Capturing the “Meat” of Market Cycles

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This summary is written by Rich based on a conversation in our CTA series between Ryan O’Grady, Chief Executive Officer and a Founding Principal at ROW Asset Management, and the podcast hosts, Niels and Alan.

Key takeaways include:

• The real value proposition in a trading firm, according to Ryan, lies in managing off periods better and having a more sophisticated approach that is not solely dependent on the exposure that investors are seeking.
• Trend following is more complex than just capturing beta. Trend followers try to capture the "meat" of market cycles, and skill comes into play in determining the appropriate timeframes and adjustments to make the decision of whether to focus on short, medium, or long-term trends, and how to adjust them over time, adds a layer of complexity that makes trend following more nuanced than simply capturing beta.

About ROW Asset Management

ROW Asset Management is a quantitative investment research firm based in Newport Beach, CA and New York, NY.  Founded in 2010 by industry veterans, Ryan O’Grady, CEO and Jeffrey Weiser, President, ROW manages investments on behalf of institutional investors worldwide.  As a research company, ROW is continually focused on blending the latest academic research with practical markets and trading experience, to develop a comprehensive and ever-growing array of model styles, spanning multiple asset classes and time frames, seeking to exploit global market opportunities.

ROW's goal is to create an all-weather return profile with the divergent characteristics expected from a CTA. As a member of the SocGen CTA Index, they focus on a single adaptive strategy. Ryan emphasized the importance of reactivity in their investment approach, as they adjust positions quickly in response to changing market conditions. This reactivity leads to a trend-following approach that correlates with other trend followers. ROW is proud of its strong client relationships and the usefulness of their return stream.

Ryan O'Grady talked about the investment philosophy of ROW Asset Management, which is not limited to trend following but is agnostic to style. They constantly look for new models and strategies to adapt to changing markets, including non-trend strategies. Ryan believes there will always be opportunities to capture via research.

ROW's approach is designed to generate positive returns regardless of the market environment. Ryan mentioned that they're not only interested in uncorrelated returns to equities, but also want their performance to stand on its own. He discussed various factors that create opportunities for firms like ROW, including market participants with different objectives, behavioral biases, and risk mitigation strategies.

Importance of Research

Ryan and Alan discussed the importance of research in developing trading models and strategies. Ryan shared that their team heavily relies on academic research as a force multiplier, with a focus on identifying valuable findings and distinguishing them from overfit nonsense. They position their firm in the middle of the spectrum between simple models and highly complex ones.

The key challenge in their research is determining what strategies will be persistent over time, and intuition plays a significant role in this process. To add new models, the team identifies potential weaknesses in their existing strategies and starts developing new models before they become necessary. They also consider removing models when the core thesis no longer matches reality.

Machine learning is a topic of interest, but Ryan stated that they have not found it to be highly effective in their domain, as financial markets are constantly adapting and resistant to exploitation. They use linear regression, a simple machine learning technique, but do not rely on it to the extent where they cannot understand why a model works.

In terms of new research areas, Ryan mentioned that flows and their impact on markets are a significant focus for their team. While they are not big consumers of alternative data, they are interested in regulatory agencies' data on holdings, positioning, and flows.

In the context of the financial markets, "flows" refers to the movement of money or capital in and out of various assets, such as stocks, bonds, or commodities. This movement can result from various factors, such as changing market conditions, investor sentiment, or macroeconomic trends. When Ryan discussed flows, he is referred to the impact of these capital movements on the markets and how they can influence the performance of trading strategies. Understanding and monitoring flows can help identify potential opportunities or risks in the market, as they can indicate trends or shifts in investor behavior.

Diversification and Replication

Ryan highlighted the benefits and risks associated with diversifying across markets and strategies. He explained that diversification can improve Sharpe ratios but may introduce risks if correlations are incorrect or if there's over-deleveraging. He mentioned that his firm trades around 97 markets, constantly considering the right balance for diversification.

The topic then shifted to replication, specifically regarding an ETF that replicates the SocGen CTA Index. Ryan was asked about his thoughts on the replication of systematic strategies. The question raised concerns about using linear regression as a method for replicating strategies and invited Ryan to share his perspective on the pros and cons of such an approach.

Ryan discussed replication of trading strategies and the risks associated with formulaic approaches. He mentioned that his firm has a program that can replicate returns from a set of simple models, but the goal is to outperform such replication by being better and more forward-thinking.

Niels questioned the risks and trade-offs associated with these replication approaches. Ryan explained that the main drawback of a formulaic strategy is its lack of forward-thinking and adaptability to changing market conditions. He emphasized the importance of being anti-fragile and having a mix of strategies that can handle periods when trend following is not performing well.

Ryan used the analogy of outrunning a bear to describe the objective of staying ahead of competitors and mitigating drawdowns. The real value proposition in a trading firm, according to Ryan, lies in managing off periods better and having a more sophisticated approach that is not solely dependent on the exposure that investors are seeking.

"Antifragile" is a term coined by Nassim Nicholas Taleb in his book "Antifragile: Things That Gain from Disorder." It refers to systems that actually improve or benefit from shocks, volatility, and uncertainty, rather than just being able to withstand them (which would be considered "resilient" or "robust"). In other words, antifragile systems thrive in chaotic and unpredictable environments, adapting and growing stronger as a result of stressors and challenges.

In the context of trading and investing, an antifragile strategy would be one that not only survives market turbulence but also capitalizes on it to generate profits or improve its overall performance. Such a strategy would be designed to adapt to changing market conditions and take advantage of opportunities that arise from market disruptions and volatility.

Risk Management and Drawdowns

The discussion then focused on risk management and managing drawdowns in the context of a multi-strategy approach. 

Ryan clarified that their firm doesn't believe in drawdown management based on reducing risk as losses occur, because it can lead to a "death spiral" where an investor gets trapped in a cycle of cutting risk and not making as much as they would have otherwise. Instead, they focus on having a mix of models that respond well during drawdowns.

Ryan explained that the presence and weight of trend-following strategies in their multi-strategy approach contribute to the similarity of their return profile to that of trend-following strategies. Carry strategies also tend to have a positive correlation with trend-following strategies due to their reactive nature.

Regarding managing risk in the portfolio, they have a pyramid of concentration and limit checks in place to prevent over-concentration. Their combination of systems is designed to reduce positions as market cycles start to exhaust themselves, which differs from the "pedal-to-the-metal" philosophy some investors follow. Ryan believes that both approaches have merits and can serve different investor needs, but their approach aims for more consistency in performance.

Capacity, Fees and Flows

Niels and Ryan discussed the growth of the industry and its impact on the fees and capacity of different managers. 

Ryan highlighted that fees generally depend on the market demand and the complexity of the strategy. Performance fees are preferred in the industry as they align the interests of managers and clients.

Niels asked if there is a limit to how much money can be in the CTA industry and whether this might force managers to adjust their strategies. Ryan agreed that this should be considered and pointed out that the entire market has been growing as well. He used the analogy of the poker boom, suggesting that as the industry grows, the best players will have to adapt and differentiate themselves from the good players. This growth may put more pressure on overly simplistic approaches, causing a performance gap between highly sophisticated strategies and less advanced ones.

Niels acknowledged the adaptability of the industry and the importance of investors being able to discern which types of strategies may suffer due to growth and increased competition.

The Role of Multi-Strategy Portfolios in a Multi-Asset Portfolio Context

While pure trend models often serve as diversifiers, multi-strat portfolios may provide additional exposures that clients may already have. Ryan acknowledged that despite the benefits of adding CTA strategies to traditional stock/bond/cash portfolios, the allocation to these strategies remains lower than expected. Ryan suggested that some clients may be more focused on return goals rather than specific ratios or risk targets.

Ryan explained that in order to determine if a particular strategy is beneficial or redundant, clients should drill down into the details of each strategy to see how it interacts with their existing portfolio. This can provide a clearer understanding of whether the strategy truly offers diversification or simply adds another layer of risk.

The challenge, as Ryan pointed out, is for managers to make it through the initial selection process and differentiate themselves among numerous competitors. Clients may become discouraged after choosing a manager who performs poorly and may be hesitant to invest in similar strategies in the future.

Misconceptions of Trend Following

Niels asked Ryan if there is a common misconception about trend following that he disagrees with. 

Ryan brought up the concept of trend beta, which he finds interesting. He pointed out that there is no single "trend beta" since different trend-following firms can have significantly different returns despite all claiming to be pure trend followers.

Ryan suggested that trend following is more complex than just capturing beta. Trend followers try to capture the "meat" of market cycles, and skill comes into play in determining the appropriate timeframes and adjustments to make the decision of whether to focus on short, medium, or long-term trends, and how to adjust them over time, adds a layer of complexity that makes trend following more nuanced than simply capturing beta.

In summary, Ryan challenged the notion that trend following is a straightforward, easily replicable strategy. He highlighted the diversity of performances among trend followers and emphasizes the importance of skill in capturing market cycles effectively.

Outlook for 2023 and Beyond

Niels asked Ryan about his excitement or concerns for 2023. 

Ryan discussed how the central banks' control over the market, which was especially prevalent from 2010 to 2019, could diminish in the future. This reduced control may lead to more opportunities for trend following strategies, particularly in equities.

Ryan mentioned that political changes and the rise of populist governments may also contribute to less central bank control. Additionally, the increase in competition, nationalism, protectionism, and inflation, along with the decline in globalization, could create more volatile market conditions. These circumstances are generally favorable for adaptive strategies, like trend following, that don't have biases or benchmarks and can quickly react to changes.

However, Ryan cautioned against trying to time the market or view trend following as an opportunity that can be missed. Instead, he suggested adopting a steady-state approach and focusing on long-term trends. This perspective allows investors to better manage their expectations and adapt to market conditions over time.

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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.