Wed., Aug. 31, 2010—Evaluating an emerging manager is a fickle task. By definition, emerging means that a manager is up and coming (or maybe just coming, and not even up yet) and likely has a shorter track record. The relative lack of experience and limited actual trading done by an emerging program usually leaves us with very little to evaluate beyond what the manager tells us.
Because of this, we typically avoid highlighting a manager until they have at least a two-year track record (preferably longer) and have had the opportunity to analyze the trading on our own books for at least a year.
However, many of our readers have asked for more information on emerging managers, and we have looked for ways to oblige that request without just throwing up a spotlight on a manager and program we know very little about.
Enter Applied Capital Systems, whose manager we have known for many years and whose track record we have been tracking “live” on our books for the last 10 months, with their first client opening an account with Attain. So, we can hopefully appease the request for an emerging talent without sacrificing too much, seeing as how we have been able to develop a level of familiarity and comfort with the actual trading that has occurred over the last year.
Today’s spotlight on Applied Capital Systems highlights an emerging manager that is familiar with both sides of the CTA industry. For many years Greg Callegari, who is a principle in the ACS program, spent his time allocating to trend followers, while always wishing that a shorter-term alternative was available.
Enter Antony Drew, who, after recently completing his studies at the University of Chicago, came to Callegari with a short-term commodity system that was “different” from other multimarket managed futures programs. Drew and Callegari became partners and in October of 2009 officially launched Applied Commodity Systems.
THE MANAGER
The trading models used by ACS were written by Tony Drew. He is the head trader at Applied and is charge of all trading and trading model development. In contrast to many money managers who major in finance, engineering or computer science, Drew took an unlikely path to becoming a CTA, graduating from Georgetown University with a degree in Russian language and philosophy with a metaphysics concentration. Tony was also an All-American rugby player at Georgetown.
Upon graduation, Drew jumped feet first into trading as a trading assistant on the Canadian Imperial Bank of Commerce World Markets interest-rate swap desk. It was at CIBC that Tony first had exposure to the futures markets as the swaps desk routinely used 10-year note and 30-year bond futures contracts to hedge their positions.
Drew soon realized he wanted to make a full-time career out of trading futures and enrolled in night classes to study finance and programming (one rarely goes without the other these days). He even moved to Chicago to get closer to the action, taking a job on the trading desk with ABN AMRO.
Moving to ABN proved to be a smart decision as this is where Tony first met his future business partner & co-principle of Applied Capital Systems, Greg Callegari. While in Chicago, Drew received his MBA from the University of Chicago with a concentration in behavioral and analytical finance. It was at U of C that Drew became a convinced that systematic, technical trading was the most logical way to trade. He immersed himself into learning technical analysis and came away with his own price action based indicators including the original ideas that are used for ACS. Drew lives in New York, and can be found skiing or playing tennis when not behind the computer looking at the code for Applied’s trading models.
Greg Callegari began his career in 1995 when he worked at Barclays PLC in New York. Throughout his career, Greg has done due diligence on a wide variety of managed futures programs and trading styles, first through his role running a global CTA allocation program he founded for Barclays in London and later working in a similar capacity for ABN AMRO as a CTA allocator and proprietary trader.
Callegari says he always aspired to run his own CTA, and actually has found that starting as an allocator allowed him to learn the necessities to becoming a successful manager and how avoid the pitfalls that can plague other programs. According to Callegari “Being an allocator to CTA’s earlier in my career and a trader later really helped me gain perspective on what models work and what does not. I saw firsthand what models worked and what did not, and our objective with Applied was to create something that functioned better and had sustainability. Yet one of the biggest obstacles was creating a model which outperformed on a risk reward basis and had shorter trade duration.”
Greg lives in Chicago with his family of three kids plus his dogs.
The final piece of the ACS team is Chris Stephan who is an administrative partner and an attorney. As a former partner at Kirkland Ellis, Stephan brings a wealth of legal knowledge and business experience to Applied. As you would expect, Stephan is in charge of all legal issues including compliance at Applied. He also has input on day-to-day firm operations.
HOW THE PROGRAM WORKS
Applied Capital Systems is what we may call a short to medium term systematic, multimarket CTA that employs mathematical models to analyze technical market information in order to generate signals across a portfolio of 36 liquid futures markets. The program was developed by the partners of ACS and includes seven individual trading models, along with portfolio-overlaying volatility filters that look to eliminate “noise” from market data in order to portray a clearer view of the trend or countertrend environment in each market.
While the team at Applied Capital tends to think of themselves as a short-term program (the proper categorization might be shorter term), they do have some models which will hold a trade for a single day only, but they also have some trades which could last several months to a year in their longest-term models. On average, their trades last about 12 days, making them shorter term than many of the classic systematic multimarket programs, but not quite as short-term as some programs whose average hold time is one to two days.
As alluded to above with the programs trading across multiple timeframes (1 day to 1 year), the ACS program is designed to be diversified across multiple facets of risk, employing a multi-strategy, multimarket, and multi-timeframe approach.
MULTI-STRATEGY
The program uses seven separate systems which are applied to each of the markets it tracks. The seven different models include programs based on regression analysis, volatility breakout, pattern recognition, oscillators, countertrend models and what the managers call “anticipated” trend models.
The systems are employed together based on a belief that they will be uncorrelated to one another over the long term, although it is possible for similar trades to be generated over the short term. Typically, each system is only active about 60 percent of each year on average due to the various noise and volatility filters used to identify poor trading periods.
While most of us know what a trend strategy and even a countertrend strategy is, Applied Capital’s anticipated trend strategies certainly sound like something new. And while some other programs actually do similar things, it is a far less common (read: unique) method, as traditionally this type of model is much more difficult to develop because the program is attempting to identify a trend in the market BEFORE it happens. In contrast, most trend-following managers look to enter into a trend AFTER it has appeared (e.g., when prices break out above a 100-day Bollinger band).
The anticipated trend strategies ACS utilizes are designed somewhat differently, looking to predict future market moves rather than simply react to trends that have already taken place. If you’re thinking no model could predict a future trend with accuracy any better than a coin flip, you are probably right.
But if you reread our recent column The Percent Profitable Fallacy, you’ll see it doesn’t really matter how good they are at predicting them. It’s all about doing quite well when they do predict them correctly and not doing extremely poorly when they don’t.
Applied Capital put a lot of thought into the latter part of that formula (not doing extremely poorly when they are wrong), the result of which is their portfolio-wide risk overlay/filter which only allows a fraction of the actual trades signaled because of the possibility that current market conditions may not be conducive to a winning trade.
MULTIMARKET
Applied trades the usual suspects amongst the active U.S. futures markets, including currency, energy, equity, fixed-income, agriculture and metals sectors. All seven systems trade across all 36 markets.
Operationally, each of the seven systems orders are executed market on close (MOC) when Applied believes markets are typically more liquid. Another somewhat unique aspect is Applied’s risk controls, where none of the systems have resting stops in the market. Rather, the ACS program uses what the managers call a “time” stop where they give each trade a specific time frame within to work and then re-evaluate as necessary if the trade is not working as expected. They note that the actual use of the time stop does not occur frequently and is designed and used more to enforce the short term trading theme of the program.
The systems also use what the manager calls “fair-value” targets, which are projected targets or crossover points for which each market will eventually reach. These fair-value targets are different from traditional profit targets in that they are not based on the overall profitability of the trade; rather, they have been determined by the conditions of the marketplace. Once the system has detected a fair value point where it believes the market is fairly priced it will look to exit the trade.
ACS also manages risk by employing dynamic updating portfolio parameters and weights. This entails using a restricted mean-variance weighting system along with some forward looking dynamics (including expected returns and covariance) for selecting markets and weights for the next monthly trading period. Currently, each trade can take up to 5 percent max risk of total portfolio capital although most trades are between 2 percent and 3 percent.
Despite the presence of multiple systems across 36 markets and multiple timeframes, the program only trades 1,000 R/T per million on average. This a low number for a shorter- term trading program, and Drew credits this to their active filtering, which eliminates trades that have a lower chance of success.
ATTAIN COMMENTS
The past 24 months have been rather turbulent for most multimarket CTAs, as they have battled declining volatility and high correlation across portfolio components. Despite Applied Capital starting right in the thick of this poor period, it has stood out to us as a unique trader that has been able to take advantage of both short-term trends and countertrend market moves.
One unique feather in the Applied team’s cap is that they have had success trading the forex markets, which many multimarket programs tend to struggle with given their often sharp pullbacks. Typically, currency markets are one of the most difficult sectors to trade with a systematic program due to government intervention as well as numerous spikes in the market around key reports and interest rate decisions.
Another positive point is that even though the Applied Capital Systems program is new to the CTA space, it is being managed by pair who have been there before and have been in and around large CTA allocations and trading volume.
Callegari’s experience allocating fund and bank capital to various CTAs, in particular, seems to have taught him that the primary job of a CTA is to be a risk manager first, then a return generator, not the other way around. Furthermore, his experience as an allocator to money managers has given him a unique point of view of the pitfalls that trip up new managers and trading programs. Because of this, we expect that Applied Capital will be able to avoid many of the common organizational mistakes we see from new CTAs.
CONCERNS
Possible concerns include the fact that Applied Capital is a new CTA and therefore is likely to experience some bumps in the road eventually and the program’s willingness to risk up to 5 percent on certain trades. On the $500,000 minimum, that represents a loss of $25,000 on a single trade, which would be a bitter pill to swallow for any investor. Many managers are found eventually decreasing their program’s leverage from what their testing shows to a more moderate number that is more in line with client expectations, and if a few of those 5 percent risk levels are hit by Applied, we may see them do the same in the near future.
But for now, Applied has managed to avoid losing too much on any one trade, or even any series of trades, standing out in what has otherwise been a gloomy past 10 months for many CTA programs. Since getting started last October, the managers have outperformed many of their competitors in the multimarket sector, which is made more impressive by the fact that they are trying to produce non correlated returns with the classic multimarket managers.
Finally, considering the program started off in drawdown right off the bat (9.21 percent), it is nice to see them make a nice comeback over the past three months to new equity highs. August is nearly in the books as well, and it looks like Applied will be positing another number in the black, with our early estimates showing the program up just over 0.60 percent for the month. With increased market volatility on the horizon for the third and fourth quarters of this year, we expect that this program will finish the year strong.
If the new normal is for quicker trends, reversals, and an overall continuation of the poor conditions for most other multimarket programs, a shorter-term systematic manager like Applied Capital may be worth considering for those adventurous enough to sign up with an emerging manager.
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.