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How robo trading works

John Wasiliev

Over the past few years active investors have been offered computer software packages that purport to make trading easy. They come with claims that computers can not only be used to analyse financial markets easily but can fully automate a trading strategy.

While no assertions are made about how successful these automatic systems are, investors need look no further than the managed funds sector for a realistic indication of the challenges. It shows that trading can be tough for even the most professional investors.

When global financial turmoil caused share and other investment markets to crash in 2008, a small group of managed funds went against this trend in an impressive way. While all around them the financial world was in chaos, this group, described as managed futures funds, generated returns of 20 per cent plus at a time when global shares plunged 40 per cent.

They had a number of things in common – the most significant being they all engaged in active high-volume trading, using strategies that were totally computerised and seemingly applicable to a wide range of tradeable investments from shares to fixed interest to commodities and foreign exchange.

Their success suggested a brave new world of investing where computer-driven strategies using intricate programs developed by maths experts trawled global financial markets, finding opportunities with electronic speed. Employing pattern-recognition techniques well known to technical traders and incorporating risk and money management, they were designed to identify money-making opportunities not only from rising markets but falling markets.

As it turned out, they made their most impressive returns in the bear market that followed the 2008 crash. Their performance since hasn’t been particularly outstanding, although some have done better than others and many professionals believe that funds with computer-driven strategies do have a role in a diversified portfolio.

There is certainly logic in their strategies, says Keith Dickie, head of absolute return investments at AMP Capital. They work by seeking to identify investments that display momentum. Their rationale is the herd-like behaviour of investors that often sees prices in trading markets overshoot both to the upside and the downside.

Whereas human investors are often troubled by perceptions of investments being either over- or undervalued, computers have no such emotional issues. They can be totally detached and so seek to take full advantage of any market moves.

The strategies these funds follow, says Julian Robertson, a senior research analyst with Morningstar Australasia, certainly have the scope to capture a trend in either a rising or a falling market. They can do this in a disciplined way because they are fully systematic with no human intervention except for research. Once they have been set up, he says, everything is computer-driven, including their risk budgeting that is designed to spread risk across various investment sectors to which money has been committed.

That said, there can be a wide dispersion of returns delivered by different managers. In the past month, they ranged between 11 per cent and 1 per cent.

While there is strength in their ability to identify and capitalise on momentum, their bête noire is directionless or choppy markets where there are few identifiable trends. Similarly, they haven’t done well when markets are highly correlated and whip-sawing about.

According to fund manager Winton, which offers the Winton Global Alpha fund through Macquarie, a key challenge is markets that are much more correlated than they have been historically. This has made things particularly difficult for managers which rely on the diversification of having lots of baskets in which to place their eggs.

Dickie says that after doing well in 2008, funds that follow computer-driven trading strategies across a range of markets have found the going a lot harder, especially in 2011-12. That’s because to make money they need an established trend before their models click in.

Robertson says that like many investment funds, the managed futures group requires a medium-term commitment. The track record of managed futures funds shows a potential for long-term performance in the low double digits, although they can give up past performance in quite a short time when markets are adverse.

Dickie says that past performance shows returns can be quite lumpy.

So investors are better off treating them as investments that will provide support to a core holding of direct shares or general share funds.

Robertson says that committing any more than 5 per cent of the growth portion of a portfolio would be “adventurous”. Managed futures funds have other risks such as complicated and opaque strategies that make it difficult to be confident.

While Morningstar gives Aspect and Winton a bronze rating, which suggests top quartile performance, it’s important to note they are very different to traditional managed funds.

You may also be interested in reading Successful online trading strategies

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