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42 Why You Need this Trading Strategy TODAY with Kathryn Kaminski of The Institute for Financial Research, Stockholm – 2of2

"Benchmarks in our industry are like taking a fruit salad and comparing it to an apple." - Kathryn Kaminski (Tweet)

Welcome to Part 2 of our conversation with researcher and co-author of one of the definitive books on trend following. In this conversation, we dive into the the models that she used in writing the book, as well as her thoughts regarding risk management, what you should be asking a manager during due diligence, and what the future holds for the managed futures industry.

Thank you for listening and welcome to the second part of our talk with Kathryn Kaminski.

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In This Episode, You'll Learn:

  • What Kathryn looks at when evaluating the track records of managers.
  • Her thoughts on the recent performance of trend followers.
  • About price range compression.
  • If she has a favorite statistic to look at when analyzing a manager.
  • How she and her co-author came up with the trading strategy that they use in their book.

    "We focus on position sizing; creating one key formula which is a function of several key variables." -Kathryn Kaminski (Tweet)

  • Why the exit from a position is just as important as the entrance.

    "The point of a trend following strategy is that there is both the entry and the exit." -Kathryn Kaminski (Tweet)

  • What trend leakage is.
  • Her views on how inflation and other environmental changes affects trend following strategies.

    "Extreme environments tend to have divergence, and thus more opportunities for trend followers." -Kathryn Kaminski (Tweet)

  • About diversification.

    "There are pros and cons to how much you diversify your process." -Kathryn Kaminski (Tweet)

  • About risk management; how Kathryn defines risk and what is important to look at in risk management.
  • Kathryn explains the topics of hidden and unhidden risk.
  • What kind of drawdowns should be expected from a trend following model.

    "When you look at trend followers, they have a lot more drawdowns over time than equity, but they are way shorter." -Kathryn Kaminski (Tweet)

  • A discussion of the drawdowns that trend followers have experience in the last few years.
  • Seeing drawdowns as a buying opportunity.
  • How to detect if a manager’s models and system has stopped working.
  • The biggest challenge for the CTA industry right now.
  • What she would ask of David Harding.
  • What questions investors should be asking of managers when doing their due diligence.
  • What personalities traits a good trend following manager should have.
  • Her thoughts on regulation, especially for smaller managers.
  • What her plans are for the future and how she sees the managed futures industry going forward.

Resources & Links Mentioned in this Episode:

This episode was sponsored by Swiss Financial Services:

Connect with The Institute for Financial Research, Stockholm (SIFR):

Visit the Website: www.sifr.org

Call SIFR: +46-8-736 91 01

E-Mail SIFR: katykam@mit.edu

Follow Kathryn Kaminski on Linkedin

"In my opinion, risk management is the greatest asset of the CTA industry." - Kathryn Kaminski (Tweet)

Full Transcript

The following is a full detailed transcript of this conversion. Click here to subscribe to our mailing list, and get full access to our library of downloadable eBook transcripts!

Niels

Absolutely. Now you mentioned the word track record, and I just wanted to ask, from your perspective from a resource-oriented view, track records are difficult. Some of them are very long, but clearly we know that the way a strategy starts is certainly not the way it operates today. So there is this evolutionary element which can be very hard to grasp as an investor. What do you think is important to look at when you look at a track record? What would you look at if you were evaluating a manager, which of course you did a few years back? 

Katy

Well, I think from being on the investor side, the most important thing for us is to understand the strategy and what we think that they are doing, and then for us to have a track record which is consistent with what we think that they tell us they're delivering. Now that's easy to say, but it can be really complicated to test, and especially in the systematic world where you don't know their strategy. You just know that they're saying that they're doing this or that. You have to go back and test it. I would say that track records are... even if we know that we're not biased by them; we're always biased by them. That one second glimpse that you take of them and the sharp ratios and Sortino ratios, we already sort of add that picture into our head. So I think the most important thing looking at a track record, for me, is not the past, but actually a combination of things, and that is A: I have to understand the strategy, but B: that strategy has to perform in line in the past with what I expect that particular strategy to deliver, and as I watch that strategy out of sample, the strategy has to deliver what I had expected within reason. So you can imagine, if you have a strategy like trend following, where somebody thinks you're long volatility, that's a problem because then volatility goes up and you get a phone call; or equity goes down and you get a phone call, and you have a really hard time to explain that. 

Niels

I had a question the other day from someone here based in Switzerland, Roman, in fact, and he asked about people's perception about trend following that perhaps it's performed poorly in the last couple of years because there's been too much money chasing trend following after the great year of 2008. When you hear something like that, what comes to mind? 

Katy

Well, I actually just wrote an article which is coming out for Eurex on this exact topic, and I call it Return of the Trend: It's All About Correlation. I'll just give you a view on this. If you look at a trend following system, any portfolio system in general, we depend on correlation. We depend on the diversification across markets, and regardless of looking at the capacity in the industry, not even thinking about that, if you take a graph of correlations pre in the last twenty years, it almost looks like a step function. So up until 2008 the correlations are pretty low across all futures markets, and they just shot through the roof in 2008 and they stayed there until earlier this year, or until late 2013. If you think about portfolio construction, the returns of trend following is driven by divergence and we've had some divergence over this period of time: quantitative easing, all sorts of events like the nuclear meltdown in Japan, those are diversion events, but in this sharp ratio is also the diversification and the risk. When you construct a portfolio, it's not only the volatility, which has been low, but also the correlation across assets that allows you to have proper diversification. Correlation being high means diversification is low, which means that even though there maybe some trends, there's a lot of risk because it's sort of like a one trade world. If you look at that, that coincides with a period that has been difficult for trend following strategies. So they do have profits in some areas, but there was just not enough diversification across their portfolio I think to support their performance as consistent with history. 

Niels

Have you looked at price range compression? We published a short article in a hedge fund journal a couple of months ago about price range compression which is also very easy to see when you just look at the difference between the highs and the lows on a rolling three year or six month period across many, many markets, you'll see how this range has really compressed in the last few years, and of course with compression comes smaller trends and hence smaller opportunities for trend followers. Did you look at that? 

Katy

I've seen some studies of that. I would like to see... what I think is interesting is that I agree with most of these studies, but it's interesting that now we have divergence, and the strategies are performing again.  

Niels

But you're also having somewhat of an expansion of price ranges, I would imagine, at the same time, but we don't need to go there. 

Katy

But I think Niels, you're right, it's both. We had both way too high a correlation for the strategy and we also had price compression which decreased the ability to capture the divergence moves, and both of those combined is a tough environment. 

Niels

It certainly has been. Now I never ask the managers I speak to about their stats because I think it's frankly a little be boring to talk about, but when I have someone like you on, I want to take the opportunity and just ask you, because you've looked at this for so many years, do you have a favorite statistic when you analyze a manager? 

Katy

Oh, that's a hard one. I can't honestly say I don't. I think you have to sort of look at so many; especially sharp ratios are terrible because sharp ratios hide a lot of risk. I think correlation analysis is very important - conditional correlation analysis. I know that from my time at RPM we spent a lot of time, for any particular strategy, what do we want? Now let's find some statistics that can show if they deliver that. That means that it's really a bespoke thing. If you have one type of manager or another, you're going to have to look at a completely different basket of performance measures. 

Niels

Sure, sure. The next area I want to talk about is what usually is the trading program, but today, in our conversation it will be about the trading strategy or the model, however  you phrase it, that you've used in your study that really represents the performance over this long period. Tell me about how you and Alex constructed this and feel free to go into as much detail as you want. 

Katy

OK, yeah, this is a very important and good question, Niels. One of the chapters of our book that I'm most excited about is actually chapter 3, and this is one called Systematic Trend Following Basics. I found that when I looked at most other books on trend following, and those sort of descriptions, it's very hard to find a specific formula that you could use as "this is the formula" for trend following. So what we did, instead, is we tried to create a framework with one formula. This one formula obviously, as I said was science and art, can be ejacted and made much more complex by any particular manager, but we actually used this formula to build a framework for style analysis later in the book. So we started off by asking what are the four key question of trend following? We need to determine when to enter? How large of a position to take on? How to get out of a position and how much risk to allocate to any particular position? We then go on to define the five key building blocks of a trend following system, and these include data processing (which is pretty straight forward), signal generation, position sizing, market allocation, and execution. In this process, the most important part that we focus on is position sizing. So we focus on creating one formula for position sizing which is a function of several key variables. So this function is that the nominal position amount is a sizing function which tells you the size, and we leave that very open in the book because that is a lot of art right there. So the size of the position is a sizing function, times the risk loading (this allows you to gage leverage up and down), times the capital allocated to that particular market, divided by the total adjusted dollar risk, times the dollar risk of a position. So, basically let me do it in laymen terms - I'll do it as if I was telling it to my husband. So what you do is you say, OK the sizing function tells you how strong your strength, your conviction is. So if your models, like your moving average models say that this is a very strong trend, then your sizing function weights based on those rules. The risk loading is just a simple loading of risk across markets, which allows you to lever the position up and down. So if you want to have more or a larger exposure, then you can expand every position at the same level. The capital allocated; that's simple, it's just a dollar amount that you put into the position. You're going to multiply that by the dollar risk of that one contract and then, because not all futures contracts are created equal, some are more volatile than others, we need to divide it by the total dollar risk of the position. This allows you to adjust, if you have something like lean hogs compared to oil, you're going to adjust the one that's more volatile down because you need to put less capital in it to expose yourself to the same amount of risk as the other contract. 

Niels

Sure. Now you mentioned signal generation. I guess there are two main forms of signal generation, I guess in trend following, one that uses moving averages, the one that uses price breakout channels, what did you use in your study and why? 

Katy

So we actually left that open as part of the sizing function, and then later in the book we will apply that to the sizing function. So if we do an example, we'll say that this is a moving average system, which means that the moving averages were used to create the sizing function. And we also explained that it's obviously not going to be perhaps one moving average, but it could be a basket of moving averages, where you take this average over a range. This is where art comes in here. So the sizing function is the science but the application of that depends on how sophisticated you get in terms of creating that function. 

Niels

I think you also mentioned something about... I think a lot of people are focused on where did you buy something, and if you talk to people in general, and they talk about their investments, they would always say, "oh, I've just bought IBM, or I've just bought Facebook stocks," but you rarely hear them say, "I've just sold Facebook, or I've just sold IBM," but you actually put a lot of emphasis, I think, on the exit of a trade relative to the entry point. Talk to me a little bit about that and why this is important for investors to be aware of. 

Katy

If you think about... a lot of people think that predictability is coming into play when you are talking about using it in a trend following strategy. If you're following a trend, you're not necessarily starting it. So I think the point of a trend following strategy is there's both the entry and there's the exit and we explicitly explain that these decisions are different and actually the exit is a very important part of the whole process. What we do to do this analysis, and this is kind of an exciting part of the book too. Is that in chapter 5, after we explain this concept of the divergence and divergent risk taking and the importance of cutting your losses. We look at trading systems that have agnostic entry rules. What I mean is that, imagine that, instead of actually using any sort of indicator to get in, you randomly flip a coin to which market to get into. It turns out when you look at that system there's still performance that comes from getting out of the position. So that tells you something about the driving of the getting out. The exit decision and how important it is. You see that that varies over time. Then we also look at the entry and try and determine, OK, is there some predictability? So we look at a concept called trend leakage. The idea is how often is a trend following systems position positively correlated with a future trend position? We see that trend leakage actually does exist and it's also time bearing, so for some periods of time some of these trends seem to leak out into market prices, but there's also plenty of times where trend leakage is actually rather weak. What that tells us is that, in some scenarios, you may actually have some trends leaking out if you use a systematic approach, but there's other times where it's actually... and a lot of times where it's really that sort of getting out of the position when the trends are disappearing as well, that drive a lot of performance.  

Niels

Right and I think that's the key to understand, those few words that you said at the end that exits to a large extent can be the driver of the performance.  Environment: we talked about it already about when these things don't work and when they work, but I want to talk about environment in a different context because investors, and in particular institutional investors they often talk about inflationary versus deflationary environments and how is this all going to shape up. I noticed in the few pages that I did see from your book that you actually have a chart of annual inflation rate in the US and the UK. I think it goes back to the 1700s actually, and then you show the performance of a trend following system in these different periods. Talk to me a little bit about these kinds of environments and how that is framed in your and Alex's mind when it comes to trend following. 

Katy

Well, I guess this goes back again to the same philosophy of trend following. Trend following is long divergence, so if inflation causes divergence, great for the strategy. Maybe not great for everybody, but it's really about understanding that if inflation will drive divergence and prices, then it should work. I don't have the polar view on low inflation; high inflation is good. I just think that this is a type of strategy that is meant to adapt to spectacular moves. So if we see that over time, as a result of the inflation, then inflationary environments of different types will be interesting for us. The same is true for interest rates and I get that question a lot. 

Niels

So if I understand you correctly, Katy, what you're saying is it doesn't really matter whether we have deflation or inflation, and obviously for the last 40, 50 years we've pretty much had inflationary environments of some degree, but recently, it very much looked like deflation could be back on the table. But what you're saying is it doesn't really matter as long as it creates divergence, it's OK for trend followers. 

Katy

When you look at the statistics from 1720 to about 2013, which is a roughly 300 year period. We see that the average return during a low inflation to deflationary environment is about 10.4%. The 5% to 10% inflation is about 10.1% and for high inflation, it's actually about 15%. So what I would say is that extreme moves... extreme environments tend to have divergence and thus opportunities. So from history it doesn't look like there's less or more momentum in a sort of low inflation vs. moderate, but it seems to be that high inflation, really high, and possibly extremely low, or extreme periods of deflation may actually cause things to be interesting for someone who is divergent. 

Niels

Sure absolutely. I know you talked about risk allocation before, but do you also deal with the issue about whether you should follow strategies that are fully diversified versus strategies that are focusing on financial markets, do you deal with that, or do you have an opinion about it? 

Katy

I do have a little bit of an opinion about that, but I think it can depend. I think diversification is important. I think there are pros and cons to being more or less diversified. We address the issue of diversifying the diversifier at the end of the book, but there are definitely pros and cons to how much you diversify your process. So, for example, a larger well diversified CTA will, with many different strategies, will be much more robust over time because they mix some convergent with divergent, but it depends on what their investor's portfolio is. There you can also have a pure trend following portfolio, which is a pure divergent play and you don't add any leaning in that system, then that's a good compliment to somebody who's a pure... has a very, very convergent value and sort of traditional approach, then that may be a one shot solution to what they already have. So I think it really depends on... investors are very heterogeneous. Some of them, I think would benefit from a pure trend following strategy, and some would benefit with a diversified approach. Of course, all of those have to be done in a very appropriate manner and of course more resources are needed to have a diversified approach.  

Niels

Katy, the next thing I want to talk about is risk management and based on everything you've done and the way you look at these things, I wanted to find out how you define risk and what is the important risk to look at when you look at these strategies? 

Katy

Yes, and this is a very important question because in my opinion I think risk management is the greatest asset of the CTA industry. What I mean by that is that risk management and being sophisticated about that is the value added that a manager has over someone hiring two guys and saying OK, build this trend following system. Read Katy's book, read this book, implement this. Having a sophisticated understanding and very good risk system and an allocation... understanding of how to allocate risk over time is one of the greatest attributes of professional management. Let me give you an example of this, which I think we go over with in chapter 5 of our book. So the example works the following way: imagine that you, one year from now, had perfect knowledge of the price of one particular market. So you know that oil's going to trade at X in one year. Now that seems like really valuable information, but if you just take that position and hold it, over time, the risk of that position could be huge, because markets could go up or down, or up or down, over time and you may actually get completely wiped out based on just the price movements. So what we do is we sort of add risk management to that trade and sort of start managing risk. What you see is that as you manage risk, over time (so maybe half of it is using the forecast and half is not using the forecast) the sharp ratio approach improves dramatically over time. Drawdowns also improve. So risk management is the way that... the major value added of any trend following system and it's the art that a manager adds to any sort of simple product or adding two guys on a team and telling them to, "hey code this." The systems are, in theory, not complicated, but in practice, having a very sophisticated approach to risk and understanding how to dynamically adjust it properly is where you can really add value. 

Niels

Sure. Risk can come out in many different ways, meaning people can look at standard deviation, value at risk, margin to equity, risk to stops, whatever it might be. Is there something that, from your point of view would give you more comfort knowing or looking at when you look at a strategy or a manager? 

Katy

Understanding how they change their risk. How did they allocate risk? Having a good idea of what causes them to allocate more or less risk to a particular position is very important. I think the real danger is when you have dynamic leveraging, or when you have positions growing at risk and accelerating. That's what we're trying to avoid. So understanding if risk allocation is actually conditional or not. We actually touch on this in the book as well when we talk about drawdowns and we also talk about leveraging over time. We discuss how you can look at leverage inter-day or day to day and sort of determine if leverage is a function of past P&L or not, can tell you something about how the manager takes his or her positions.  

Niels

Sure, you also mentioned something called hidden and unhidden risk, what do you mean by that? 

Katy

Oh yes, that's one of my favorite topics. I like this topic from going back to... I wrote a paper for the CME about this, and it was about 2011, and I was thinking of this a lot. Trend following strategies, and futures strategies in general contain much less of these hidden risks. So what are unhidden and hidden risks? In our book, we say unhidden risks are risks that come up in price, so price risk. Hidden risk are risks that come up not in price, so they inflate sharp ratios. So liquidity risk is a hidden risk, because it doesn't show up until it shows up, and it's very hard to measure prior to it arriving. Credit risk is also hidden. It's very hard to estimate credit quality, so it will come up in shocks and sort of out of the blue and the numbers will not. No matter how hard you try and estimate default probabilities and things like that, there are always very few observations, which means that it's very, very hard to actually calibrate properly, and risk adjust for credit risk. Another important one is leverage. Leverage can be very transparent, but there also are ways to imbed risk in leverage, and we go through that in detail. We say leverage should be very transparent, but there are actually methodologies like using dynamic leveraging where you can increase risk by creating some cyclicality in your leverage application that won't show up on a slower frequency. So what I mean is that if you're losing you double your bets. Most trend following systems don't do that, but some do. If you do the right analysis, you can see that it makes sense because it creates some cyclicality in the application of leverage over time, which is fine as long as it doesn't catch you in the wrong direction, in the wrong moment. 

Niels

I think it's actually quite topical. You and I, we're talking at the end of October of 2014 and from what I hear, certain strategies out there in October had a very rough time. I'm thinking here about option strategy which, again managed futures, which is a word that is being thrown around a lot, covers many different strategies not just trend following, and part of that universe is option strategies. Talking about divergent and convergent strategies, it's a good example, so it's just interesting about that particular area because clearly there are risks there in those kinds of strategies that investors may not be aware of, and we'll see how the month ends, but it looks like it's going to be one of those months where some of these hidden risks have come out. 

Katy

Well Niels, if I give a little comment on that, just to kind of bring this back to Derivatives 101 or something like that. If you look at an option strategy, it applies dynamic leveraging. So let's say that you want to invest in a call option. The delta of the call option increases as a function of P&L. So that means that, in some sense, you build your positions and the leverage increases with an option strategy and so what that shows is that a month like this where maybe your leverage might have hurt you, an options strategy would suffer, but a trend following strategy that doesn't do that, won't. 

Niels

Sure, absolutely. Great example, thank you. 

Katy

The manager that does that in their strategy will probably have a harder time than a trend follower that doesn't use any dynamic leveraging. 

Niels

Yeah, true, and speaking of drawdowns, which is typically the next thing I talk to people about, in your opinion, from a 30,000 foot view, have you come up with any measure that could explain or give a framework for investors in terms of what kind of drawdowns should they expect from a trend follower without the red lights going completely berserk? 

Katy

What I would say is that, if you look at trend followers, they have a lot more drawdowns over time than equity, but they're way shorter. So if you look at a history of a drawdown picture, and we do this in the beginning of our book of an equity strategy, long equity versus trend following, you'll see that there's a lot of small drawdowns and they're very often. This is because most of the time I would say that a lot of times... if you go back to the same analogy of venture capital versus private equity, right, 2/3 of the time or maybe over 50% of the time there may not be any opportunities. But when there're opportunities you gain way more than you've lost. So as a result, you're going to have to expect that a strategy like trend following that has lots of price risk and no other hidden risk, because hidden risks - what do they do - they create huge drawdowns and they happen rarely. This type of strategy is very systematic, only has exposure to price risk, and thus has lots of small drawdowns over time which are compensated by larger returns.  

Niels

You say that, and I accept it, of course, coming from that world, but on the other hand, looking at the last few years, what we did see was that many managers including those who have been around for 20, 30, 40 years, saw in most cases much bigger drawdowns than they have seen before and longer drawdowns. I know that it's very dangerous to start calling for the death of trend following and this time it's different is some really dangerous words to use, but how do you, having done all this research and studying, how do you frame the last few years for CTAs and trend followers, and the performance, and the expanded drawdowns and prolonged drawdowns, how do you frame that in the overall picture? Is it just because we feel it's a little bit different because we're looking at the last 20 years, that we remember, or was it a bit different this time? 

Katy

Well I think it's perfect you ask that because an academic from Edinburgh, there's a new paper out that he's by, I think it's Hutchinson and O'Brien, and this particular paper is called Is this Time Different for CTAs, and I think it's a very good paper to go and look at because here's what they say. They look at many different past crisis periods for trend following and CTAs, and they show that the performance of trend following tends to be somewhat depressed post the crisis, and this happens to be the case for every single crisis that they looked at. It got me thinking a little bit, listening to them talk about it in that, in some sense we spend a lot of time here talking about debt overhang and the difficult period post-crisis recovery. It's sort of a recessionary period, and it seems that after the profits are made from the divergence in a crisis, there is a period where markets have to re-stabilize, people have to... the market ecology has to readjust. I would say that it just happens to be that this particular period the crisis was so bad and we see that when we look at what's happening in financial politics that it's still sort of sorting itself out. I'm sure you might actually find some similar results if you looked at the great depression, which also took a lot of time to recover. So it's quite possible that these sort of delays and reestablishing what is the new paradigm in financial markets. How long will we be sitting with still trying to deal with EMIR and still trying to figure all these things out? It's not surprising to me that that's the case, but honestly with correlations coming down and with a lot of these issues starting to get sorted out in financial markets and in the financial industry as a whole, we are seeing again that the strategy seems to be bouncing back, so that's why, for example I wrote Return of the Trend. I think that momentum, just like value, just like other sort of risk premia are time bearing, so hopefully we're back in that time again.   

Niels

I think in fact the paper you refer to is written by a couple of guys from Bath University, and I have a feeling that that's the one that was helped to come to light by Aspect Capital and therefore I would have linked to this in the episode that I have recently done with Martin Lueck from Aspect, so people can find it there if they want to. 

Katy

Yes, that's correct. 

Niels

Now, in terms of drawdowns, you need to help me here because drawdowns, for a manager of course, clearly create some emotional roller coaster. We know that, and we learn to deal with them over time. I think one of the biggest challenges for us really are to get investors comfortable and help them through the emotional roller coaster, because what often happens is they tend to redeem or reduce their investment at the worst possible time. They almost become trend followers on trend followers, meaning that they buy high and sell low, which is not a good strategy, so how do we educate them a bit, and how do we explain that a drawdown is not quite the same as a drawdown in an equity market, where there's kind of an open, and the risk - it could go to zero like what we have seen with some stocks. How do we explain that, do you think in a language that would make them comfortable about being in a drawdown and maybe even see it as a buying opportunity? 

Katy

So we actually... this is a really important question, and it's actually one of the chapters of our book as well, it's called Dynamic Allocation to Trend Following. What's interesting about this is that if you take the concept that risk premia are time bearing, and there's some cyclicality, you should actually buy low and sell high, and investors tend to do the opposite. They buy high and sell low. This is because, if they understand... if we can explain better the divergent/convergent type of concept. If you have a strategy like trend following that over time, they actually tend to be mean reverting. The strategy over a long run is somewhat mean reverting. So momentum, actually, goes in waves, so if that's the case, then you need to sort of try and make sure that you actually buy in a mean reversion sense. So you shouldn't trend follow trend following; you should actually do the opposite. As an investor, you should buy low and sell high. So when I talk to certain investors who maybe are very familiar with this, what I see now is that in the last couple of months, some of them have started to say, well equity markets are at all time highs historically in relative terms. That makes me concerned, so I'm going to readjust and start thinking about adding more CTAs and those that did that really profited. So those who were able to lock in some of their profits on the equity market and start thinking about alternatives, really, really did well. The intuition was pretty clear. Equity markets are at really major spectacular wins, what's the chances it's going to go that much higher? Those who I talked to who did that, they really sort of profited from that. 

Niels

Sure, sure. I have one more question on drawdowns and again, I'm trying to rephrase a question that I would ask a manager, but I want to ask you the same question. Looking at the strategy, knowing all the bits and parts that you know about it. Is there anything that would keep you awake at night if you were running a trend following strategy? Is there any risk, so to speak, that you don't feel that the strategy handles fully? 

Katy

I think that it's very hard to... I mean one of the things is the great advantage of a trend following strategy is that it uses futures. So this means that there's only a certain amount of capital that's at risk. Because of that and most investors who... I spent several years teaching futures markets in school and stuff like that and even there you see the fact that you have certain amount of capital at risk, and you have limits in terms of price moves for some markets, means that in some sense the amount of risk allocated is really controlled and trend following managers and futures managers have a very strong history of understanding how much exact notional risk that they are out, that they have outstanding. In the case of more traditional investments, that's not always as obvious to me that we have an exact calculated exposure that's quite as transparent. So, let me think about what would make me nervous... the only things that make me nervous are things like operation risk. Something like MF Global did some bad stuff to our industry, but I mean hidden risks make me nervous. Credit risk is not an issue. Liquidity risk tends to not be an issue. If you look at the swap markets and the derivative markets during the financial crisis, there were over 800 swap dealers that went bankrupt, or that couldn't give a price and futures markets were all open. That doesn't mean that history will repeat itself, but it tells you something. 

Niels

It certainly does. A question that I get from time to time also from my listeners and that is how would you detect if a manager of, in this case a trend follower, if his or her's system has stopped working? Is there anything that they can look for? 

Katy

Whoo, that's a good one. I think this comes back to the idea that we'll probably talk about later which is benchmarking and understanding the style of a manager. 

Niels

Why don't we do it now? 

Katy

I think the challenge is that we've seen this over time with different managers. It depends on if what they tell you they're going to deliver isn't delivered then you start to ask some tough questions. One of the problems is there is noise. I know that we've seen this in the last two months. There's been tremendous discussion of this issue: well this manager is up 10%, and you're only up 2%, are you five times worse? The problem with that is that every system is meant to capture divergence, and each divergence is different. So you just hope that the signs are roughly in the right direction, and you have to determine why and asking some questions. Why did you make 2% as opposed to 10%? Do you have some explanations for this? Was it one position or was it a sort of general risk allocation that caused this difference in performance to your peers? If so, is there a reason that you have that that may help me in a different scenario so that I shouldn't be concerned? This comes into the style analysis question that we spent a tremendous amount of time thinking about. One of the things that I think that is important with the book and that Alex and I did was we need to fit... not only do it our way and the trend following CTA way, but we need to also fit analysis and understanding into a structure that most traditional investors are comfortable with and understand.  

So, when we got to the point of benchmarking, it was really funny, because we had a lot of ideas about things like dynamic allocation, and we had lots of ideas. When it came to benchmarking, that was one of the chapter and sections of the book that we were the most irritated about, because the point is that benchmarks in our industry is like taking a fruit salad and comparing it to an apple. The problem with that is that people do that, they say, "here's a fruit salad, and here's your apple, let's compare." There's a huge amount of return dispersion from each of the fruit. So if you compare one strategy to another, they vary tremendously, and this is just something that has irritated investors, because they say, "well you all have high correlations but how come you're so different?" So what we did is first we looked at return dispersion, but then we had in earlier parts talked about classifying different styles... we designed different types of systems and compared them. We called them system 1 to system 8. So for example, system 1 is like the purely agnostic equal weighted risk, no bias to equities, and medium term; and 8 I don't remember exact what it was but there were 8 of them, whatever. So then what we do is we took this concept and said, we don't need to have 8 systems. What we can do is we can look at different construction factors. So we create the structure similar to the Fama French 3 Factor model, where you have a pure... and we go back to the concept of divergent risk taking and we construct a pure divergent risk-taking strategy. So this is actually similar to a Bayesian strategy. It's very simple in its application, but it's sort of the best estimate of the uptrend is how you determine what the position is. So Bayesian system and then you have simple trailing stops to get out for every position, We take a basket of these strategies, and this creates an index which we call the market for divergent risk taking. So this is our benchmark strategy. It's very basic. It fits with the ideology of trend following. We say OK that's the simple one. Now what can we do next?  

If we take that system, we can start to do some tweaks. One tweak is that we can decide that we have maybe some capacity constraints or that we want to constrain our risk allocation as a function of the size and liquidity of each market, so we create a size factor, which basically is a difference between the market capacity-weighted index. Instead of equal allocation we allocate as a function of capacity minus the equal weighted. This tells us the value added to having smaller markets in your portfolio. So we call that the size factor. Then we look at equity bias, which is another construction tweak that many managers use, so we look at long minus short, and we can see how much added equity bias changes your strategy or is included in your strategy and then we look at trading speed. So trading speed is slow minus fast. What's interesting is, imagine those are three different ways that you might be able to tweak your divergent approach. Then we can take these and actually analyze individual managers to try and determine... OK, so say we take a large manager. This large manager is going to fit the model moderately well, but they may have a market capacity bias and they may have an equity bias because they add some cash equities into their portfolio and maybe their slower because they don't trade as often. So when you take that structure you can see where the simple model... does this manager fit into that structure? What are the loadings for these different factors? For example, 2013 it was actually the case that the size factor was very negative, which means that bigger markets well outperformed smaller. So the size factor alone tells us something about why one manager was good in 2013, versus another.  

Niels

So size does matter. Now the next area I just want to talk about is just trend following, the industry as a whole, and just a few questions to get your take on that. CTA industry: clearly at a difficult juncture at the moment. What do you think the biggest challenge is right now?  

Katy

I think the biggest challenge is overcoming the past and delivering and hoping again, being agnostic, hoping there are diversion opportunities in markets that we can capture. Getting back into the mainstream list of which hedge fund strategies people are interested in. I think the other key challenges are going to be adapting to a new environment. We definitely have all been doing that. There're more players in the market. There's different flows of capital, different retail to institutional, and there is a lot of competition, so making sure that you deal with that and that you deal with the new stress, like the HFT traders that are involved now, so different things that can change how we have to play the game. 

Niels

Yeah, absolutely. I also want to ask for your help actually. That is I typically ask my guests to help me come up with a question for my next guest on the podcast. I was just wondering, what would you want to ask a manager coming to talk to me, what would you be really interested in knowing about it, and maybe I can add a little bit of flavor and that is, what if that manager was David Harding? 

Katy

Ooh, let me think for a second there. I think, I don't want to ask him a question he gets asked all the time. Let me think for a second. This is a challenging one. 

Niels

I'm still hoping that he's going to come and join me for a conversation of course. 

Katy

I don't want to ask a mean question either. 

Niels

No, of course not. 

Katy

I think the key question that he's probably getting and that all other managers are getting is how do we explain our value proposition? How do we do that in a way that justifies our fees and our value that we propose to investors, because I think that's something that he will have a good answer to, but it's a good question to ask him. 

Niels

Sure, appreciate that. Now before we jump to the last section, you've obviously done due diligence on a number of managers. I'm sure you've been exposed to the whole process many, many times. As a manager, I certainly feel that there are a lot of questions that investors are not asking and that they should be asking. What do you think investors should be asking that you don't think they're asking today of a manager? 

Katy

I think asking for more transparency in terms of how different strategies are put together is an important point. Also asking questions about how they... about backtesting and how they think they are not data fitting to the past is an important question that they ask, but I think they ask me to ask it more. I also think that managers should take a closer look at leverage - inter-day because one manager to another you can't always... they can be very different. We talk about that in our book. I think having a better understanding at a more granular level of how leverage is applied I think is an important question. 

Niels

Last topic really, Katy. I call it general and fun, so it's a little bit unpredictable I guess.  What do you think it takes to become a good trend follower? What should someone who wants to deploy this strategy for himself, or become a trend following manager, what kind of person or personality traits should a manager have like that? 

Katy

So I think this is a good question for me because I spent some time as a start-up and I've also been an advisor for many different small CTAs and this experience has taught me about how to talk to them about what they should do. What I generally tell them is that you need to be able to communicate. You need to know exactly who you are and you need to be able to sell to your investor what you're going to deliver to them and how you're going to do it and how you're going to handle risk for them appropriately in an extremely clear and structural point. Without that then you're lost. I've seen people... you can work on it, and I've seen people across the board in that point and one CTA that I was working with and have great, great fondness for - Flyberry Capital, in Boston. They're a big data CTA and I met them in the very beginning and it was a lot of fun to work with them because that's what we spent a lot of time talking about is how can you have the right profile and how do you know the needs of your investors, but also find a way to communicate your value proposition to them. They have had tremendous success with that. I think that that's really number one. Beyond that, I think that it's really a long journey and a process of sort of... you know better than many Niels, the process of building a CTA from small to large requires a lot of hard work.  

Niels

Sure, absolutely. I would add to that if I may because you talked about the how and the what. But actually I would add the why. I think people need to understand why a manager is doing what they do. Often the why is really what differentiates one manager from another. We all want to be a little bit different, not too different, but a little bit different, so I think communicating the why is really, really important. I have a cheeky question for you, and that is what book would you recommend people to read, and you're not allowed to say your own book. 

Katy

OK. A trend following book? 

Niels

It could be a book related to trend following, and frankly a lot of people have referred back to the Market Wizards book, but it could also be another book that just made an impact on you, on your career that helped you or just inspired you? 

Katy

Then I have a couple. One, if I'm going to go trend following, I have a very good friend in Zurich named Andreas Clenow, who's also a Swede. I'm not a Swede, but he's a Swede, and I really liked his booked called Following the Trend. 

Niels

Sure. I have read it, and it's a good book. 

Katy

Then if I went for ideological books, let me think for a second... I like a lot of the books like The Outliers. I actually liked the David and Goliath book by Gladwell. Those books are very interesting, and I personally, me as from a woman's perspective, I also liked Lean In, that was a good book for those of you few female listeners out there. That was a good book for me. I enjoyed it. So I can't promote my own book. 

Niels

Well I think you've done a pretty good job today of making sure that everybody knows that that is a must read for sure, so that I think we've done. Now just a couple of short questions before we round off. One thing that I think a lot of managers are feeling is becoming more and more difficult, in particular the smaller managers and that is regulation. Is there anything in your studies, in your research that you've come across about regulation in general or do you have an opinion about it?  

Katy

Yes, we spent some time thinking about this and I had written a piece about it a couple of years ago, and what we kind of determined is that regulation and government intervention in general is sort of a mixed bag from a price perspective. Sometimes it creates divergence you can capture, sometimes it doesn't. So that was sort of a challenging question because a lot of people assume, oh, there's an intervention, you're going to make money off of that. That doesn't always happen. From a more business perspective, I know that here in Europe that AIFMD regulation is definitely very challenging for small managers because there is... you can be a sub-threshold manager, but that limits who you can actually get as an investor, so this kind of suggests to me that these regulations are going to be very, very tough on the hedge fund industry becoming... maintaining its innovation from the lower ranks. I think that's really sad because that's where we all know innovation happens, where new ideas come to life and if regulations become too punitive and the industry becomes too over-regulated then it's going to actually ultimately cost the investors more to pay for all this. I know it's good, but it is going to be more expensive, and there'll be more barriers to entry, and I already see that. 

Niels

Yeah, no, absolutely, I think that's a good point. Katy, could you tell me a fun fact about yourself, something that even people who know you may not know about you, and I don't mean your husband, I mean sort of people a little bit outside of that. 

Katy

OK, I guess one funny thing about me is my advisor, Andrew Lo always used to tell me... call me the counter-example, because he always said that people meet me and they think I'm one way, but I'm actually different. For an example, I'm a very friendly and very approachable person, but I actually used to play college hockey - women's ice hockey, so whenever I'm in a tough situation and I've got that smile on my face, I just think about, "Katy, put the helmet on!" So I tell myself to put my hockey helmet on and then I get in that zone. I played hockey in college as a previous figure skater, so I'm very eloquent, but I love that sort of... I have a tough edge to me as well that's what most people don't know. 

Niels

Fantastic, great, great. Now I said earlier today that there's certainly questions that investors in my mind fail to ask, or may not think about, so I also want to turn it on myself today. Is there anything you feel that I missed in our conversation, something that you want to bring up? I want to make sure that I do justice to your book, yours and Alex's book and to the topic we've discussed. 

Katy

Honestly, Niels, I've really enjoyed the conversation, and I think you touched on so many important issues. I think especially risk management is something that I think that you should keep going further and asking people about, because I think it is part of the major value proposition. So that's one area that I hope that you sort of can pick at a little bit more with more professionals in the future because I think that investors need to know that. Otherwise, it's been great talking to you. 

Niels

Great. Final question, almost there... looking into the future Katy, what do you see for trend following/managed futures and what does your own future hold? 

Katy

Well, I think that hopefully the worst is over for us in the trend following space, but those of us who have been in this space know that it's always a bumpy ride, and we just have to keep sticking to what we believe in and over time the risk will be payed. So this strategy will... and this industry has a value added over time, so we just have to keep doing what we do and keep delivering what we can over time. For me, personally, so we had the large quest of finishing the book and that sort of came out in August and I've actually decided to return to the industry and I will be, and have been in discussions and now have signed to join Campbell and Company as a Director of Investment Strategies, because I want to go back into  the world of hedge funds and working with investors and working with traders and with the markets every day. 

Niels

Fantastic. Well, on that topic I can only remind our listeners, in fact the President of Campbell and Company, Mike Harris, was on the podcast last week, so there is definitely much more to be learned on that Company and strategy for there. Congratulations!  Final thing, if people want to reach out to you, Katy, and learn more about your book or some of your publications, where's the best place to find you?  

Katy

I have some publications at the CME group, but we also have... sort of you can find our book on Amazon, iTunes, pretty much anywhere. I also have... if you're interested in convergent/divergent I did a TEDx talk on that topic, so if anybody is interested in that, and also via email. I think my email is out there. 

Niels

Otherwise, we'll link up to you on the show notes, and if you have any publications you want us to feature on our website, feel free to send them to me. This was really fun. It was a pleasure Katy. I thoroughly enjoyed it, and I hope that we can continue our conversation at a later stage and see how you're doing in your new journey and yeah, really enjoyed it. Thank you so much. 

Katy

Thank you Niels, it's been a pleasure, and really great talking to you. 

Niels

Great stuff, thank you so much. Take care, bye. 

Ending

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