Kathryn Kaminski is one of my favorite people to discuss Trend Following with, because she has a great way of simplifying and explaining some of the key concepts of the strategy. Today, we talk about the phrase Crisis Alpha, and how it may be better to think about these strategies as Divergent strategies, because in reality we don’t need a crisis in order for Trend Following to do well. Years like 2014 and 2017 are great examples of this. Q1 of 2019 is perhaps a more recent example too. We also touch on Convergent strategies, which, in my mind, are 'short volatility' strategies- even if not all investors realize this. I think 2018 gave us a taste of what is to come when volatility starts to re-emerge in the markets. So enjoy these unique takeaways from my conversation with Kathryn, and if you would like to listen to the conversation in full, just go to Top Traders Unplugged Episode 41 & Episode 42.
Is Trend Following just a hedge for bad Equity markets?
Niels: Absolutely. Now, I want to stick with the cover of your book and especially the last part of the title: The Search for Crisis Alpha. Now, I know you are responsible for coining this term ‘Crisis Alpha’ and I want to talk to you about this. Before I do so, I also want to offer a slight concern that I have about the perception of the role of Trend Following in a crisis and it goes something like this. The way I see Trend Following being positioned, and this is not new. This is something that has happened for many, many years. It's kind of a hedge against equity markets if and when they run into trouble, and that always gets labeled as we're in some kind of crisis and that's obviously where the crisis alpha is linked to, but there are far more bonds than equities in the portfolios of investors and I never really hear any debate about trend following as "a hedge, or a protection" against periods where bonds might run into trouble. Especially in a time where bond prices are, to say the least, very high, how do you think about that and is there a concern that when we hear the word 'Crisis Alpha' and trend following, that people automatically think that this is relating to equities?
Katy: So now going back to your point about bonds and commodities. That's something that really bothered me as well, because I kept getting that question all the time. So in the book we talked about crisis alpha for commodity indices. We talked about bond crisis alpha. We talk about commodity crisis alpha, but over the course of writing this book I actually had moved more towards a new idea, and this is the idea of divergence. What we do in the book is we explain that trend following strategies are long divergence. What that means is that the most divergent moment in history is always crisis, wherever it comes from. Yeah, so crisis alpha is part of that. That's extreme divergence. The story is a little bit more clear to me now that it's really about being long divergence in markets, and divergence can be driven by many things. The reason that equity is the central point is that most of us have a home biased equity markets. Our focal point from an emotional standpoint, are equity markets, so they have a little bit more impact on the psychology of the general marketplace, and that's why they can be more extreme, but they're in no way the only thing that drives divergence.
"Convergent risk-taking strategies are used when we believe that the world is somewhat stable, knowable, understandable, and quantifiable. Divergent on the other hand.."
Niels: Sure. I want to talk about the convergent and divergent strategies, and I'd love for you to explain this, but I have to say, I think certainly that many investors are perhaps not... and maybe we don't have enough data, but it will be interesting to see how trend following may actually also be very, very useful in a period where we get a massive crisis in the bond markets, which, on a personal note, I would say looks very likely in the next few years. But let's take you back to the story about divergent and convergent strategies and let's be sure that we're mindful that not all listeners are familiar with these terms, so maybe you can break it down in your usual good explanatory way?
Katy: OK, so if you step back for a second and you think about risk as a concept, risk is really sort of what we face every day in every aspect of our life. It's sort of a dynamic process. How we handle risk depends on both what our frame of reference is as an individual, our experiences over the past, and also our beliefs. So if we think about that, those three things come together to give us an idea about which type of strategy we're going to use, in any risk situation, whether it's personal or financial. Convergent risk taking strategies are used when we believe that the world is somewhat stable, knowable, and understandable, and quantifiable. Many, many risks in life actually are somewhat convergent, or quantifiable. When we believe that the world is like that, then we tend to apply one set of strategies, convergent risk-taking strategies. Now on the other hand...
Niels: Can you give me an example of a convergent?
Katy: Yes, so I'll get there in a second. Let me explain the two first, and separately and then I'm going to show you some examples of both. I'll explain some practical examples and also a trading strategy.
Katy: So the difference between convergent and divergent is that we all know that Taleb has made this very famous with his "black swan", is that life is about risk, but it's also about uncertainty. So uncertainty is when the conditions and situations you are facing are unknown to you and unquantifiable. So when we feel that the world is governed by uncertainty, we have a very different approach to how we handle risk taking.
So let me explain the difference here and give you an example. So if you're a convergent risk taker, you have a particular view. Let's say that you view that equity markets are going to go up, as an example. If equity markets go up, you tend to take profit on that. When they go down, you'll tend to do the opposite. You'll say, wait a minute, I know that equity markets go up over the long run, this looks like a buy opportunity. I should actually double my bet, or at least hold my bet and not sell it. So in that sense, over time, when you're convergent, when you win it reaffirms to you what you believed. When you lose, it actually goes against your fundamental belief structure which is sort of a threat in some sense, causing you, in some sense, to often reaffirm your beliefs. Now divergent is the opposite. If you imagine a scenario where you have no idea if A, B, or C is going to do better than the others, what you'll do is you'll invest, or put a small amount of investment in each of them, and if one of them starts to do well, you'll say, hmm, this could be it, I don't know, but A could be the one. So you'll double your bet on the thing that's going well. Every time you lose you don't have any prior expectations about a particular position or particular view, so you'll cut your losses. So those two philosophical views are very different. For those of you who know... you yourself being a trend following manager, you know that trend following managers, in general are divergent. When they're asked what their view is about the dollar, they may give a view, but they don't... they would change their view as soon as their indicators said something else. Global macro investors are not the same. Same with value investors, they believe in the value of a particular company. It really depends whether they work - if the world is actually governed by risk or uncertainty. So, let me give you some examples. Let me give some examples outside of finance and also some examples in finance. One of my favorite sort of analogies is actually social networking. I have a lot of Swedish friends who, I think in Sweden it's very focused on having a good, close network of friends over a long horizon. If you're socially a convergent risk taker, that means that you find a small group of people that you know, that you believe in and you nurture that: those relationships, bringing in some new, but not as many new.
"Niels: Often people believe that Trend Following by definition is just a long volatility strategy, but what you're really saying is... it's long divergent? Katy: Yes."
A divergent risk taker, socially, actually is one of those social butterflies, who goes from table to table knowing everybody and waiting until the next big opportunity comes. So they cut their losses very well. They have very good strategies for that. They find a way to go to the next table very easily. So that's an example in sort of your personal life, but another good example that I have used with some consultants and with other investors that I think is a good one, is the world of private equity. In the world of private equity there are two common strains: one is venture capital, and the other is the more mature leveraged buyout stage investing for private equity. The predominant strategy type in the mature world of private equity is actually more of a convergent approach, which means that you find the companies that you believe in; that you believe are undervalued; and you invest a lot in those companies, and you do a lot of the fundamental analysis to confirm your beliefs and make sure that you are doing the right, prudent thing.
On the other hand, the world of venture capital and entrepreneurship, there is so much uncertainty, so what successful venture capitalists do is they go out with a small amount of initial investments, and they invest across a basket of many interesting and possibly exciting entrepreneurs. They do analysis, but they just can't do the same type of analysis of cash flows and potential earnings that their friends in LBOs do, because it's just not possible. So in that case, where you're dealing with risk and uncertainty: things that are hard to predict, it's much better to put small investments, which means you limit your losses on the downside, hoping that one of these new startups will be the next big LinkedIn, or Skype, or Facebook, and the profile of these is very consistent with what we see in our world, which is the trend following world. Trend following is just a systematic example of a divergent risk-taking strategy.
Niels: I think you maybe mentioned this earlier, and I think it's an important point, because often people believe that trend following by definition is just a long volatility strategy, but what you're really saying is it's long divergent.
Niels: Of course divergence and volatility is somewhat related, but it's not the same thing.
Katy: Yes, divergence and volatility are correlated. They're positively correlated maybe at 20%. The reason is that... I was just giving a talk about this recently for the CME, and what I said was that if you have low volatility, you tend to have low divergence, but if you have high non-directional volatility, so that means where things are going up and down, and up and down, but they're not really going anywhere. This is actually a nightmare for a divergent trend following strategy, so there's no divergence in that. It's actually low divergent. But if you have high directional volatility, then you have high divergence. So divergence is more if you take... it's basically the amount of discernable trend in price. So if you take this, sort of over an horizon and you divide the amount of movements, you're actually taking the volatility out. So if you have lots of volatility, the divergence is really the signal to noise ratio in prices. So when there's lots of volatility there's lots of noise, and therefore divergence is not very high.