Systematic vs. Discretionary Trading

October 28, 2017 12:00 PM
One of the first decisions a trader will make is whether to follow a systematic approach to trading or a discretionary one. Here, in the first part of two, we look at whether one style provides superior returns over the other.

A Deeper Dive
As we mentioned above, all systematic strategies generate trades based upon technicals, even those that incorporate some fundamental data into their program. While the vast majority of discretionary traders generate trades based upon fundamentals, most incorporate technical analysis for entry, exit and risk management. Both styles are practiced throughout all time frames. Talking of particular strategies and sector foci, there are areas of overlap between the two where one style or the other is the predominant approach. The reasons for this stem from what return drivers – carry, momentum, value, etc. – the program is trying to capitalize upon, as well as what is the most efficient or pragmatic approach to do so.

For instance, there are practical reasons why the majority of trend followers are diversified and systematic. As mentioned earlier, technical analysis is the trade generator for systematic strategies. Trend followers focus on exploiting momentum. Many programs may have contra-trend or mean reversion components but are predominantly trend following. In general, markets do not trend for the bulk of the time. Trend traders typically take many small losses hoping to catch a few good trends that more than compensate for the multitude of small losses.

Statistically, the odds improve when applied to a greater number of markets. It would be difficult to have a deep understanding of, analyze and monitor the fundamentals—whether supply/demand or macroeconomic factors—of 25 to 75 markets. Hence, a systematic approach to trend following in a broad array of markets is the most proficient way to capitalize on the return driver of momentum.

On the other end of the spectrum are discretionary fundamental traders. These traders immerse themselves in the fundamentals of select markets — doing deep dives on a wide array of factors. Discretionary physical commodity traders are a good example of this. Like other fundamental traders, commodities traders analyze a wide variety of fundamental factors. The majority of discretionary hard commodities traders seek to exploit the return drivers of carry and relative value as well as momentum.

Frequently, these are opportunistic in nature. A major reason that these markets lend themselves to this approach is the more complex cost of holding these types of asset classes. In addition to a financing rate – the cost of holding a financial asset — there are the costs of storage, transport and insurance. Additionally, the benefit of holding the asset — the convenience yield — varies between market participants. Many discretionary fundamental traders are niche traders and focus on just one market or market sector.

Jesse Blocher, Ricky Cooper and Marat Molyboga explain why physical commodities lend themselves to the fundamental discretionary approach to trading in their 2015 white paper, Performance Persistence in Commodity Funds.

They describe how commodity traders have the opportunity  to gather more information from diverse sources than equity traders and can apply that expertise. They note how skilled traders who understand the nature of data can exploit overreaction to early production forecasts and limited weather information by exploiting more sources. They can also find data on seed and fertilizer purchases that provide them an informational edge.

The paper states, “In some ways, commodity analysts may actually have some advantages over equity analysts. Publicly traded equities have significant requirements for disclosure, but often the most important information about customer demand and supplier capacity is labeled ‘inside information,’ on which it is illegal to trade. In contrast, commodity funds are legally able to gather important information about supply and demand, and deploy it in profitable trades.”

The paper describes a number of fundamental market factors in commodities markets that underscore the importance of being able to tap into a vast flow of information. Consequently, physical commodities provide unique opportunities for a trader to gain a competitive edge via fundamental analysis to capitalize upon carry and relative value. The carry trade is affected by the interaction between supply/demand and the cost of holding the asset. As opposed to a value play in equities, relative value seeks to exploit mispricing in relative values rooted in geography or related commodities, WTI vs. Brent crude oil, for example, or Soybeans vs. soymeal.

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About the Author

Mike Dancey, CAIA, is VP of Institutional Services and Head of Research at Managed Account Research Inc.  He consults on CTA selection, due diligence, portfolio construction and integration.