In the October issue of Futures Magazine, on the very last page, is an example of how to use overarching hypotheses about markets to develop trading strategies. In this case Peter Matthews, a founding partner in Mint, a legendary trend-following CTA, decided to create a new managed futures strategy. And launch a new fund, PJM Capital.
Matthews started with the hypothesis that markets are complex adaptive systems. (That’s not the thought process described in the article, but I suspect that my version is more accurate.) The four characteristics of markets that put them squarely within the CAS model are: “1) markets are made up of heterogeneous agents (different traders trading different models with different knowledge and risk tolerances), 2) they use a feedback process (each new price can alter what a trader will do next), 3) they are based on limited resources and 4) they are self organized (there is no central authority setting price.)”
Most important for Matthews are two corollaries of the CAS model—that markets have fat tails (bubbles and crashes, large standard deviation moves) and that price movement is unpredictable. The first corollary vindicates the trend-following methodology—being on the right side of outlier moves. But, having been there and done that, it was the second corollary that captured his imagination. If you can’t predict what will happen, no matter how sophisticated your statistical models and how modulated your probabilities, you can’t ask someone to invest in the future. Basically, “there is no such thing as investment.”
Matthews therefore decided to replace the statistically-based trend following system used at Mint with a risk management trading system, what he considers the “next generation of quantitative systems.” His focus is on position sizing—trading in size when the cost of error is the smallest and avoiding most high-risk trades altogether. The goal is to manage drawdown while maintaining returns similar to the trend-following fund. Although this has a familiar ring to it, my hunch is that by moving risk management from bridesmaid to bride might be fertile ground.