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Beyond Trend Following

Beyond Trend Following

This summary is written by Rich based on a conversation in our CTA series between Kevin Cole, CEO and CIO at Campbell & Co. and the podcast hosts, Niels and Alan.

About Campbell & Co.

Campbell & Company is headquartered in Baltimore, Maryland, USA and is a systematic multi-strat or quant multi-strat hedge fund that has been in business for 50 years, starting with trend following on liquid futures markets in the 1970s. 

The company expanded into quant macro, equity market neutral, and short-term statistically driven strategies. The conversation covers the importance of research and innovation in staying competitive in the markets. The episode will specifically cover various topics related to trend following and managed futures which forms a part of the company’s investment programs.

The company believes that markets are not perfectly competitive, and they can find opportunities arising out of investor psychology, behavioural mistakes, and the impact of central meetings and economic forces on markets. 

Research and innovation are the core of the team, and the company continues to focus on these processes as markets evolve. 

The company's objective is to deliver strong absolute returns, low correlation or diversification to traditional assets, and a stable level of risk across their programs. They focus on delivering meaningful alpha above and beyond risk premia factors. 

The company offers a flagship absolute return program that is equally balanced between trend, macro, short-term, and equity market neutral, with a focus on delivering strong risk-adjusted returns, stable risk, and low correlation to stocks and bonds. 

The company also offers standalone trend strategies for large institutional investors looking for a trend-specific profile. 

These strategies aim to deliver strong returns, complementarity to traditional assets, and crisis alpha risk mitigation by focusing on very liquid strategies and markets.

Use of the Sharpe Ratio to Evaluate Portfolios

Niels asked Kevin about their investment philosophy and evolution of their approach. Kevin explained that they believe that markets are not perfectly competitive and they can uncover opportunities by using various strategies such as momentum, macro, short-term, and equity market neutral. 

They focus on delivering strong absolute returns, low correlation, and a stable level of risk across their programs. However, they also take care to avoid increasing Sharpe by using less high-quality means.

Beyond Trend Following – The Many Strategies of Campbell & Co.

The conversation then shifted to equities, and Kevin explained that they have been trading equities since 2001-2002, using strategies such as stat arb, fundamental, and momentum. They trade individual stocks and focus on relative value neutral opportunities to trade momentum in cash equities. They believe that there is not much marginal value to trading trend signals directionally on individual stocks compared to trading a broad set of stock indices on the futures side.

Niels asked Kevin about the different strategies that Campbell runs and how they should be allocated within a diversified multi-asset portfolio. Kevin suggested that the investor's sophistication and the amount of capital they have to allocate should determine the best fit for them. 

For large institutional investors with a diversified book and a team of sophisticated analysts and team members, a targeted allocation to trend can be useful, as they understand what they're getting with the strategy and can evaluate it in the context of the overall book. 

However, investors that do not have as large of an amount of capital to allocate or maybe they just aren't as sophisticated, there's a clear argument for having a broader multi-strat type of diversifier. Kevin also mentioned the importance of the behavioral aspect of making it easier for people to stick with the strategy over time.

The multi-strat approach also has a number of other benefits beyond the behavioral aspect, including embedded leverage of the markets they trade and fee netting. The integrated risk management of the multi-strat approach allows for adjusting the risk at the top level and concentration limits to make sure that they're not overexposed to any one area.

Use of a Crisis Risk Offset or Crisis Alpha Strategy  - A Client Centric Approach

The conversation shifted to the history and evolution of managed futures, with the focus on its increasing use as a crisis risk offset or crisis alpha strategy. Alan asked Kevin whether there is a need to cap equity beta or be more responsive to trading equities in order to optimize the trend portfolio for use in a multi-asset portfolio.

In the context of trend following and managed futures strategies, an equity cap may be used to limit exposure to the equity market when it is not the primary focus of the strategy. This may be desirable for investors who are seeking a diversifying or risk-mitigating component in their portfolio, and who do not want the strategy to be overly exposed to equity market risk. However, an equity cap can also limit the potential returns of a strategy, particularly in bull markets, when equity exposure can be a significant driver of performance.

Kevin's response to Alan's question on whether to cap equity beta or be more responsive to trading equities was that it depends on understanding the objectives and profile of a particular investor. For trend-only mandates, some clients have exposure caps on equities or beta caps or correlation caps on equities. These clients understand the trade-offs with these caps, where the full sample strat would be lower, but other risk-mitigating properties like convexity or skewness would be better.

However, for other clients, it may be better not to put on such constraints. Therefore, understanding what's best for the client is critical. In other words, Campbell's approach is to tailor its strategies to fit the specific needs and goals of each investor, rather than having a one-size-fits-all approach.

By understanding the client's objectives and profile, Campbell can work with the client to determine which strategy and approach would be most suitable for them. This level of customization ensures that the client's needs are met, and the risk-mitigating properties are optimized, ultimately leading to better performance for the client's portfolio.

Moreover, this approach also reflects the firm's commitment to transparency and working in the best interests of its clients. By having open conversations with clients and understanding their needs, Campbell can ensure that its strategies are aligned with the client's objectives and goals.

Views of Replication Methods

The conversation turned to the topic of replication, which involves attempting to reproduce the returns of successful managers like Campbell using quantitative models. Niels mentioned a replication strategy that uses the constituents of the SocGen CTA Index and daily returns analysis to replicate Campbell's exposure across 14 different markets.

Kevin expressed his belief that the replication approach is not an efficient way to build a low-cost trends strategy, particularly because the understanding of how to build a basic trend strategy is now fairly well-known, and there are many reputable managers in the space who offer competitive pricing. He also noted specific risks associated with replication, such as the lag in measurement and estimation and the inference from regression of a manager's returns to a few key factors, which might not work well during turning points.

Overall, Kevin welcomed the evolution and competition in the space, but believes that investors should prioritize experience and risk management overlay from reputable managers over replication.

Campbell & Co’s Research Process

Kevin discussed Campbell's research process and the importance of ensuring that they are not picking up unwanted beta, such as equity or bond beta, in their strategies. 

In the context of this conversation, the term "beta" refers to the sensitivity of an investment or portfolio to broad market movements. For example, if an investment has a beta of 1.0, it will move in the same direction as the overall market, while a beta of less than 1.0 suggests that the investment is less volatile than the market, and a beta of greater than 1.0 suggests that the investment is more volatile than the market.

Campbell's research process aims to ensure that their strategies are not unintentionally exposed to market risks that are not part of their intended investment objectives. In particular, they want to avoid picking up equity or bond beta, which could lead to unwanted market exposure and compromise the diversification of their portfolio. By carefully designing and reviewing their models, Campbell aims to create strategies that are robust, effective, and free from unintended risks.

He mentioned their "metamodel" of research, which involves identifying new areas of research, undertaking the research, and reviewing it in a rigorous way to ensure that it stands up to scrutiny. 

Campbell has a peer review process in place where new models or research ideas are discussed with other team members to challenge the idea and think about where it might break down or why the thesis might not hold.

To avoid finding spurious relationships or strategies, Campbell places importance on having an investment thesis or rationale that's dated and written down before they start looking at the data. They want to have some understanding of where the strategy might work and where it might not work. They also use an out-of-sample holdout or out-of-sample test to validate the idea.

Kevin noted that they put more weight on the whole data series in understanding the behavior of their models and less on recent data. When a strategy is no longer suitable for the market environment or isn't performing in line with expectations, Campbell uses statistical guidance to help them with that decision. They define a distribution of expected outcomes for every strategy in the portfolio and monitor that in real time. If a strategy is pulled, it stays within their repertoire and can come back on if it starts to show life again.

Importance of Diversification

Niels asked Kevin about the importance of diversification in both the number of markets traded and the types of strategies employed. Kevin explained that the concept of effective bets is the organizing principle that Campbell uses to maximize the number of effective bets traded while ensuring each bet has a positive Sharpe or positive expected return.

The concept of effective bets is the organizing principle that Campbell uses to maximize the number of positive expected return trades or bets that they make. As good quants, they want to ensure that each trade has a positive Sharpe ratio and contributes positively to the overall risk-adjusted return of the portfolio.

In order to increase the number of effective bets, Campbell looks to trade a diverse set of markets or effective markets that have low correlation. This means that as they add more markets or strategies, they are increasing the expected risk-adjusted return to the overall portfolio.

Campbell recognizes that adding more of the same markets to their portfolio will not provide much incremental value for directional strategies due to high correlation. However, adding highly correlated markets for relative value trading can increase the number of effective bets by neutralizing to common variation and picking up on residuals.

In the context of trading, "relative value" refers to trading one asset against another asset. When two assets have a high correlation, their prices tend to move in the same direction, so trading them against each other may not yield a significant return. However, when two highly correlated assets are traded against each other for their relative value, their common variations are neutralized, and the trader can benefit from picking up on the benefits from residuals.

This means that the trader can still make a profit by trading the small differences in price movements between the two highly correlated assets, even though they move in the same direction most of the time. Thus, by adding highly correlated markets for relative value trading, the number of effective bets can be increased, leading to better diversification and potentially higher returns.

When considering new markets, Campbell takes into account factors such as liquidity, trading costs, regulatory restrictions, and operational lift. They want to ensure that they devote their resources to the most impactful markets that will provide the biggest marginal impact.

In terms of strategy diversification, Campbell recognizes that adding new strategies such as macro, equity market neutral short term, and other low correlation strategies have added a lot of value to their existing portfolio. However, when it comes to diversifying within trend, the underlying momentum factor is already strong, and there may not be as much incremental value in adding more trend strategies. Nevertheless, Campbell continues to diversify their trend book to capture short-term random variation in their trades.

Overall, the concept of effective bets ensures that Campbell is maximizing their positive expected return trades or bets and diversifying their portfolio to reduce risk and increase the expected risk-adjusted return.

Campbell has been finding new opportunities by basing some new alphas off underlying trend signals and using relative value or other mathematical methods to capture different themes on top of the trend beta exposure, which has been a big focus for them in recent years.

Relevance of ESG to CTA’s

Kevin discussed Campbell & Company's approach to ESG (environmental, social, and governance) investing. The firm has been gradually opening up to ESG for a few years now and has received more questions about it from European investors. The firm has a UCITS fund that has an exclusion list based on ESG criteria. The firm has also done research on how to apply ESG themes to their portfolios using risk factors at the country level to identify a country's level and rate of change of progress in ESG indicators, but this has not been put into production yet due to a lack of investor interest.

Kevin also mentioned that the firm has been exploring weather as an important factor for some markets and has a model that trades based on weather data. However, ESG investing is not the firm's highest priority, and they continue to explore it but have not made it a significant focus of their investment strategy.

Finally, Kevin mentioned that the firm follows rules and does not have an opinion about the investments they make, meaning that they allow others to transact in certain markets, but this does not necessarily mean they have an ESG footprint.

Risk Management and Dynamic Position Sizing

Alan and Kevin discussed risk management in trend following and multi-strategy portfolios. For multi-strategy portfolios, their risk management objectives involve delivering a stable level of risk, diversification among styles, and avoiding concentration in any one dimension to prevent tail risk. 

They use risk factor libraries to measure their exposure to market, sector, and macroeconomic risks. 

On the other hand, trend-following portfolios have less tight constraints on tail risk measures because they allow for more concentration in these portfolios. They use dynamic risk targeting to adjust the risk level of a portfolio based on its complementarity to equity exposures.

Kevin also noted that while systematic trading is valuable, it's not realistic to have a 100% automated system. Human judgment is still required for the research process and allocating decisions. 

Campbell has an investment committee that meets daily to analyze exposures, positions, and risks in the complicated set of portfolios. This committee helps to make sure they are not missing anything and they're up to speed on where they have exposures. The investment committee is also useful in cases where the standard risk management process might not fully be suited for event risks that are upcoming. In such cases, they work with the risk team and other researchers to build in additional layers of protection. 

Finally, there are rare cases where human judgment is needed, such as temporarily removing an exposure that is not suitable for the portfolio.

Niels and Kevin discussed the debate between static and dynamic position sizing in trading. 

The argument for static position sizing is that it allows traders to stick with outlier trades and capture the large number of effective bets, while dynamic position sizing may result in a smaller exposure during outlier trades. However, Kevin believes that dynamic sizing fits better with their investment philosophy, which takes into account changing market volatility and correlations to avoid tail risks and capture effective bets. 

He mentioned that they even sped up the reactivity of their position sizing and models after COVID, as they believed that markets are evolving more quickly now and require faster adjustments. Kevin didn’t argue for one side over the other but stated that dynamic sizing works for them, and another approach might work for someone else.

Capacity, Fees and Flows

Niels and Kevin discussed the topic of capacity, fees and flows. They discussed how after the 2008 financial crisis, many managers had great inflows, some of which may have hit capacity without realizing it or admitting to it. As money left the industry, it left a lot of capacity, which allowed certain types of investors to put pressure on fees and negotiate better deals with managers.

Niels then asked Kevin about his thoughts on fees and whether they should go up. Kevin agreed that systematic quant firms are earning their fees and that continuing to lower fees further doesn't make sense for the investor, allocator, or manager. However, when thinking about capacity, Kevin differentiated between pure trend strategies and multi-strat portfolios and starts at the granular level of individual strategies to think about their capacity. He mentioned that some strategies, like short term and equity market neutral, are fairly capacity constrained, while momentum is less so.

Kevin also mentioned that they are being thoughtful about the fees they offer for different products and have seen good interest from investors at the fee level their products are offered. He noted that there have been strong flows from retail investors like 40 Act mutual funds in the US, but on the institutional side, the evaluation process takes longer, so the industry may see more institutional money flowing to the space in 2023.

Overall, Kevin believes that it's the industry's job now to continue making the case and helping investors see the value they can get by investing in their space.

How Investors Should Think About Expected Returns for Trend Following

Kevin suggested using the long-term experience of realized strategies in the industry to provide guidance on expected returns for trend strategies, which tend to have a realized Sharpe ratio of around 0.5. However, he also emphasized the importance of thinking about the complementarity of these strategies to an investor's overall portfolio, rather than just their Sharpe ratio.

For multi-strategy portfolios, Kevin expected to deliver a higher Sharpe ratio than a trend-only strategy, as diversification can maximize the number of effective bets. He also suggested that a sophisticated trend follower could potentially generate 10% to 20% more outperformance than a vanilla trend follower, but variability, risk management considerations, and short-term performance deviations should also be taken into account.

Alan also asked about cash management for systematic investment strategies, which has become more of a tailwind due to rising interest rates. Kevin noted that cash management can more than cover the cost of fees, and that their firm works with an external cash manager who invests in extremely safe assets, without seeking to go into more risky areas to achieve higher returns.

Misconceptions of Trend Following

Niels asked Kevin about the one thing he hears about trend following that he disagrees with the most. 

Kevin responded that it is the idea that trend following is easy. While it is easy to come up with a trend signal and replicate the basic idea, there is a lot of sophistication and complexity underneath the surface that high-quality managers undertake in terms of risk management, execution, and thinking about the market set that really can add value. 

He also disagreed with the idea that all there is to know about trend following has been uncovered. 

Kevin believes that continued innovation is still occurring in the area, and it is something that still warrants further research as well.

Outlook for 2023 and Beyond

While he didn’t claim to be a macro prognosticator, he noted that their models are adaptive and can be repositioned quickly. 

Overall, Kevin's focused is on remaining adaptive and responsive to changes in the market, while continuing to innovate and add value to their trend-following strategies.

This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.