Inside the Black Box: Interview with Daniel Leman, Managing Director of Leman Capital Management

09/12/2016 02:19 pm ET Updated Sep 27, 2016
Algorithmic Trading, Artificial Intelligence, Big Data
Algorithmic Trading, Artificial Intelligence, Big Data

Whenever you buy something from overseas, regardless of the product type or exactly where it has come from, you are participating in a foreign exchange trade. The manufacturers of goods in a particular country want to be paid in their home currency, so importers must exchange the equivalent value of their own local currency into that of the other country.

And at an even more practical level, it is most likely the case that whenever you travel overseas and pay for products or services with cash, you will have had to exchange your home currency into whatever is used locally.

Daniel Leman is the Managing Director of an algorithmic currency trading firm, Leman Capital Management, whose Quant Fund generated a 34.6% positive return in the first half of 2016, after a strong year in 2015 also, a time in which most funds performed badly. Daniel believes that foreign currencies offer a promising opportunity for investors to diversify their portfolios outside of mere stocks and bonds.

In this exclusive interview, Daniel tells us about the process of currency market investment management, and briefly outlines his firm's proprietary algorithmic trading business.

Can you tell a little on the history and background of your company, principals and funds?

Together with my partner, Reinis Lācis, I founded Leman Capital Management with personal capital after spending over 10 years working for Credit Suisse in Global Markets. I am now the Managing Director, and Reinis directs portfolio management and trade execution for the firm. In 2012, we were joined by Robert Bourke, who took on the role of Head of Technology following a 9-year stint at Nuance Communications (previously ScanSoft).

The original team has been strengthened later with directors of operations and business development, an assistant portfolio manager, risk management professionals, financial controller and one investor relations specialist. Currently, we are a team of 14 professionals, of which 5 are Board Members. Our diverse team is talented and innovative, specialising in research, development, portfolio management, and trading.

In 2011, Leman Capital Management was established as the management company for the BVI-domiciled Quant Fund; at present this is the only fund our investors can buy into.

Tell us about the company’s client base, and your total assets under management.

As of September 1, 2016, the Quant Fund held over USD100m in assets. Our focus has always been on long-term investors who are attracted to our returns and investment strategy. Investors in our fund come from all walks of business, including some institutional and fund of funds, but the majority, in excess of 70%, are high net worth individuals, wealth advisors and family offices. In terms of geographical spread, US investors account for approximately half of assets, with the remainder coming from Asia and Europe.

Can you explain how the foreign currencies market is different to the equities markets, and why you selected this particular sector?

The foreign currencies market, also known as the ‘FX’ or ‘Forex’ market, is relatively inefficient in nature, as a result of the various different trading intentions of financial transactors and speculators, who are the primary participants in this market.

Speculators and arbitragers do not serve clients, and have no interest in maintaining a continuous market; rather, they try to profit from trading in the market directly. On the other hand, financial transactors are not necessarily primarily concerned with currency itself, but will often enter the market as part of a financial risk reduction strategy. The FX market is dominated by central banks, though they use currency as a policy lever more often than to generate profit. Large corporations and commercial banks will trade in the FX market as part of a hedging strategy, as well as to control foreign currency revenues and expenses. The number of different players in the market, as well as the diverse motives for their activities, lead to short-term inefficiencies that can be exploited by proactive position-taking to generate outsize risk-adjusted returns.

With a huge number of participants trading at any particular moment, the FX market is the largest, and most liquid, global financial market. Its high liquidity generally leads to lower transaction costs and proportionally tighter spreads than can be achieved via equities.

From the perspective of simplicity, currencies provide comparatively few investment opportunities, when compared to equities. Only 18 currency pairs are actively traded, with the top eight pairs contributing over 70% of the total Forex volume, and combinations of USD, EUR, GBP, JPY, CHF, CAD and AUD represent 95% of all speculative trading. This means that currency trading is easier to follow than selecting amongst thousands of stocks to identify the best deal.

The FX market is mostly concerned with variations in economic data releases, whereas the stock market performance is susceptible to a wide range of financial news factors, as macro and microeconomic data both influence individual stocks.

Forex also offers greater leverage opportunities than equities. If you are trading stocks, then you are probably doing so without the advantage of leverage. If you are trading on a margin account, generally the maximum leveraging for stocks is two-three to one. There are also qualifying criteria you must meet before you can trade like this, and not all investors are approved for a margin account. For currencies, on the other hand, there aren’t many restrictions on qualification, and the leveraging ratios are greater.

Another thing that equities are unable to provide is a 24-hour active market, across different time zones and financial centres, meaning all traders will always have access to the same trades. By contrast, spot FX is tradable around the clock, across the globe, from Sunday 22:00 to Friday 22:00 GMT.

There’s also a concern that the Forex market is vulnerable to the same high frequency trading risk issues that triggered a flash crash in the stock market in May 2010. Algorithms respond to specific market scenarios, but because interbank Forex is a decentralized market, the risk of traders applying HFT techniques across markets, which can trigger a negative ripple effect, is very slim.

Finally, Forex offers more flexibility and is more predisposed to taking long and short positions. The nature of foreign currency trading is to consider both sides of the currency pair, buying and selling simultaneously with each trade. Stock investors, however, tend to be less inclined to sell short.

These are just a few of the main reasons why we think quantitative investing techniques are most successful in identifying and systematically exploiting inefficiencies in the FX market.

The Quant Fund returned over 62% in 2015, despite it being a tough year for hedge funds. How would you explain such an outstanding performance?

Our focus on the FX market is our primary differentiator – it is our belief that we are one of the few managers that exclusively concentrates on currencies. Last year, we outperformed a large number of our competitors, who were forced to reduce leverage, or shut down entirely. One of the key factors in this success is assets under management.

Investment managers pursuing quantitative strategies with more than USD1bn in assets would find it extremely difficult to generate significant returns in the FX market; for this reason, we will limit the size of the fund to the opportunity set.

We are entirely confident that, in the coming years, the smaller, agile and more focused funds will have the chance to distinguish themselves, and many of the largest managers will appear more like index trackers than genuine alpha providers. As such, a lot of investors are now beginning to question the value that some of the managers they own really add.

Another reason for our success is our focus on long-term technological advancement and innovation, instead of on promoting asset growth. Granted, technology has allowed investors to participate more actively in the financial markets, but better-equipped participants have more advanced capability than others. Our technological platform allows us to access data and act on information far quicker than participants with less advanced technologies.

Can you explain your investment approach? What kind of fundamental and technical analyses do you carry out, and what type of risk control structures do you utilize to safeguard your fund’s investments in various market conditions?

We operate algorithmic trading strategies that apply advanced quantitative research techniques to exploit short-term pricing anomalies, which can arise in timescales as small as a few seconds, making them impossible for a human trader to perceive.

Our activities prioritize capital preservation and income generation through proactive portfolio management, supported by a proven technological platform and rigorous quantitative analysis. A proactive investment strategy enables maximum flexibility to exploit investment opportunities as and when they arise. This approach is especially useful in today’s volatile markets.

We design quantitative models that provide trend pattern recognition in a far more sophisticated and data-driven manner than traditional technical analysis methodologies. These models utilize various sources of market and macro data to make trade-relevant predictions. This approach is nearly 100% automated, with next to no human intervention into investment decisions. And because the approach minimizes human bias, it implements a disciplined strategy that removes emotional and behavioural investment risk. By implementing rules-based strategies, the quantitative approach can also decipher huge volumes of big data, which in turn can improve the effectiveness of future trading.

Our FX Wave algorithmic trading platform is distinctly more advanced than many typical quant-driven "black box" solutions. The speed at which Leman's mathematical models operate allow for rapid analysis of quotes and trades in the market and the identification of liquidity opportunities, which can be used to make smarter trading decisions.

We believe that risk should only be accepted when it is completely understood, and can be controlled. We strive toward lower volatility in the fund, and measure risk/return performance efficiency via a set of indicators.

Importantly, algorithmic trading plays an essential role in risk management. We use algorithmic trading as a technique to take a big trading lot and fragment it into lots of small market orders, thus spreading the risk.

Can you give us some insight into the technological design of the FX Wave platform?

Initially, FX Wave was created as a basic implementation of the Elliott Wave Theory. In 2007, alongside Reinis Lācis, we began building a wave analysis system based on the Wave Principle discovered by Ralph Nelson Elliott. We tested similar algorithms to analyze market cycles and predict market trends.

According to the Wave Principle, there is a specific and methodical repetition in the ongoing movements of the markets, creating trends that reverse in identifiable patterns. These patterns can be observed in any time frame, and in increasingly smaller degrees. Looking deeper, we discovered that smaller patterns are joined in a sequence of larger patterns, and when these multi-layered pattern structures aligned, this could trigger a signal to buy or sell.

In the current era of round-the-clock news cycle, and easy access to a large and diverse array of news, data sources, opinions and real time updates, quantitative investors must make sense of the constant bombardment of "market noise" in order to make more efficient investment decisions. Our research has uncovered a large volume of noise trading that exists in the Forex market.

Technically, market waves are much like the sound waves used by speech recognition systems. Due to the significant volume of noise in the markets, trend patterns must first be filtered, just as speech recognition systems use adaptive digital filtering for noise cancellation.

In 2012, Robert Bourke left Nuance to join the company as Head of Technology. His specialism in speech recognition and natural language processing has contributed vital insight into the further development of FX Wave. We started to employ the same algorithms utilized in language processing for latent variable extraction from market time series, and created proprietary algorithms for layering multiple quantitative and fundamental trading strategies to generate trade signals.

FX Wave was initially built in the Lua programming language and applied metamodeling techniques as a predecessor of the machine-learning technology we utilize today. In 2012, we totally re-designed the architecture and translated our core algorithms into C++. Machine learning and execution models were integrated into the second-generation FX Wave platform. Later, we integrated a fundamental analysis block and linked the platform to streaming financial data feeds for instant access to global market and macro data.

Today we employ deep machine learning to improve the quality of our trading decisions, and we believe that FX Wave version 3 will dramatically increase the overall performance.

Has your risk management been stricter in the last couple of years, due to the increased turbulence across financial markets?

Since inception, the Quant Fund has successfully weathered various market conditions. The last two years have been particularly volatile, on both the downside and upside; nevertheless, our technological platform and investment strategy were shown to be resilient across all economic environments. We have seen great momentum in recent years, and are confident this will be maintained for the foreseeable future.

Do you utilize any leverage to maximize your returns?

We do employ leverage to increase our returns, but we cap potential losses to under 2% of the account value either side by using trailing stop-loss controllers. We utilize quantitative high and medium frequency trading techniques, and our leveraging strategy is a further reason why we are able to outperform long-only investors.

Is there a particular investor niche that you try to attract for investments into your fund?

The quality of our algorithmic trading and our recent strong performance have helped us to attract a wider pool of investors. Many investors who stepped back after the 2015 turmoil have now understood they need investments that can yield real returns; consequently, successful, innovative managers began to attract investment proposals from big institutional investors.

We consider the present climate to be one that is positive for fundraising, but it is still necessary to identify the right investment partners at the right time. It is our belief that investment performance is harmed by diseconomies of scale if assets under management increase too significantly, too quickly. As such, we maintain our size advantage for investors by limiting the fund’s available capacity.

Typically, we tend not to accept larger investments, as this would lower the overall performance, and, generally speaking, our potential investors are high net worth individuals and families, rather than institutional investors.

How do you think the Quant Fund would be beneficial for a potential investor looking to gain exposure to currencies?

The hedge fund industry is beginning to grow again, and a greater amount of investors' money is now flowing to smaller managers. Recently, we have reached a peak in assets under management of USD100m, and we have a long list of prospects who have indicated their interest in investing with our firm.

Currently, we are hearing from prospective investors not only from the hedge fund world, but also from the traditional sector, who are seeking managers that can add value to their portfolios, rather than the traditional equity and bond managers they have used for many years but have failed to deliver.

Currencies offer a range of benefits that are frequently disregarded by investors more familiar with equity markets. Last year's lackluster performance in the hedge fund industry and the beginning of 2016 served as an important wake-up call for a lot of investors, who are now seeking investments that provide uncorrelated returns, real liquidity and risk control. We believe that Leman Capital ticks all these boxes, by proactively investing in foreign currencies and implementing a proven, multi-layered risk management framework.

What will your management team focus on in 2017? What are the key milestones you are hoping to reach in the next year that you believe will add value to the business?

Our success motivates us to continue the course of innovation, and next year is extremely important for us progressing in our aim to improve investment performance by applying innovative science and more advanced technology.

Our focus has consistently been, and will continue to be, on improving the firm’s technological capabilities, whereas our competitors spend time and money marketing their products and aggressively growing assets under management, thereby significantly damaging performance.

This year is a busy and productive one, and next year promises to be equally busy and productive. We expect to adopt the updated version of the FX Wave trading platform in early 2017. This is an entirely new technological platform that has already achieved impressive results in backtesting and proactive testing, and we hope it will continue to perform well for the benefit of our future and current investors.

Investors want to see that management has “skin in the game”. Tell us a little about how your management team is invested in the business.

In order to align our interests with our investors, we invest our own assets in the fund. Currently, employees of the company account for over 15% of the total assets under management. Furthermore, the management team is also actively invested in the development of Leman's next generation FX Wave version 3 trading platform.

What global trends have you noticed recently that, as an investor, you find interesting?

One thing I'm always amazed at is how quickly technology progresses.

For a long time, capital markets and exchanges were physical locations where buyers and sellers would have to meet and negotiate on the trading floor. When electronic exchanges and trading facilities had been established, one of the key new developments was the advent of financial information exchange protocols and algorithmic trading systems. After that, we observed an ongoing shift towards automation in financial information processing. Later, machine learning was introduced, able to execute human-level performance in the financial markets and a wide range of other areas and sectors, including healthcare, financial services, telecommunications, and even crime prevention.

Today, we have access to incredibly advanced artificial intelligence technology, which will revolutionize the way our investment decisions are made. Recently, "Deep Learning" has arisen as a new global trend in big data analytics. This is a machine learning technique that uses algorithms to identify patterns in multiple layers of data, known as neural networks.

After Google open-sourced TensorFlow in 2015, the barrier to entry for machine learning has dramatically lowered. You do not have to be a wealthy hedge fund manager to implement deep learning in finance, or possess expert knowledge of advanced math models and optimization algorithms to implement deep neural networks. Many small quantitative investment firms, and also private investors, have begun to explore the technology, looking for connections in big data to identify market trends and successfully capitalize on them.

Deep learning is the state-of-the-art approach to building artificial intelligence algorithms. It proves that artificial intelligence is not the future. It is already becoming a global trend.

In a sentence or two, what do you think makes Leman Capital such an attractive investment?

Leman Capital Management is a pioneer in proactive investment management. What sets us apart is our proven technological platform, proprietary quantitative research and light-speed execution.

More information available at: Leman Capital Management

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