Breaking the Rules: Why Investment Success Requires Thinking Outside the Box

---

This summary is written by Rich based on a conversation in our CTA series between Harold De Boer, the Head of R&D and Managing Director at Transtrend and the podcast hosts, Niels and Alan. 

About Transtrend

Transtrend is a Netherlands-based asset management firm that specializes in systematic trading strategies, primarily focusing on diversified trend following. The firm was originally established as a research project within a physical commodity trading firm before expanding into financial, stock, and currency markets. As of September 2021, Transtrend managed approximately $5 billion in assets under management (AUM).

• Transtrend's origin and focus on diversified trend following: Harold explained that Transtrend began as a research project within a physical commodity trading firm. They initially planned to focus only on commodity futures but later expanded into financial markets, stock markets, and currency markets. They found that trend following was the most effective approach, and to do it well, they needed to diversify across various markets.
• Importance of not adhering to conventions: Harold emphasized that successful investment strategies must avoid sticking to conventions. He used the example of the Turtles, a group of traders taught a specific trend-following system, and notes that the most successful of them adapted and evolved their strategies over time. Harold argued that money is made by doing something different and that embracing conventions limits growth and performance.
• The need for constant evolution in investment strategies: Harold highlighted the importance of constant evolution and adaptation in investment strategies. He explained that markets are continually changing, and successful investment strategies must change along with them. He cited the "CTA winter" of the 2010s, where many CTAs underperformed due to a lack of adaptation and diversification in their strategies.
• Market impact and the significance of biodiversity in investment: Harold discussed the importance of market impact and biodiversity in investing. He argued that having a diverse range of investment strategies is essential for the overall health and performance of the market. When too many investors follow the same strategy, market impact increases, leading to reduced returns and poor market functioning.

How Transtrend Uniquely Positions Itself

Harold discussed some of the unconventional choices Transtrend has made to differentiate themselves in the market. He highlighted the following key points:

• Synthetic Markets: Transtrend trades not only outright markets but also synthetic markets, offering a broader range of investment opportunities.
• Portfolio Perspective: The company focuses on a portfolio-level approach rather than individual markets, with diversification as a key element. This enables them to make different choices in comparison to traditional market strategies.
• Response to Market Events: Harold provided an example from when Russia invaded Ukraine, illustrating how a diversified portfolio helped them navigate market changes. While they experienced losses in Eastern European currencies, they also had long positions in commodity markets, which were growing. This balanced approach allowed them to maintain profitability without reacting hastily to individual market fluctuations.
• Unified Team Structure: Transtrend operates with a single team managing the entire program, which prevents them from being distracted by local issues that might not impact the overall portfolio. This holistic approach enables them to better take advantage of diversification and make more informed choices.

The Need for an Investor to Understand the Objectives of CTA’s

The discussion then centred around the broader trend-following industry and the objectives for CTAs (Commodity Trading Advisors) and trend-following programs. The key points raised were:

• Industry Tendency: There has been a tendency for managers to include non-trend components in their strategies to compensate for lack of trend returns and to smooth out performance, possibly due to investors' preference for steadiness and consistency.
• Optimization Pitfall: Over-optimization in research and strategy development can lead to vulnerabilities when unexpected events occur, such as the pandemic or interest rate changes. This applies to all investment styles, not just CTAs.
• Index Composition: It is important to note that the composition of CTA indices changes over time, as different managers with different styles are included. Managers should focus on delivering good absolute returns rather than trying to replicate an index.
• Transtrend's Objective: Harold emphasized that Transtrend aims for absolute returns while differentiating from others in the industry. They make investment choices based on what they believe is the best investment, not for correlation or tracking error purposes.
• Overall, the conversation highlighted the importance of understanding the objectives of CTAs and trend-following programs and the potential pitfalls of over-optimization or trying to replicate an index performance.

Some of the Pitfalls of the Research Process to be Aware of 

Harold and Alan discussed the pitfalls of research processes and overfitting to specific market environments. Harold emphasized that computers should not replace human intuition and understanding, as computers can become a disadvantage if used excessively for testing and optimization. He also highlighted the importance of human input in trading decisions, which is often underplayed in the industry.

Alan raised the issue of discretionary decision-making in trading, and Harold asserted that human and computer cooperation is more effective than relying solely on computers. He gave examples of situations where human decisions were crucial to the success of trades.

Views of Replication Methods

Niels brought up the topic of CTA replication strategies and their weaknesses. Harold pointed out the issue of trading with large sizes on limited timeframes and the denial of market impact. 

In discussing market impact Harold was referring to the assumption that large trades can be executed without affecting the market. This assumption is often made by some trading strategies or replication strategies that assume they can trade in high volumes without impacting the prices of the assets being traded.

However, in reality, the market impact of participants trading is an essential factor that moves the market. Large trades can cause significant price fluctuations as they create an imbalance between supply and demand, thus affecting the market prices. Denying this impact can lead to unrealistic expectations and ineffective trading strategies, as it underestimates the effect that large orders or trading decisions can have on the market.

He also argued against the passive investment approach, as it reduces diversification possibilities for allocators. Harold believes that seeking low tracking errors, a type of passive investment approach, costs investors money and goes against the goal of achieving better returns.

When Harold discussed the passive investment approach, he was referring to strategies that aim to replicate a market index or a benchmark, rather than actively selecting individual securities or making discretionary decisions. Passive investment strategies often have lower fees and are built on the premise that it's difficult to consistently outperform the market over the long term.

However, Harold argued that this approach can reduce diversification possibilities for allocators, particularly in the context of alternative investments like CTAs (Commodity Trading Advisors). The reason behind this is that when investors focus on passively tracking an index, they may end up concentrating their investments in strategies that deliver similar returns, leading to a less diversified portfolio. In contrast, if investors select different CTAs that perform well in various market environments and have low correlation to each other, they can achieve greater diversification and potentially reduce portfolio risk.

Harold emphasized that allocators should seek a broad range of alternative investments with different characteristics and performance patterns to maximize the benefits of diversification in their portfolios. By focusing solely on passive strategies or aiming to minimize tracking error, investors may inadvertently forgo these benefits and miss out on the risk premiums that can be earned by embracing different sources of market risk.

Niels and Alan discussed how some investors want greater certainty in getting the return series of managed futures and trend following, and Harold suggested that these investors should instead seek potential outliers and make different choices for diversification.

Importance of Diversification

Harold discussed the importance of diversification in trading and how the number of markets one trades can impact a portfolio's performance. He disagreed with the notion that "the more markets, the better" and notes that having too many correlated markets can make a portfolio slow to adapt and pick up new trends. He explained that markets have become more connected over time, affecting the way diversification and correlation work.

He also emphasized that the focus of their investment approach is on maximizing diversification rather than quickly adapting to market changes, which allows them to hold positions in less liquid markets. They have shifted from a market-centric to a trend-centric perspective, aiming to invest in different trends to maintain diversification.

Harold went on to discuss the importance of market reliability, citing examples of countries or exchanges where they stopped trading due to concerns about trustworthiness or interference from political or central bank actions. He stressed that counterparty risk must be avoided, and they only trade in markets where they can trust the reliability of the counterparty.

In summary, Harold highlighted the significance of diversification, the changing nature of market correlations, the importance of focusing on trends rather than specific markets, and the crucial role of reliability and trust in trading decisions.

Impacts of Capacity Constraints and an Investors Desire for Low Fees

Niels asked Harold about capacity constraints in diversified trend-following strategies and the impact of low fees negotiated by pension funds. 

Capacity constraints refer to the limitations on the amount of assets a particular investment strategy can manage effectively without negatively impacting its performance. In the context of trend-following strategies or CTAs (Commodity Trading Advisors), capacity constraints occur when a strategy becomes too large, making it difficult to execute trades efficiently, respond quickly to market changes, or maintain its historical performance levels.

As the assets under management (AUM) increase, the strategy may experience diminishing returns due to the challenges in executing trades at the desired price levels or within the required timeframes. This can result in increased trading costs, reduced diversification, and lower overall returns. Capacity constraints can also be exacerbated when multiple CTAs follow similar strategies, as they might compete for the same limited opportunities in the market, thus driving down performance for all involved.

Harold acknowledged that trend-following strategies are indeed capacity-constrained, and the constraints become even more significant when multiple CTAs do the same thing. He emphasized the importance of embracing dispersion to ensure the success of different CTAs.

Harold noted that during the "CTA winter," the amount under management decreased, which helped from a capacity standpoint. He clarified that Transtrend will not reduce fees to attract more money as it contradicts the idea of a capacity-constrained strategy. He argued that it's worth paying for the best possible strategy, and allowing an unlimited amount of low-cost investors would negatively impact existing investors.

Harold mentioned that the increasing belief that liquidity is available for free has had an impact on the markets. To adapt, Transtrend has changed its approach to execution and trading, acting more as a liquidity provider instead of a liquidity premium payer. As a result, the current capacity of their program is larger than it was in the past when they managed above 10 billion, even though they now manage a lower amount.

Relevance of ESG to Trend Following

Niels and Harold discussed the relevance of ESG (Environmental, Social, and Governance) criteria in the context of trend-following strategies and CTAs. Harold mentioned that while they don't explicitly label their approach as ESG, their trading inherently involves environmental factors due to the impact of climate-related events on commodity and energy prices. He emphasized that trend-following CTAs essentially trade on the price risks associated with various assets, not directly investing in the underlying commodities or companies.

Harold also highlighted the importance of being involved in markets undergoing significant change, as the transition away from fossil fuels and other shifts in industries create risks that need to be managed. Futures contracts, in this context, serve as ideal tools for transferring risk. While they may not call their approach ESG, Harold believes their strategy aligns with responsible investing, as they actively participate in markets experiencing change and manage the associated risks.

How do we Frame the Notion of Expected Returns from Trend Following to Allocators?

Alan asked Harold about how allocators should think about expected returns from trend-following strategies when incorporating them into their asset allocation framework. Harold emphasized that they focus on controlling risk, and the return is the upside they hope to achieve in the long run. However, he refrained from predicting returns.

When asked about guiding allocators, Harold explained that it's difficult to provide an absolute return expectation. Instead, he suggested that investors can look at the environments in which trend-following strategies are likely to make money and how their returns correlate with other types of investments. He reiterated that trend-following strategies offer diversification in a multi-asset portfolio and investors should accept whatever the market provides.

Addressing the suggestion of reducing equity exposure in trend-following strategies, Harold disagreed, arguing that limiting the range of traded markets would hinder diversification within the strategy. He believes that better diversification comes from trading a variety of markets and managing risk through long and short positions, as well as identifying different trends and understanding how they work together.

Ideas about Trend Following that you Disagree with Most

Niels asked Harold about the one thing he hears about trend following that he disagrees with the most. Harold responded that he strongly disagrees with the notion that trend following is just a factor, implying that it is much more than that and cannot be simplified to a single aspect or characteristic.

In the context of Harold's response, a "factor" refers to a specific characteristic or attribute that helps explain the risk and return patterns of an investment or a group of investments. When people say trend following is just a factor, they are suggesting that it is merely one of many explanatory variables that can be used to understand the performance of a trading strategy or investment portfolio.

Harold disagreed with this notion because he believes that trend following is not just a single aspect or attribute; rather, it is a comprehensive trading strategy that involves various components, such as risk management, diversification, and adapting to changing market conditions. By reducing trend following to just a factor, people may be oversimplifying its complexity and underestimating its value as a standalone investment approach.

What the Future Holds for Trend Following

Harold shared his hopes and concerns for 2023. He was most excited about the potential resolution of the situation between Ukraine and Russia, which would bring greater stability to the region. He believes that addressing this geopolitical issue is of utmost importance.

On the other hand, Harold expressed concern about the ongoing COVID-19 situation, particularly in China, where many people are still suffering and dying from the virus. He hopes that the pandemic will finally subside, and improvements will be made in the last areas struggling with the virus, preventing further loss of life.

---

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.