Never Ending Quest for Diversification

---

This summary is written by Rich based on a conversation in our CTA series between Douglas Greenig, CEO and CIO of Florin Court Capital, and the podcast hosts, Niels and Alan.

About Florin Court

Douglas discussed the current macro outlook and its relationship to trend following with the hosts, Niels and Alan. Douglas is the CEO and CIO at Florin Court Capital, which is a systematic trend following program focused on alternative markets.

Douglas believes that trend following is particularly suitable for an environment characterized by instability, regime shifts, and major changes. He argued that the current macro environment is fundamentally unstable and presents a great deal of uncertainty and instability across various dimensions, including political, economic, and energy. He suggested that allocators need to think hard about how they want to own the tails instead of getting owned by the tails and believes that trend following fits into that strategy.

Niels and Alan also briefly discussed Florin Court Capital's performance over the last six years and their approach to alternative markets. Florin Court Capital's trend following program has had an excellent year in 2022, but they have also had an even better year in 2021. 

Florin Court Capital is approaching $2 billion in assets under management (AUM), and Douglas mentioned that things are going very well for the firm. They focus tightly and exclusively on alternative markets, and their program is systematic in nature.

Alan asked Douglas why Florin Court Capital focuses on trend following and alternative markets. 

Douglas explained that trend following is an evergreen strategy that has worked well over the years because trends tend to reverse with a burst of volatility, and this interplay of volatility and trend is key to the process. 

Capturing the trend and getting out when there is a burst of volatility is the essence of a good trend following program. He added that trend following is largely dependent on the behavioural bias of anchoring, where people have trouble interpreting new information without reference to the past. Therefore, when novel things show up or there are big dislocations in the macro environment, things don't necessarily move as quickly as they should. He also notes that the role of volatility around trend reversals is underappreciated.

Alan asked Douglas why Florin Court Capital focuses on trend following in alternative markets. 

Douglas explained that trend following can go through periods of quiescence, and one way to address this is to increase diversification. Adding new markets that are genuinely diversifying, such as regional carbon emissions in the US, Malaysian palm oil, or emerging market interest rates, can provide sufficient independent bets and ideas, better diversification, and better trends. This results in better returns, less crowded and less kurtotic markets, and a better skew and tail characteristics. 

Additionally, expanding diversification is a good way to remain like a CTA, rather than diluting the great benefits of a trend following program. The diversification argument is straightforward, while the better trends argument is harder to demonstrate, but it is probably true.

Alan asked Douglas whether Florin Court Capital trades both major and alternative markets, or whether they focus purely on alternative markets. Douglas explained that Florin Court Capital is focused purely on alternative markets, with a heavy emphasis on diversification. 

They trade in markets such as New Zealand interest rate swaps, but they stay away from US and G3, IRS, and bonds. The reason for this is that experienced CTA investors who are potential allocators to their program likely already have exposure to developed markets and do not need more overlap. 

Instead, Florin Court Capital offers an orthogonal alternative markets pure play that is very additive to what investors are already doing.

The Role of the Sharpe Ratio and Crisis Alpha

Niels and Douglas discussed the concept of Sharpe ratio and its relevance to CTAs. Douglas believes that Sharpe ratio, in itself, is an incomplete measure, and CTAs should also care about skew, kurtosis, and drawdowns. However, he also argued that by keeping trend following pure and focusing on crisis alpha, it is possible to get a better Sharpe ratio by trading a bigger set of diversifying markets. 

The key is not to add more line items but to have truly diversifying different things in the portfolio and trade them with trend. 

Douglas believes that the term "crisis alpha" is slippery and needs to be defined according to the specific crisis. He believes that capturing the move from one regime to another is the essence of crisis alpha. The regime shift alpha happens when there is a major sustained move in markets as they look for a new equilibrium in the new environment. 

He thinks that we are going to see some major sustained moves in markets as they look for a new equilibrium for this new environment, and this represents a regime shift. He also thinks that the term "regime shift alpha" may be more appropriate than "crisis alpha."

Alternative Markets

Douglas explained how their focus is on alternative markets and how they offer orthogonal alternative markets pure play that will be very additive to what investors are doing. He also discussed Sharpe ratios and how they measure performance. 

Douglas explained that they add 50 to 70 new markets a year and specialize in studying markets carefully, studying the distributional properties of the markets, and understanding the details of trading those markets. They look for markets that are suitable for trend following, have nice distributional properties, or are orthogonal to the things that they do. 

Douglas explained that while liquidity and operational lift are important factors to consider when trading in alternative markets, they do not necessarily guarantee success. In fact, when it comes to emerging markets, he believes that most of the time, they end up doing well as a consequence when there is a problem.

This is because as a trend follower, the strategy involves getting short as things start to break apart. So when an emerging market has a problem, it results in an exaggerated move in the direction that the trader is already trading in, resulting in profits.

Of course, this is not always the case, and there are risks involved in trading in any market. However, by carefully studying the distributional properties of markets, doing the necessary operational work, and focusing on diversifying markets with nice distributional properties, traders can potentially achieve success in alternative markets.

Niels asked Douglas about the risks involved in trading off-exchange in alternative markets, particularly in countries where counterparty risk might be an issue. 

Douglas noted that minimizing bilateral counterparty risk is essential, and they always try to novate and face only the most creditworthy counterparties. They also have thought carefully about how onshore they want to be with China, and they have been a pioneer in doing this offshore through swap structures to avoid money getting trapped onshore if a dispute arises between the US and China. 

As they move towards a multipolar world, they have to make sure that the way they do business is going to be robust to the kinds of problems that are likely to arise, and they always think about counterparty risk and bad situations.

Alan asked Douglas if the ability to make returns in equity downturns is as stable as alternative markets given that they are not as linked to micro factors. 

Douglas explained that alternative markets are still linked to macro factors, such as the macro reopening story in commodities and the emerging market central banks taking the lead in fixed income in 2021. 

He also mentioned that they do catch idiosyncratic trends, but their big money comes from bigger macro trends, such as emerging market interest rates moving higher or a big regional shift like Latin American currencies or interest rates. 

When Alan asked if markets like interest rate swaps will no longer be regarded as alternative in the future, Douglas said that it's hard to know but markets tend to become more popular and commoditized over time. However, he believes that as long as they keep adding new markets every year, they will continue to be diversifying, which is key to good risk-adjusted performance.

What Trend Models are Used for Alternative markets?

Douglas discussed how they focus on alternative markets and trend following. He explains that they use a range of smooth and breakout-type momentum models, allocate differently, and maximise the diversification benefits in their book to achieve returns. 

He mentioned that they use very similar models across all markets with appropriate adjustments for liquidity and different mixes depending on the special characteristics of a sector. 

They also aim to maximise the diversification benefits in their book and allocate as much risk to everything, thereby keeping themselves nimble and class leading. 

They trade FX relatively quickly, as it acts as a risk buffer against slower-moving markets, and they are quicker in Chinese commodities than almost any of their competitors.

Risk Management

In terms of risk management, the number of independent bets is much higher and the approach is to spread the risk out in order to maximize diversification. The risk management process is not much different from traditional programs. 

The program has relatively small positions in a lot of things, which keeps it manageable and nimble. 

The program does not take on a significant amount of equity beta, and the beta exposure is reasonably tight. The gross exposure level of the program is probably very slightly higher than traditional market trend following programs. The volatility target of the program is 10, and it is dynamically adjusted by continuously measuring the correlation and the volatility of the return streams from the various models.

During the discussion on risk management, Alan asked Douglas whether having a macro appreciation becomes more important in market selection. 

Douglas stated that it is important to be aware of political risks and says that they have chosen to sidestep the problem of having money stuck in China. He also pointed out that the changes underway in decarbonisation and the Green Revolution are likely to create a regime shift for the molecular economy, making it very worthwhile to have exposure to markets like Chinese commodities, if you can do so in a safe and appropriate way. 

Douglas thinks that these markets will move over time as we don’t have the materials we need to achieve our goals in terms of sustainable and renewable energy and decarbonisation.

Views on ESG

Niels and Alan asked Douglas about the topic of ESG in relation to their trading in alternative markets. 

Douglas responded that it has not been raised with them more than with any other manager. He mentioned that they have made the decision to stop trading coal a few years ago, and they are conscious of these issues. However, he also noted that they have taken steps to be carbon neutral as a firm.

Why Florin have office in both London and Abu Dhabi

Florin Court Capital's decision to have offices in both London and Abu Dhabi is due to the need for trading desks in multiple time zones when trading markets around the world and around the clock. 

The United Arab Emirates' time zone is beneficial as it overlaps substantially with London, but it is four hours ahead, allowing for two functioning offices that feel like one. 

In addition, strict travel restrictions in Hong Kong and Singapore due to COVID made it infeasible to consider those cities. Abu Dhabi's welcoming ecosystem, laid-back lifestyle, and beautiful weather for eight months of the year were other factors that led to the decision.

Alternative Markets Versus Traditional Markets

In the past decade, there have been periods where alternative markets have performed more strongly than traditional trend following, which has been attributed to factors such as central bank behaviour and lower market volatility. 

However, in the event of a crisis in developed markets, a traditional CTA might do better than Florin Court Capital, which specializes in alternative markets. On the other hand, if the crisis is focused on emerging markets such as China, Latin America, or South Africa, Florin Court Capital would likely make more money than a developed markets CTA. 

It's tough for any trend follower in a placid environment, but the sources of instability are much stronger, so CTAs in general are expected to continue to do well.

Misconceptions of Trend Following

Douglas disagreed with the notion that trend following is easy and highlighted the operational lift required, especially when dealing with alternative markets. He thinks that people have read too much into the decline in the performance of developed market trend following after the great financial crisis, attributing it to the central banks' application of liquidity to the global economic system, which has created imbalances that could ultimately break things. 

He believes that trend following is not obsolete, and when applied in relatively fresh and new places, there is a lot left for the future.

Outlook for 2023

Douglas doesn't have concerns about his investment program, but he is concerned about the war in Ukraine and how it may escalate due to Russia's regard for it as an existential matter. The situation is complicated and tragic, and he is uncertain how it will be resolved. 

He doesn't think volatility will die out in his investment program, but he is concerned about the instability in the world.

---

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.