The Big Picture: Journeying into Exotic Markets - Diary of a Quant

Introduction

In the first edition of The Big Picture, I explored the disruptive potential of artificial intelligence (AI) on asset management. Today, I’ll delve into another of the major evolutions I have witnessed as Chief Investment Officer at Man AHL, namely the journey from trading easily accessible instruments such as foreign exchange (FX) and futures to pioneering systematic investing in alternative and exotic markets. I’m referring specifically to those markets that are typically harder to access, perhaps owing to execution, operational or regulatory challenges, but that can give investors access to unique risk factors and offer potential diversification benefits.

Our starting point

We started trading markets systematically in 1987. At that time, most of our research team had backgrounds in academia, while our trading team’s experience was heavily biased towards generic instruments. We recognised that in order to expand beyond futures and FX into alternative markets, we needed to diversify the team’s experience to also include industry experts who had deep knowledge and experience of over-the-counter (OTC) products. This applied not just to the research and trading teams but across functions – from legal to compliance to the back office – given the significant amount of operational work required across the business before strategy development can even begin.

The gateway to more complex markets

‘Get the basics right, and the results will follow’ is a well-known adage, but it holds true when trading exotic markets. Without laying strong foundations and putting in place the infrastructure to systematically trade exchange-traded instruments, it would be extremely difficult to even begin exploring more complex markets.

Initially, when we began to look at exotic or alternative markets, many of which are traded OTC, our expectation was that they would be small markets which would be complementary to mainstream markets. How wrong we were. There turned out to be many more markets than we had originally anticipated. We also quickly learned that just because a market is hard to access, it does not mean it is illiquid.

With that said, it can take months – or even years – to understand the nuances of some markets. As I alluded to earlier, there is often a significant amount of non-alpha or operational research required involving multiple areas of the business when advancing beyond trading futures markets. Pricing, data availability and data cleanliness are just some of the challenges we have faced over the years. Barriers to entry such as these can, once overcome, lead to greater rewards.

What is the allure of alternative markets?

First and foremost, many of these markets provide an opportunity for portfolio diversification, giving investors access to risk factors complementary to those offered by traditional markets, in other words, differentiated alpha. In sum, trading a richer range of markets can increase the quality and robustness of portfolios, and has the potential to improve overall portfolio performance. Further, trading more markets can increase overall capacity.

Recalibration is the norm

We set about systematically trading credit default swaps (CDS) in 2005 and from there have researched and integrated instruments, ranging from bonds to interest rate swaps; to cash equities; to volatility (trading strategies that seek to profit from how much prices move up or down); to be announced trades (TBAs or forward contracts on US mortgage-backed securities), China markets, catastrophe (cat) bonds and crypto into our strategies.

There have been several occasions when our research into these markets has facilitated – and necessitated – a shift in our thinking. This has ranged from recognising that a particular market is deeper than we first thought, to a change in our approach to trading certain instruments. When we began looking at cat bonds in 2004, largely owing to their significant diversification benefits, we initially thought we may be able to trend-follow them. However, the more we examined the market, we saw that it was unsuitable for trend, namely because of its more intermittent trading patterns and wider bid/offer spreads.

Further, as quantitative investors, we look for signals – indicators which guide us as to whether the price of an asset is likely to go up or down – but we ultimately concluded that natural catastrophes are essentially impossible to forecast. The general view at that time was that credit could not be systematised, but we knew that not to be the case, so we persisted. The approach we ultimately developed to trading cat bonds, which involves adopting a more passive approach in order to secure more favourable pricing, was not what we originally foresaw and underscored to us the importance of flexibility in our thinking, particularly when foraying into uncharted territory.

In the last edition of The Big Picture, I highlighted how artificial intelligence can empower our researchers in making discoveries more quickly and effectively. It’s perhaps worth adding as an aside here that in the case of cat bonds, we have found large language models (LLMs) particularly useful in extracting the key details from offering documents, which can help increase business scalability.

The road into crypto

Cryptocurrencies have become much more mainstream in recent years as the asset class matures, but I clearly remember one of my team returning from holiday enthused about the possibility of trading crypto after reading the original paper on the topic by Satoshi Nakamoto. At that time, the AML and KYC processes for crypto were rudimentary and the exchanges they were traded on lacked the robustness required for institutional investors so we put it on hold. In 2020, however, we decided to revisit the question of whether the exchanges were still unsuitable for institutional investors, given what crypto could offer in terms of its low correlation to other asset classes, as well as the benefits of including an allocation to digital assets as part of a diversified portfolio. We have since developed strategies which place a strong focus on active risk management, given the asset class’s high and variable volatility.

Dead ends are par for the course

Everything I have written about so far suggests that our exploratory research over the years has all borne fruit, which is certainly not the case. Indeed, I could write a parallel ‘diary of a quant’ on the research that didn’t yield results, but that’s par for the course.

To give just one example, some years ago, we experimented with trading physical aluminium given it is one of the few positive carry trade metals (a metal that offers a higher yield or return relative to the cost of holding or financing it, making it profitable to hold over time). We bought a few thousand tons of NASAAC (or North American Special Aluminium Alloy Contract), housed it in a warehouse in the US and sold it on, with the goal of discovering what the profit and loss experience would be and whether it might be additive to our strategies. Some unfortunate tax implications, however, meant that we’ve been in no rush to pursue it any further!

Ultimately, we accept that there will be some dead ends – especially when researching exotic markets – but the message we give to our teams is to keep exploring. In doing so, we stay at the forefront of investing and portfolio management, and ultimately seek to yield the best results for clients.

The next frontier

We are regularly asked whether we have run out of new markets to trade. The reality is that the number and complexity of markets is ever increasing. A decade ago, it would have been hard to believe it would be possible to trade cryptocurrencies in a liquid fashion, but here we are. As well as maintaining a keen eye on crypto as it matures, some of our current research areas include new commodity markets such as battery metals, as well as climate-related contracts.

Securitised credit also presents opportunities. It is an extremely deep trillion-dollar market, but is traded manually by most of the industry, in part owing to the high barriers to entry in terms of the specialist knowledge required to understand often complex structures. We began trading the first mortgage passthroughs in 2013, but our ongoing research has shown us that we are only scratching the surface of what is available beyond forwards markets. The potential opportunity to trade these instruments at scale is compelling.

Closing thoughts

Our pioneering spirit has kept us at the forefront of research and market exploration and today we are trading more than 400 markets beyond traditional trend-following futures. Each new market presents unique challenges, pushing us to adapt, innovate, and recalibrate but has the potential to become a valuable addition to a portfolio. As markets continue to evolve, we look forward to where our research may take us next.

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