs the whole system, and this is how we can do this by being 2 or 3 people. How do you open the Pandora's box enough for them to feel comfortable about what's inside?

Luc

OK that's a very good point. Actually, at the same time makes the point well, this program is not for everyone for the simple reason that it's very difficult to explain this say, to my friends who don't know anything about investment and derivatives. If they know something about stocks and bonds, it's fine, but if you talk about volatility, and volatility risk premier, and how you can arbitrage it, and how you can combine trades, and then make it delta neutral, and these kind of things, you see the whites in their eyes, which is not the objective. So it is definitely something which you have to tailor to a certain segment of the market. So this is a program which we can only offer, and we only want to offer it to institutional clients, because if not, we wouldn't be able to explain it without going through a lengthy course, which is not the objective.

If we explain this to institutional clients, they get the message quite quickly and they say well, this is something that we don't want, or this is something we could be interested in, and if they are interested in... we had a conference call yesterday with a Swiss group of investors and said well, that's a good point you brought up there, could you send us some illustrations of some previous trades and walk us through the mechanics of how you did it. We have no problem doing that. Why? Because the markets that we trade, first of all, are very big, very large. These are trades from the past. We don't fear any reverse engineering by showing that, and that helps building the confidence. So you have to say, well, if you put on these trades these are the risks, so how do we handle these risks? You walk them through the example. You go back in time a couple of weeks. We had, of course, the example of the 31st of July when there as this big drop. The S&P was selling off about 5% and then reversing back about 6% up only in like two or three weeks’ time. So it was a great time for volatility trading. If you can show the people what you did and what went wrong and what went well, that builds a lot of confidence.

Niels

Absolutely, great stuff. Now, I want to go and talk about the trading program itself and dive into that, but before we do so, I want you to explain how should people read your track record? The reason that I ask for this is that I think sometimes people believe that if they look at a track record, that this is what they can expect for the future, not realizing that usually these strategies evolve over time. Some of them evolve dramatically over time so whatever it looked like 15 years ago is nothing like what it looks like today. So I think it's always useful for people to understand how they should read a track record and, in fact, I've certainly debated with some of my previous guests as to whether or not it's better to look at a backtest of the current configuration to understand what the program is all about, rather than looking at an historical track record that shows many iterations of the same model. I would be delighted to hear your view on that as well, but I also want to really understand how should we look at the program today and the track record itself?

Luc

Niels

I really wonder two things. First of all how many of the large managers today are willing to share that information? That's one question I would say. The other thing is, I've never come across any investor who've asked for that kind of information. Give me your latest test of your current configuration, and I'll use that as my basis to judge what you are doing. I think that's very interesting that that very rarely happens because what you allow them in that, and I think what you are explaining is that by offering it and by the investor wanting to see it, you're putting them very deep into the current research thinking and I think that must be critical for anyone to understand with any manager that they are willing to part money with, so I think that's really interesting. Thank you for sharing that, Luc.

Now, the next topic really is the trading program. Let's start with the DPI, I think we can certainly also touch upon Kairos. I think that they are both fascinating. Tell me first. I know that you mentioned that you are a risk averse person, and maybe that's a place to start, and really just for me to ask, what's the objective of the DPI program?

Luc

OK, at the same time bringing up the critical issue: how do we develop systems, how do we trade? Well, it has to do with, of course, the person. If I try to come up with a new trading idea it will definitely be biased, by what kind of risk I'm willing to tolerate, what kind of losses I'm willing to absorb, what kind of return I'm shooting for and so on, but key to all this, and in everything that we do is in fact volatility because we are convinced that high volatility is not a good thing and people know that and realize that, but they don't know, necessarily, to what extent it can really hurt a portfolio. There are different things related to that; I think. If you talk about DPI, if you talk about Kairos actually this same philosophy is behind it and it has to do with the fact that if you have a high volatility trading method, even if it is a winning trading system, this high volatility will actually turn this winning system into a losing system under the condition that returns are not consistent. So at the same time it's good to say well, if there is a lot of volatility I like it, but then the return stream must be extremely consistent. If not, even a good system will end up losing, and it can be shown mathematically very easily. But more importantly, if you don't have what people describe as a significant sustainable edge and alpha as they call it. If that alpha is actually absent, well any volatility will actually erode the investment return. If you see erosion continues for a couple of years, the drawdown will become so big, relatively speaking, that it will become very hard to overcome.

So the first thing you need to do is to make sure that you don't get into this situation where the hole that it has been digging has become so deep and so big that you can't get out of it. That has to do with the fact of how can we avoid this dangerous high volatility and so you have to make sure that you control the risk, because if you control the risk you can limit your exposure; you can reduce the potential dramas that occur or that can be created by trading a system or a method in a too aggressive fashion. So the cornerstone of this, of course, let's try to find something which has this structural alpha. So this sustainable edge which is there on a recurring basis because, and I think it nicely fits in with your previous question, what are people really looking for, are they looking to buy a track record that they have seen? No, actually they want to know what's a realistic estimate for the return, and for the risk - in a way the persistence, the predictability, the robustness of this trading approach. To what extent can I rely, or can I be confident that the returns that are being shown here in this track record can be seen in the near future, if I invest with this manager I give him X 100,000, X million, whatever and I close my eyes for three years and I come back after three years will the return be more or less similar to what I see here on this historical track record, or this backtest, or whatever, and that is what it is that people are actually buying. They want to know how predictable, how recurring are these return streams. Is it something which is spiky, very volatile, it could have a huge year making 17% in a month and then giving back 1/2 of it in the next two week, or is it someone who is making say between 1% and 2% on average, never the less we'll have a bad month now and then and may see a drawdown of 5% or 10%, whatever, so that they get the realistic feel for what kind of risks in the returns are available.

Niels

Let me ask you this. The way I see the investment universe over time has been that there's been lots of strategies that have claimed to be very stable and they have indeed looked very stable then suddenly one day they get completely wiped out because what they were doing had some kind of weakness. We all remember long term capital and so on and so forth. Now on the other side we have the traditional CTAs trend followers who have been, over time, very profitable, but they have not been able to take the volatility out of that return so you get the profits, but you also get the volatility. Now what you are suggesting is the best of both worlds where you get predictable returns - good returns, but without the volatility, so the question, of course, is how do you do that?

Luc

Well it has to be with what I described earlier as the sustainable edge.

Niels

Yeah, how do we get that sustainable edge?

Luc

Niels

When you talk about it like that it reminds me of a conversation that I had with Scott Foster of Dominion a few weeks back where, he is also in the short term space, what he was explaining was that what they look for is universal truth, things that simply don't change over time and that's what they want to explore, is that the same thing that you are trying to say here that you are looking for something that is so fundamental that it will simply continue to work?

Luc

Absolutely. So that's, I think, a very good summary. So you are looking for some patterns which are repetitive to a certain extent, which will not be there every week, definitely not every day, but you can more or less count on it that on a regular basis, across a nice spectrum of markets they will pop up here and there. If I take an example, we have some trading systems which have been tested and developed for a specific market and in the process of trying to come up with a trading strategy for the S&P, to name just one, we do something very weird and people say, well, why are you testing it, say T Bonds, why are you testing it on Euro/dollar? Why are you even testing it on dollar/yen that has nothing to do with S&P? That's true, but you have to remember that the nature of the beast can change over time, and I gave the example earlier with the Swiss franc which has been trading extremely predictably to a certain extent, up until a couple of years ago and then the advantages went away... Why? ...because the nature of that market changed.

If you're on the plateau, which is not the same level of optimal return nor the level of minimal risk, but you will be having a more stable and more balanced location than if you were to be at one of these extremes. That's actually what people should look for; traders should look for, and also, investors should look for. They shouldn't be hunting for the manager that was making the highest return this year and then hoping that he's going to be again the highest return, because we all know that returns are not very persistent, neither are the performance of the managers, but you need to find some kind of stability where you say I know with this manager my risk adjusted return is going to be in that ball park. It's not going to be extremely high. It's not going to be extremely low. We know it's going to be probably in that confidence interval, and then you have a better probability of reaching your objective in terms of what you were hoping for in terms of risk and return.

Niels

Ending

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