The key to trading: don't lose, says Trader Vic

Humans have a fundamental problem when it comes to food, sex and money. We lack discipline. "Everyone knows how to lose weight," said Victor Sperandeo, head of Alpha Financial Technologies and better known as Trader Vic, at a press briefing in Hong Kong this week. "The difficulty is doing it."

People have the same problem when managing their money, so Sperandeo has come up with the trading equivalent of a gastric band -- an investable index that he has created together with Royal Bank of Scotland (RBS) that lets flawed human investors take advantage of a disciplined trading style. "It makes you do what human beings tend not to want to do: take losses and go short," he said.

Sperandeo runs a trend-following hedge fund -- known as a CTA or commodity trading adviser -- and has been a successful Wall Street money manager for more than 40 years. His so-called Trader Vic Index, which Vic refers to as the TVI out of (perhaps belated) modesty, comprises a basket of 24 futures contracts spread across commodities, currencies and US interest rates, and aims to consistently make money regardless of market direction.

CTA strategies came back to prominence in 2008 when they generated big returns despite a collapse in asset prices across the board. While everyone else was blaming their losses on the unprecedented market conditions, managed futures funds were having their best year of the decade. Back-tested, the TVI returned close to 21% in 2008 and many CTAs reported much higher returns even than that -- which in turn has led many product providers to find ways to cash in on that stellar performance by marketing these strategies to the mass market.

Investors are right to consider adding some CTA-like exposure to their portfolios, but not because they can help deliver short-term outperformance.

"You don't invest in a hedge fund to outperform, that's where the trap came in last year," said Sperandeo. "Hedge funds are not supposed to outperform, they're meant to make money all the time. But investors say: 'I'm paying you 2 and 20, you've gotta outperform.' And that's why what we have today are really leveraged funds."

Instead, investors should not focus on making the most money, but on losing the least. "According to Einstein, the greatest force in the universe is compound interest," said Sperandeo. "And that means don't lose. If you don't lose, you compound interest, but if you lose you have to make a lot more to get back to even."

Unsurprisingly, the index he and RBS have created does a good job of not losing. From July 1990 to May 2009, it would have recorded positive returns in 98.1% of the 227 rolling 12-month periods and its worst 12-month performance would have been -0.9%. And its annualised return would have been 13%, with a volatility of 7.3%. Compare that to the 6.7% volatility and 7.3% return of the World Government Bond Index during the same period.

The trick to this kind of performance is a complex algorithmic trading strategy tailored for each of the 24 futures contracts in the portfolio. Using moving averages of the percentage changes -- rather than price changes -- in the underlying, the system identifies trends and bets on them. The result is a trading strategy that profits when volatility is high.

However, one thing CTAs aren't good at is picking tops or bottoms of markets. During the transition from long to short, there is inevitably a period when the strategy isn't making money because its purpose is to follow, not to predict.

So, while CTAs had a great year following the bear trend in 2008, they are not doing so well in 2009 -- just as some of these CTA products are coming to the mass market. Trader Vic's index, for example, is down slightly more than 1% year-to-date -- and was down as much as 7% at one point. The 12-month performance is still up more than 5%, but negative numbers for 2009 could make for a tough sell in Asia, even if the long-term rationale is sound.