212 Systematic Investor Series ft. Alan Dunne – October 1st, 2022

[00:00:00] Intro

You’re about to join Niels Kaastrup-Larsen on a raw and honest journey into the world of systematic investing, and learn about the most dependable and consistent, yet often overlooked investment strategy. Welcome to the Systematic Investor Series.

[00:00:22] Niels

Welcome, and welcome back to this week’s edition of the Systematic Investors Series with Alan Dunne and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor. Now, if you’re new to the show, I hope that today’s episode will trigger your curiosity enough to check out the back catalog and listen to past episodes that you may have missed.

Like last week’s episode with Mark, where we discussed the trend following Renaissance that we may be witnessing, and why investment banks seem to be very obsessed with developing models to front run signals of trend followers, who by the way, are clients of the same investment banks.

Also, I would really encourage you to listen to the midweek episode where Cem and I, once again, were joined by natural resource expert, Adam Rozencwajg, for a really important conversation about the real reason behind the current energy crisis which ended up forming part of a two-part conversation. The second part we will release in a few weeks, but it’s a big topic and that was much to cover, so we decided to split it into two.

Anyway, Alan, great to be with you as always, and I know you’re not at home. How are you doing? How are things where you are?

[00:01:32] Alan

Very well. Yeah, I’m over in the U.S. at the moment, so speaking from Connecticut. But yeah, there’s been lovely, lovely sunshine over here. Been traveling for the last week but great to have the chance to speak to you.

[00:01:44] Niels

Yeah, yeah. We’re going to hear more about your trip later on, I think. So anyway, you’ve been traveling this week, obviously you didn’t miss much. Nothing really happened in the markets, Alan.

But we are recording on the last day of September and it’s hard to pick among all the events that have taken place during your travels. During the month, actually, I would call it a September to remember. Since we normally stick to what took place in the most recent week, I do think the collapse of the trust in the British economy and policies is perhaps the most important event that the week could offer.

But of course, it also included warfare, let’s call it that, by certain parties against the naughty countries, when it comes to energy infrastructure. Specifically, of course, this all took place in the Baltic Sea where the gas pipelines, Nord Stream 1 and 2, have been put out of commission from, what looks like, four deliberate explosions.

Now, the reason I mentioned that the events that took place in the UK this week is, perhaps, even more important is because in the last year or so, maybe even a bit more, I have been saying on the podcast that I do worry about what happens when the markets lose trust and confidence in the institutions that we rely on.

The fact that the Bank of England had to go out and intervene in the British government bond market this week, perhaps even to try and avert a collapse maybe (or at least a big issue in the pension fund system), is quite remarkable. I can’t stress how important this is because what we saw in the UK could also happen in other Western countries.

So anyways, Alan, I don’t even know if you’ve had time to follow what’s been going on while you’ve been traveling, but what’s been catching your eye maybe this week or maybe this month?

[00:03:46] Alan

Yeah, I guess we’re seeing the continuation of what we’ve been talking about, this going back a couple of months, the market got a little bit complacent that maybe we’d seen the worst in terms of inflation, and Fed, and central bank hulkishness. Since then, it’s just continued to ramp up, and obviously that’s been a continued theme. I guess what we’re also seeing, as well, is some of what you see in these periods. You have policy responses that can trigger certain things, but you can also see unforeseen reactions.

I’m sure this is what the policy makers in the UK are experiencing now. They wouldn’t have envisaged, when they decided to cut income taxes, that you would’ve got such a severe reaction. There were warnings that this could happen, but this certainly wasn’t their best-case scenario.

I think we’ll probably get onto this as we talk today. That’s one of the areas why you do get such big moves in markets sometimes. That’s the way the market is set up, that certain thresholds can be breached that are outside of expectations. That was part of the story I think with the gilt market, that some of the pension funds would’ve had some liquidity on hand to deal with this type of eventuality, but the moves in gilts were so severe that they ran out of cash and had to start selling assets very quickly.

It’s as we’ve been saying, you have to think outside of the box and be planning for eventualities that have been outside of what we’re used to in recent years.

[00:05:18] Niels

Exactly. Imagining the unimaginable, which suddenly becomes quite imaginable and very realistic all of a sudden. Now from a trend following perspective, as I mentioned, we’re recording a day early today.

So, it’s Friday, the last day of the month of September. September looks like, at least last time I checked, that it could be another strong month for trend followers around the world. Really another strong month in the year of 2022. I think that investors are starting to see the benefit of having a different investment process in the portfolio.

Because even if this has been a great year for, say, global macro in general, and then looking at all the opportunities that the year has provided, when I look at the Barclay Global Macro Index, it’s only, and I say only up about 7% at the end of August.

So, I wonder a little bit if these more discretionary type investors are really able to put on the “bearish” position when it comes to pulling the trigger on a certain view that they may have, or if they just end up going into cash as their “risk-off stance,” rather than what we would do if the models say we have to be short. We’re just going to go short. We’re not going to second guess that. Of course, in fixed income and equity markets, fixed income in particular, that has been very important.

Speaking of fixed income, I think it’s fair to say, and safe to say, that they have played another important role in this month’s return when all the tallies are made up. I guess we’ll see that fixed income is the biggest contributor of performance in September.

Also, currencies have been a positive contributor in September. Of course, if we look at a single market, I would imagine that the British pound has been a very important part of that return from a short stance of course. (Positions that we would have had on for months.) I know, certainly from our point of view, this was a short position that we entered into even last year, actually. So, it’s nothing to do with recent events or anything like that. It just shows you how suddenly a position can become very profitable. I will say of course that there have been a few… I don’t know if they actually intervened in the FX markets as well, but certainly the pound has bounced a little bit towards the end of the month.

Energies, most likely it could have been a loss this month for long term managers, but shorter-term managers would probably have made money since energy’s do continue to go lower in price, which we’ve seen in the last couple of months.

Equities are much more difficult to call, I think. It could be quite mixed, depending on your look-back period. Actually, the rest of the sectors in a diversified portfolio (at least the ones I look at), are probably relatively muted compared to the main return drivers.

My own trend barometer continues to be pretty strong. It closed yesterday at 59, so that suggests, certainly, that we should have a strong set of numbers for the end of September once the CTAs start to report.

In terms of numbers, these are as of Wednesday, I think yesterday was a mixed day, nothing too big. Friday, right now, looks to me the same, maybe a little bit down but nothing major. But the BTOP50 index was up 4.4%, and up 19.73% for the year. SocGen CT Index was up four and a quarter, up 26.4% for the year. SocGen Trend Index is very strong, up 6.25%, up 36.2% now for the year.

The Short-Term Traders Index is up 1.74% in September, up 13% for the year. Comparing that (and this is as of yesterday, so the 29th), MSCI World is down 8.6% in September, down 25.7%, now, for the year. The S&P 500 Total Return Index is down 7.95% for the month, and down 23.62% for the year. The World Government Bond Index just continues to bleed with another down month, 3.35% so far with a few hours left.

Before we jump into the topics, maybe Alan, anything that you’ve picked up on your travels in terms of the month of September, we’re going to round that off?

[00:10:07] Alan

The big thing, probably (obviously), bonds were a big driver, but currencies as well and some of these long-standing positions. I guess just taking up on your point that you’ve made there on macro versus trend and CTA, it would’ve been very hard to stick with some of these trends all the way as a macro trader. Cable went all the way down to $103 or so, whatever it was, in the agent session on Sunday night. Equally the move in gilts, they have just been so extended. If you were to have a fundamental view, you could set so many points. You might have said, “Okay, we look like the trend is petering out here, or am I top out at the highs?” It just continued.

I think it isn’t an environment that really lends itself to that systematic approach because, from a fundamental basis, macro trader, there would be an enormous temptation to take profits along the way. Particularly in those moves in sterling gilts, et cetera, which have had really exaggerated moves this week and this month.

I think that’s what you’re seeing in terms of that performance differential. Obviously, what you’re seeing in performance across trend following, it’s been a very good year for simple trend. If you look at the SocGen Trend Indicator, that’s up. Which is just basically a 21/20 day moving average cross, that’s up 46% this year now. Obviously, that won’t do as well every year, but it just highlights the fact that basic simple rules-based trend following has been the way to go this year, because we’ve had such exaggerated and sustained trends.

[00:11:53] Niels

Yeah. A couple of thoughts on that. What you said, by the way, I should say that, actually, I have seen some reports from some of these well-known famous global macro funds. They are doing pretty well this year. So, I’m not talking about necessarily the star global macro managers. They may well have done really well. Of course, we know that many of them (interestingly enough) come out and say that they tend to make most of their money to the downside when things are a little bit rough. A lot of them also say that they tend to make a lot of their money actually in the fixed income.

If there’s been one big trend this year (and it hasn’t been that difficult to call, really; we started talking about inflation a while back) it’s been the short bond trade. Good for them, let’s call it that. Now, you mentioned this thing about that it has been a great period for simple trend. But actually, I think it’s been a good year for many kinds of trend.

[00:12:56] Alan

For sure.

[00:12:57] Niels

We talk about it on the podcast that there is a difference between classic trend or pure (I wouldn’t even call it pure trend), but classic trend without too many things. Also, when I look at our own performance, comparing that to other managers, and as people would know, we do use dynamic position sizing and so on and so forth.

We’ve certainly enjoyed a very, very strong year. This is also why I’m not necessarily always in agreement when we hear that, in order to catch outliers, you need to not adjust your positions at all. I’m not so sure that is true. I don’t know that there is any hard evidence to suggest that. I do agree that certainly you could say that there is potential for having more open profit if you don’t adjust your positions, but the positions may be adjusted both up and down during a long-term trend. We have to always also think about the give-back because the give-back will be harder if you haven’t adjusted your position size.

So again, I don’t see any evidence that one is better than the other. That’s always been my view. I don’t see that this year either. But anyways that’s fine. This is a different discussion. It has been a generally good year as you suggest, both with the CTA Index and the Trend Index.

Hopefully more and more investors will see that advantage. Which actually leads me to your topics today, because I think that’s actually what it’s all about in a sense, but from different angles. I’m quite curious as to where we’re going to go because you brought along a number of different articles and research papers.

There’s one from the Wall Street Journal. There’s one from Aspect Capital. There’s one for Man Group. I brought along another one, which is unrelated to that, but that was another one I found in the Wall Street Journal. Why don’t we just jump in and make it a little bit of not exactly knowing where we’re going to go with this conversation, even though we know where we have a few points that we want to address.

But I’m going to let you take the lead and hopefully I can add a few things along the way.

[00:15:23] Alan

Yeah, sure. One thing I just wanted to touch on first going back a few months. We talked about what the things are that cause trends in markets. I think you can speak in generality around that, but I think what we’re seeing, obviously, is a very strong environment for trend following this year than in the last few years. So, it really is helpful in framing that and picking out some of those themes. At a high level, why do we get these big movements? If we go back and say we had this discussion about why was it difficult for trend following for a period in the past, and why is it better now, at a simple level it is because you see bigger moves in markets, and we’re seeing bigger moves in markets now. But the question is, why is that? I think there’s a few things that really, when you look at the markets over the last two to three years, firstly we’ve had random shocks.

Obviously, we had COVID first of all, that was in 2020. That clearly drove big moves to the downside initially in equities and in commodities. Eventually those reversed. We had another shock this year in terms of Ukraine. So, that’s a shock. What happens when you get a shock is you get a repricing event. Markets go from pricing assets based on one macro scenario to a new macro scenario.

Shocks contribute to repricing effects, and that can cause trends. Second thing is that when you get shocks you get a policy response. Very often what you can get is not just a policy response, but a policy error. What we’re seeing now, obviously very much with the Fed, it’s been very slow, very aggressive initially in responding to COVID, and then probably being too slow, and taking away the stimulus. That’s been a contributing factor in terms of generating trends in markets. Now, jamming on the brakes pretty aggressively, again, some people have said this is going to be a policy error. That’s another factor causing trends.

I suppose within that, why is that? It’s because you have uncertainty. So, the Fed doesn’t know how hard to go in terms of stimulus. It’s very hard to know how hard to go in terms of withdrawing the stimulus. So that uncertainty is another element to why you get trends in markets that we’re very much seeing. Then I guess from an investor perspective, you have (we always said) the behavioral aspects of investors. When we had the stimulus, it’s only a couple years, we had FOMO (fear of missing out); everybody piled into the meme stocks and equities, et cetera; you had TINA, the perception that interest rates were at 50 basis points in the U.S. in the ten-year; you had to be in equities, there was no alternative. So, everybody piled into that from a behavioral perspective. Also, you had anchoring. People assumed that the yield’s role was going to be in this kind of 1% to 2% range, 0%, 1% to 2%. So, then when you get these shocks, people tend to anchor and then initially underreact, and then presumably later on overreact.

So, again, we’re seeing that in markets. Then the other thing I would say is, often then you’ll get second order effects and unforeseen side effects in markets from policy actions. We’re certainly seeing that this month in terms of, take cable for an example. You had that big move down; I think it was Sunday night.

So why is that? It’s because you get a random shock and then you have (we’ve talked about this before) exogenous versus endogenous factors. Endogenous factors can be things like you can have options, barriers, you can have stop losses in the markets. People assume the certain levels won’t be breached, but when you do, you get a tipping point, you get a cascade effect.

That contributes to trends as well. You instigate one policy of tightening policy (say) in the U.S. higher rates, and the side effect of that is in the foreign exchange markets in the very strong dollar. That can then have unforeseen impacts on other markets.

Like we’ve seen in the UK this week, we’ve had a policy announcement in terms of cutting taxes, et cetera, and very strong moves in the gilt markets. Probably the unforeseen side effect there has been this pension situation where nobody thought about this… I say nobody. I think a couple of people had flagged LDI as a potential risk, but you have this liquidity issue whereby as gilts are going down and yields are rising, obviously, that impacts the swaps and the hedges that pension funds had put into play. They had to then raise cash and start to sell, liquid assets, and then push the gilt market down even more. So again, an unforeseen side effect of a policy action. People say, why do you get trends in markets?

I think all of these factors are ingredients and features of the market shocks: policy responses, policy errors, uncertainty, behavioral biases, second order effects, unforeseen effects. I think it’s important to keep that in mind because when you get a year like this, for trend following, it’s very easy to say 2020 was such an unusual year. We had that spike in inflation. It probably will never happen again.

So, people say that, as in 2008, that was a global financial crisis, how often do you get a global financial crisis? You know that’s a one-off thing that trend following will do. But my point would be that you have these structural factors. There will always be shocks. We don’t know when they will happen, but there will always be shocks. There will always be policy responses to shocks, and the policies are made by humans who will tend to make mistakes. Sometimes they’ll get it right, yet, they may engineer the soft landing. But more often than not, there will be mistakes.

Then you have market participants responding to these events with biases. The structure of the market is such that you will have setups from time to time, endogenous factors, which will tend to accelerate the trends. So, I think we’re just reflecting on what we’ve seen in markets over the last two to three years. To really highlight those structural factors which are always in play.

You won’t always get the big trends but thinking that this is unusual and won’t be repeated, I think it’s the wrong way to think about it. Sure, we won’t get the exact setup again. But as I say, these kinds of more structural features of markets are the reason you get trends and persistent opportunities for trend followers.

[00:21:42] Niels

Yeah, a couple of things that springs to mind. I think we should change the term FOMC to FOMT, (fear of missing trends). I think that would actually help. But, kidding aside, actually, you talk a lot about the official policy. Both mistakes, but actually trends can also be caused just from normal policies. It doesn’t have to be an error in a policy per se. Of course, trend following doesn’t just do well when there are crises, and errors, and all of that. We know that, even though some people refer to us as Crisis Alpha.

But anyways, it reminded me about an upcoming conversation you are going to have, in about a month’s time, that I can’t wait to hear. I hope you will ask him about some of these Central Bank policies. That is, of course, William White, who used to be the head of the Central Bank, so to speak, the BIS. It’ll be very interesting to hear what he has to say about what he thinks or what he knows about what goes on when it comes to Central Bank decision making and so on and so forth.

But I completely agree with everything you’ve said. It still surprises me when I hear people say, surely that’s not going to happen again. Of course, we don’t necessarily mean that the same thing will happen again, but something will happen, and that’s all we are hoping for – that change will happen. Not many strategies embrace change and uncertainty the way trend following does. It has, actually, a proven track record to demonstrate that, no matter what the uncertainty has been (no matter what the crisis has been, or the policy, or whatever we call it), it has been able to adapt and navigate through this environment.

I hope that 2022, if nothing else, one, can be a little bit of a help for those who have portfolios in more the 60/40 space, but with some allocation to trend following. But also, that we will find more people who are then becoming open to this strategy and diversification across investment process.

Anyways, thank you for doing that, Alan, and let’s dive into some of these topics that you brought along. There are three of them, they’re somewhat linked you could say. So why don’t you just set the context, yeah.

[00:24:28] Alan

That’s what prompted me. There was an article in the Wall Street Journal from Alan Blinder, who was previously at the Fed. He was Fed Vice Chair. All of these were linked to the whole idea at the moment… The question is, are we going to have a soft landing or a hard landing in the economy? What impact will that have on asset market performance? Then after I had read that, I’d come across a couple of articles from Man and Aspect Capital, which kind of address how these scenarios may play out in terms of trend following, et cetera. I’m just thinking, we’re at an interesting juncture now.

If you think about where we were maybe two years ago, it was all about, is it going to be a V-shape recovery? Is it going to be an L-shape? Is it going to be a U-shape recovery? Now everybody’s asking, are we going to have a hard landing, soft landing, or no landing, or kind of a stagflationary type landing?

It was interesting, Alan Blinder, he used to be at the Fed himself. He went back, and he looks back historically at what is the likelihood of a soft landing in the U.S.? He put it at less than 50%, but not zero. When I read it, he seemed to be a bit more optimistic than most people.

I thought probably talking a little bit from a central bank perspective of talking to prospects a little bit, he did give himself a little bit of a pat on the back because he was at the Fed in 1994 when they did manage to engineer a soft landing. But his general thrust was, yeah, it is difficult to do it, but not impossible. I think an important point that he touched on is that it’s even more difficult in trying to engineer a soft landing when you’re actually actively trying to bring inflation down, as opposed to the 1994 type scenario when inflation is already low, but you’re just trying to slow the economy to prevent it from taking off. That was the context of this.

What’s important really, and I think it is another factor in trend following strategies favor, is that we don’t know what the scenario going forward is going to be. We could be looking at deflation in a year’s time.

A lot of people are saying, look at commodity prices now, look at what we’re seeing with house prices that are starting to turn down. There is that possibility. Aspect Capital, in their paper, looked at basically three different landings, I guess for the economy historically.

The soft landing one in ‘94, the hard landing in the early 1980s, and then no landing which is the stagflation of the 1970s. It’s interesting when they look at this, they then look at the performance of trend following commodities, bonds, and equities. In each of the periods, trend following does reasonably well.

Whereas, depending on the nature of the landing, you can have commodities doing well, or bonds doing well, or equities doing well. Obviously, if you go back to the soft-landing scenario of 1994, what you saw then was actually a decent performance for trend following. But it was actually short dollar trades, short fixed income, and long commodities where trend following did well. Whereas if you compare that to the hard landing scenario of the early eighties, again, trend following did well, but it was long dollars, short commodities, and long fixed income.

Then if you go to the stagflationary period, and again, that was a positive one for trend following. It was short-fixed income and non-commodity. Again, it speaks to the dynamic nature of trend following strategies, of course, that we talk about. We’re not trying to figure out what the nature of the economic downturn is going to be, whether it’s soft landing or hard landing.

But the pattern of performance, the asset classes that might drive performance for a trend following performance will differ depending on the nature of the downturn. But the dynamic nature of the strategies means that it’s arguably a better bet than any one of those individual assets, because obviously to determine between bonds, equities, and commodities, you have to have a view on the nature of the downturn.

It was very much a case of a paper highlighting the dynamic nature of trend following. Which I think is even more important at the current juncture, because we’ve had such an unprecedented stimulus and now a very aggressive tightening cycle.

I’ve been in the kind of inflation view camp, but who knows, it could change very quickly, and if we had a really hard landing, you could certainly have a year or two where prices come down very sharply. I think that’s a very valid perspective. The other paper linked to this was from Man, and they were looking at should you maintain your allocation to commodities in this environment? Because obviously we’re starting to see that shift.

If you were to go into more of a disinflationary environment, would it still make sense to hold a long only commodity allocation? They concluded, yes. Unless you get into outright deflation, still, the diversifying quality of commodities is still valid. But obviously you’re probably even better off getting that commodity exposure via trend following, as opposed to a long-only exposure would be my conclusion based on the evidence they presented.

Further kind of thoughts, interesting perspectives on, rather than trying to anticipate what the next one to two years is going to look like, having that dynamic element in the trend following portfolio is going to be pretty important in navigating whatever the scenario.

[00:30:22] Niels

Yeah, absolutely. My takeaway from these articles, or what I thought was quite interesting is that first of all, the Alan Blinder article, when you go down history, what he writes is that the Fed has only managed the soft landing once out of 11 tries over the last 60 years.

When people suggest that they will be able to do it this time, they certainly don’t have the hard evidence to build that probability on. It doesn’t mean that they won’t be able to do it, but it just means that it’s not something we necessarily would expect from their track record, so to speak.

It is interesting. Of course, we know that there are lots of articles coming out right now about the benefits of trend following. It’s not surprising when it’s a year like this year, but looking at it the way Aspect did, I thought it was interesting because the narrative has changed. Now, the narrative really is soft, hard, or no landing.

I thought it was interesting that they’ve gone back and looked at these periods instead of just, necessarily, the typical crisis period that we all know, and have become used to talking about, and so on and so forth. Again, hopefully it can prompt some people to look at this investment strategy in a different light.

Then finally the paper from Man. Of course, they also always put out some interesting research. It’s an interesting topic, this thing about commodities actually from my point of view. I was listening to a conversation with the head of commodities at Goldman Sachs, Jeff Currie. Who I think is a really smart guy. His view is that we have entered a commodity super-cycle.

So of course, the first question you think you’re left with is that, hang on, markets have dropped significantly in the last five months for sure. How can we still be in a commodity super-cycle? Anyway, he says in these commodities super-cycles, it’s completely normal that you have these huge corrections in price. But it actually doesn’t change where we are heading in a bigger picture.

To me, there’s a couple of things in that. He could be right, for sure. There’s a lot of things that actually point in that direction. Certainly, our conversation with Alan Rozencwajg, a couple of days ago, suggests that certainly in the energy sector we could well be heading much higher in terms of price. But then it opens up the question about this thing about being long-only commodities, when you have these huge corrections.

As far as I remember, you might know this better than I do Alan, when you look at a classical commodity market, let’s just say it has a number of turning points over a 30-year cycle, or whatever it might be. I tend to remember that actually about two thirds of the time they spend going down, and about only one third of the time they spend going up.

I also remember, certainly at some point when we had this commodity super-cycle, there were a lot of these commodity indices being launched. Of course, investors got, I wouldn’t say burned, but they certainly were disappointed with being a long-only investor in commodities. I would even go as far as saying that I think a lot of investors ended up buying long-only commodity exposure earlier this year, because this narrative was so strong after the Russian invasion of Ukraine.

But it just comes back to this thing that if trend following is hard to hold onto, I think a long-only commodity portfolio is even harder. A lot of people shy away from it. So, I agree with you. I think commodity markets lend themselves much better to a long-short strategy.

Of course, we know the commodity markets, at least if I look at our own historical returns, but I’m sure this is true for most long-term trend followers, that commodities do provide profits over time, not necessarily all the time. They can certainly have their number of years where they do very little. But in the long run, it’s a very interesting source of returns from a trend following perspective. Not only in absolute terms, but also when it happens.

I think I’ve seen a paper once that suggested that when you look at crisis periods, and where trend followers then tend to make their money from to deliver some alpha during the period, it’s actually commodities that are the most reliable source of returns during these crises. That’s why they’re so important.

Now, Jeff Currie made a very interesting point about why he still believed. I don’t want to misquote him. I wish he would come on our podcast. I have to find a way to invite him on the podcast, because I think he made some really important points that people don’t necessarily understand about commodities, but it’s to do with the fact that commodities are very closely linked to volume, unlike financial instruments.

You can always produce more financial instruments if there is a big surge in demand. But with commodities, it’s different. There is a finite volume that you can buy. If demand outweighs supply, you will get these upwards trends. What he’s suggesting is that when you provide a lot of stimuli into the economy to basically the whole economy (meaning also those who have the least), then the demand for a lot of commodities will increase. But, since it’s a volume game and there is only a finite volume, then that will lead to significantly higher prices over time.

I think that’s part of what he’s basing his thesis on that we may still, even though it doesn’t feel that way right now, be at the beginning of a long-term commodity bull market. Which I wouldn’t rule out at all.

[00:36:58] Alan

I think you’re right. That was one of the messages from your interview with Adam Rozencwajg. You know, very much that it’s the underinvestment story that is the key underpinning, to bullet you. I think Adam was quick to say it’s a cycle. Whether it’s a super-cycle or not is beside the point. It’s that decade or so, and from under investment, partially, I guess related to lower prices, but also more related to ESG concerns and the incentives for the oil and gas companies.

[00:37:36] Niels

Also in the energy sector, yeah. We know that there’s been a clear under investment for sure.

But even in other commodities, right? We’ve gone through this globalization that has meant hundreds of millions of people moving into the middle class. Once you move into the middle class, you will want other types of food, for example, sugar, things like that. That’s where this volume plays a role. I don’t think I’ve actually thought about it in this way before, but it made a lot of sense the way Jeff Currie explained it.

[00:38:17] Alan

I think that your point is interesting. On the point of just it being hard to hold, if you look back at the charts, particularly the grains, there was a huge run up in soybeans, corn, lumber, these markets.

But back in the seventies there was a real explosion in the early part of the seventies. Then, these markets had significant drawdowns at different times in different markets. Soybeans, there was a spike in ’71, ’72, and then it came back down. With corn it’s more like a drawdown between, probably for three years.

In the 1970s, everybody said, “Oh, inflation commodities did really well.” Certainly in aggregate, yes, it was a very good period. Obviously oil prices went up. Gold probably went persistently up. These days if you’re in a commodity basket, you’re getting exposure across a whole range of markets. Even within a super-cycle, you will have periods where individual markets are experiencing drawdowns.

I think that’s the other part of commodity investing, is part of the return is from that rebalancing and the fact that you have different markets doing well at different times. It does tend to get a diversification benefit of selling some of the winners and then rebalancing to some of the others.

I think the final point, that I didn’t mention, that is an important part of the Man piece that they highlighted, even if you saw a less favorable environment in spot prices, most of the markets are in backwardation at the moment. That is favorable for long positions and is probably evidence of that kind of tightness, that underlying tightness in these markets. Yeah, probably not that either of us are fundamental commodity experts, but based on everything we’re reading, that longer term bullish picture is still there.

That’s not to say you can’t have significant draw downs in the short-term if economic conditions really deteriorate.

[00:40:26] Niels

The good news is, Alan, we don’t need to worry about it because we just follow the price.

[00:40:28] Alan

Exactly.

[00:40:38] Niels

Anyways, you have been, as you’ve talked about, on the road. It’s a road trip that has taken you not only to Connecticut, but to the windy city as well, where you were mixing your trend exposure with some volatility exposure, not least catching up with Hari and Cem from TTU.

What’s been going on? What are you hearing from these conversations and conferences? How are people feeling? In a sense, not that we’re experts in volatility, but it is an interesting point, because a lot of investors took the view that yes, we were worried about the high equity markets, but the better way of protecting ourselves against the inevitable selloff in equities would be volatility, based on their limited experience from March of 2020, frankly (maybe a little bit in February of 2018, with Volmageddon).

Even though that might be a more unique situation because of the XIV, and the role that played. I do think that there has been a lot of interest and a lot of disappointment, frankly, this year. As someone put it, with long vol strategies at least you have hedged yourself against (or it’s an insurance against) some kind of catastrophic event. It’s not an insurance against wear and tear. It’s been this kind of wear and tear, gradual movement, and on top of that, probably some decoupling of the relationship between the VIX and the S&P that has been tricky.

Even though we know all strategies go through difficult times. I’m not saying that this is permanent, but again it goes on also to the next point we’re going to talk about, liability driven investment strategies. We get a narrative that becomes very popular. Money flows in that direction. Sometimes (which we also saw with trend following, by the way, in 2009), a lot of money flowed into trend following, given the returns of 2008, and frankly, they were disappointed. So anyway, what’s the word on the street?

[00:43:08] Alan

I think all of what you’ve touched on is kind of part of the story. I was in Chicago at a conference moderating a panel. It was interesting. We had a mix on the panel of CTAs, trend followers, and traders who were more volatility focused. It goes to this classic debate if you’re looking to diversify away or hedge equity risk. I’m kind of reluctant to use the word hedge but diversify equity risk.

People naturally think in terms of CTAs, and trend followers are volatility traders of tail risk. Again, just as you can have, within CTAs, a range of different strategies and a range of approaches and different speeds that will provide different types of performances depending on the market environment. Once you get into the realm of volatility trading, it’s the same thing. From pure tail risk hedges to more absolute return focused volatility traders as well.  So, again, it’s very important to know exactly what you’re getting when you’re allocating to any individual manager.

Obviously, as you touched on, from this year’s perspective, there’s very much large dispersion (I would say) in the volatility trading space. Some people are still doing quite well, others are struggling. As you say, partially, there are a few different factors. The nature of the move in equities has been different.

Obviously, if you get a period where you’re going into the start of an equity bear market where volatility is very compressed, as we did in 2020, then when you get an explosion of volatility, you get a significant rise in the VIX. That was a period that was much more favorable for volatility trading and tail risk hedges. Obviously trend following did well in aggregate, but again, within trend you had some people who did well, some people who did less so depending on how quickly you were to jump on those trends.

Whereas this time around we’ve had much more of a grind lower. It’s much more like the bear market of 2000, 2002. There’s kind of a saucer shaped type of top that you haven’t had enormous moves down on any individual day, but it’s continued to grind lower.

What has that meant in terms of volatility? The VIX has bumped along between 20 and 30 for most of the year. We haven’t had that singular, real panic event. It looked like we might be on the verge of it maybe last week with the kind of heightened fears around the UK and fixed income markets.

But we haven’t had that really stand out, real sense of crisis that you often get to push the VIX up above, 40, 50, 60, something like that. Volatility, intelligent risk hedges, unsurprisingly will do well when you buy them cheap, and then you get a surprise to the upside.

In an environment where you have to carry that cost of that protection, it eats away. You have this bleed which is higher. That’s not to say that we’re saying that’s an inferior strategy. It just will work in a different environment. The environment that we’ve been in this year has been much more favorable.

Interestingly if you go back to 2008, the VIX was kind of like it has been this year. It has bumped along between 20 and 30 for most of the year, until you got to September, when you, obviously, had Lehman, and then you had a spike higher. So again, not to say that these types of strategies won’t deliver – maybe later in the cycle. But there is an element of understanding, where you’re getting your protection, how much you’re paying for it, to understand what’s the risk/reward.

I thought it was very interesting. What you do see from an asset allocation perspective (and we’ve seen this with some of the discussions that we’ve had on the allocator series) is people allocating both to tail risk, and volatility trading, and to trend following, on the view that you will get different types of equity market declines. Sometimes it’ll be a February, 2018 type of event. Sometimes it will be a March, 2020 type of event, and sometimes it’s more like what we’re seeing this year.

The irony is, going back again a couple of years, you had this narrative that equity declines are always fast, that the market has sped up. That somehow we wouldn’t get these kinds of more prolonged, slower cycles. Obviously, people are just fitting a narrative to what they’ve seen recently. If you’re in-market is long enough, you see every type of market decline.

[00:47:40] Niels

Yeah, absolutely. It’s interesting Cem actually is going to be on the Systematic Investor series in a few weeks. There’s one thing, hopefully, I’ll remember to ask him. That is, the VIX came out in 2004. So, it has only really existed through declining interest rates, no inflation. So, I’m just curious how this change (which I think will last for quite a long time. I’m a believer in these cycles. The interest rate cycle seems to be about 40 years)… So, it did change, about a year ago or so, and it might last for quite a while. Plus, if inflation is here for much longer than people can imagine, then it may have an impact on how these models are developed based on history that has only been around for a relatively short period of time and, certainly, in more or less the same regime – this carry regime type environment. So, it’ll be interesting, but that’ll be for another conversation.

Now let’s try and round up our conversation today, and then just maybe jump into this article that I saw in the Wall Street Journal about this liability driven investment strategy that is very popular within the pension fund system. As I mentioned before, and have mentioned for a while, one of my concerns is that we are going to start seeing some kind of loss of trust, loss of faith, loss of confidence in some of these institutions. If we do, traditional investment strategies (such as those that are often employed by pension funds) could be in trouble. They’re already in trouble this year to some extent. They could be in a lot more trouble.

Then I came across this article about pension funds adopting the liability driven investment strategy. In particular the article focuses on the UK. As mentioned before, the Bank of England had to come and intervene in the long gilt market this week because of the massive price drops we saw in government bonds being driven by for-selling from pension funds as well.

In the article there’s a consultant, who is from Aon, who talks about what is the start of a death spiral. I don’t know whether that’s true or not, but clearly if it continues it’ll force even more selling. By the way, that’s a completely different discussion.

We haven’t even talked about passive investing and what that might do if this continues, and so on and so forth. It is again, as you say, it might be one of these unintended consequences because of regulatory changes. A lot of these pension funds were forced into doing something else.

So, they came up with the idea of (by the way, I don’t necessarily think that consultants can be completely free of blame here. They’re usually the ones coming up with all these smart ideas for new strategies that they can go and implement) this risk of hedging against lower interest rates. So, they put on all these swaps and so on and so forth. But then when interest rates start to rise, suddenly you’re sitting there staring at massive losses that can be potentially much bigger.

To give our listeners just a little snippet of how big this is, in the UK (apparently), this liability driven investment strategy has increased from about 400 billion in 2011, and is estimated to be about 1.6 trillion pounds as of 2021.

It is a huge strategy throughout the pension fund system. I think there also was a survey of 137 big UK pension schemes in 2019. They found that 45% ( almost half) had increased their use of leverage in the last five years. By the way, the maximum leverage allowed by a pension fund ranged up to seven times, this survey found.

Once you start getting into these things, both using lots of leverage to compensate for maybe lower returns on their fixed income portfolio, combined with swaps that they may or may not fully understand what it is. What else they’ve gotten into. I do worry. I can just see, by the way, since I spent the summer here in Denmark, I was noticing some of the abismal returns that were being posted after the first half of the year from even the biggest pension funds here in Denmark.

Of course we know Q3 has only made those worse. You sometimes have to wonder a little bit why these (I’m assuming) well educated and very clever people find themselves in these kinds of situations, especially when interest rates were so low. I don’t want to say anything negative here, but you don’t have to be a PhD (let’s put it that way) to figure out that most likely interest rates were going to go higher, not lower. Yet we see now the fallout of strategies like that still being held by pension funds. Anyways, Alan, am I too negative on a Friday?

[00:63:40] Alan

I’m not sure. I think there’s a lot of talk about this. I’m not sure a lot of it is as informed as it should be. I think there was definitely a liquidity issue during the week that obviously there was mark-to-market losses on the LDI investments, the swaps, which makes sense, obviously, interest rates are going up.

The point is they have those positions on because if rates go up, they get a benefit in terms of the liability side going down. It’s okay from that perspective. I think that the issue was you need to then fund those positions or you’re into mark-to-market margin calls, et cetera. Then you need liquidity for that. How much liquidity had they put aside? That probably wasn’t enough.

So then what do you do? I would’ve thought that if your pension scheme is solvent, I would’ve thought you’d be able to get liquidity against it. But maybe everything happened so quickly that they weren’t able to, and they had to start selling their most liquid assets, which were gilts, which then accentuated the problem.

There was obviously a famous case, I think it was back in the early nineties, Orange County in the United States. That was a pension that went bust because of derivative exposure. I think that may be in the collective memory of the market that they hear derivatives and pension plans and they feared the worst. So yeah, I think there’s a lot going on with respect to pensions, because obviously when rates go up, as I say your liability side goes down.

So the other part of this is you may see more liquidation on the asset side. There was a suggestion that the UK pension funds might turn to be sellers of property, which would be, obviously it’s not something you can sell very quickly. There could be more widespread reverberations from this.

It’s, as I said earlier, it’s a repricing event, so you’ve got a big jump up in yields. We’ve been hearing about the problem of low yields, for pension funds, for a long time, which is very obvious, so it’s not all negative. If you were retiring now in the UK and you had a pot of cash, you would actually get a much better annuity, because of the higher rate.

People tend to focus on the negative aspects of this, but I think there’s more to come out on this story. I don’t know if there’s a systemic problem, there could be challenges, but I think there’s multiple kinds of second order effects here and it’s hard to say how it’s going to play out.

As I say, I think when people hear of derivatives and pension funds, they get worried.

[00:56:13] Niels

Absolutely. We shouldn’t end on a negative note. Of course, so let’s go back to the FOMT, (fear of missing trends), clearly that’s what people should be focusing on in our humble opinion.

Let’s round up this conversation. We have a few hours to go before the end of September, and it certainly looks like it will be a September to remember.

Now, if you want to support our little podcast, please head over to iTunes, Spotify, or Amazon, wherever you get your podcast from. Leave a rating and review and make sure you follow the podcast. That’s always a help. Of course, if you want to share it, that would be even better.

Next week I’m joined by Rich, so I’m sure we’ll have lots of, how should I say, hardcore trend following topics to dive into. Looking forward to that. As always, you can ask and you can send your questions, and we’re going to try and answer them, to info@toptradersunplugged.com, and we do our best to bring them up in the next conversation.

Anyways, from Alan and me, thanks ever so much. We look forward to being back with you next week. In the meantime, take care of yourself and take care of each other.

[00:57:31] Ending

Thanks for listening to the Systematic Investor Podcast series. If you enjoy this series, go on over to iTunes and leave an honest rating and review, and be sure to listen to all the other episodes from Top Traders Unplugged.

If you have questions about systematic investing, send us an email with the word “question” in the subject line to info@toptradersunplugged.com and we’ll try to get it on the show. And remember all the discussion that we have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance.

Also, understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Thanks for spending some of your valuable time with us, and we’ll see you on the next episode of the Systematic Investor.