228 Systematic Investor Series ft. Alan Dunne – January 29th, 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

[00:00:23] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor 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 some of the past episodes that you may have missed, like last week’s episode with Rich where he discussed the topic of uncertainty and the role it plays within the trend following world.

Also, I would like to really encourage you to listen to the midweek episode where Kevin was joined by David Rubenstein, and where I think we heard a rare and quite personal side of Mr. Rubenstein and what he has learned from all of his conversations that he’s had with some of the most successful investors in the world, and of course, his long career at Carlyle.

Of course, not least, you should really listen to the extra episodes that Alan and I have done with the largest CTA firms in the world and where we are, essentially for the first time, taking the pulse of all these managers, more or less at the same time, covering a wide range of topics that are relevant for the firms themselves, but also for the industry as a whole. There is much more to come in this series.

Speaking of Alan, Alan it’s good to have you with me today. How are things in Dublin?

[00:01:50] Alan

Things are good. I’m well. Good to speak to you again. We’ve done a lot of podcasts in the last while, but it’s all been great.

[00:02:00] Niels

Yeah, it’s almost like a daily occurrence. But today will be different, of course, because we are back in our usual stride with a little bit of current content and some really good topics we hope that people will enjoy. Because I have had a pretty hectic traveling schedule this week, I was thinking of doing something slightly different from what we normally do in terms of a market wrap because I haven’t really followed what’s been going on. I’m sure there’s a lot that’s been going on.

I thought maybe today, you and I could just perhaps discuss some of the bigger global macro issues or observations that we both have and use that as a little bit of a jumping board for our conversation. So if you don’t mind, I would love to hear what’s been on your radar or what is on your radar right now in terms of the bigger issues, which of course, will also have an effect on the markets as we see them and therefore also have an effect on the performance of trend followers, of course. But let’s take it one step at a time.

[00:03:04] Alan

Sure. I think it is, as ever, at a very interesting juncture. In terms of macro themes, the first one, obviously, the big focus is the economic outlook and the unfolding slowdown that we’re seeing, particularly in the US economy, but the patchy nature of the slowdown. It seems like the market is very much grappling with how bad it is and with very much conflicting signals. So obviously, we had GDP numbers out this week that were reasonably good. But we’ve had weakness in leading indicators, weakness in the ISM services sector, ongoing weakness in the housing market.

At the same time, the labor market is holding up pretty well. I think jobless claims have been pretty low and the unemployment rate stays low. I think the consensus is probably for a moderate slowdown, but it remains to be seen whether it’ll be that or worse. Obviously, monetary policy comes with a lag. So I think that’s one big theme. I think a second one is that we’ve had a mild winter here in Europe, obviously. So Europe seems to have dodged a bullet really, in terms of the impact of weather on the energy markets. I think there’s a sense of much more optimism around European equities, up probably about 10% on the month. So certainly, that’s an emerging theme as well.

To the background of a big theme influencing markets is this disinflation story. The last two or three inflation numbers in the US, on the CPI, have been better than expected and not just that the headline is coming down, the core is coming down. If you look into the details, it’s the housing component which is a lag measure that’s keeping inflation elevated.

So there’s a strong sense of disinflation, but then again, a question as to, okay, it’s heading in the right way, but is it going to get down to target or will it prove to be sticky? So I think that’s another theme. Related to that, we’ve got China reopening. Going back a few months, we had China very much in lockdown, and due to change in approach from the ruling party, a very sharp reopening. So we’re in the midst of a reopening phase in China, which I think is also shaping the optimism that maybe the global economy might be able to pull through if we get a spurt of growth from China.

It’s not obvious to me. Is China reopening? Is it inflationary or disinflationary? Obviously, China reopening is good on the production side in terms of easing supply chains. But obviously, you’ll bring in an incremental buyer, particularly in commodity markets. So I think there’s two sides of it there with China opening.

A couple of other themes I think are important, the debt ceiling is obviously back in focus in the US. It feels like every two years, you get this crazy suggestion about minting the trillion-dollar coin and you have to look up to see, where did this come from? But it’s the whole point that the US has this process of setting a limit on the amount of debt they can have, and every couple of years, they have to have a renegotiation between the Republicans and Democrats. I suppose what’s worried people this time is there’s even more acrimony in Congress and there’s this suggestion or concern that these deliberations and negotiations could be even longer than normal and we could be back to a 2011type scenario where a genuine fear of default or a US downgrade again. So I think that’s another macro theme.

A final one I’ll want to just throw in, which I think is also part of the mix as well, is that I think it got a little bit overlooked when it came out first and that was the US inflation Reduction Act that Biden brought in. It didn’t seem to be very focused on reducing inflation. But one thing it did do is provide a lot of incentives for the production of green energy projects and incentives around buying EVs and producing them in the US. That seems to have generated a lot of planned investment and even for European companies to redomicile some of their plans to the US.

Now we’re starting to see concern in Europe around this and a potential reaction from the European side too. So, it is something that we’ve talked about before, that this greening of the global economy is going to have to take a lot of investment, and that could be inflationary as well over time. But actually, we’re starting to see in the news flow a bit more tangible signs that that’s starting to kick in now. That could be one of the reasons why we are seeing strength in the material stocks and things like that, even in the face of this widespread expectation of recession.

That was my list of main macro themes digesting at the moment. I think if you were to sum it all up, markets have gone from being very pessimistic, probably like September, October last year around stagflation, and have downgraded stagflation risk in the last number of months and increased the likelihood of a softer landing and maybe even a return to Goldilocks. But whether that proves to be correct or not, I’m not sure. I’m still very focused on the fact that we’ve had a big shift in monetary policy and that often impacts the economy with a lag. So who knows when we’re going to see the full economic impact of higher rates?

[00:09:17] Niels

Yeah, it’s a great list, and many of the topics were not even on my list. But I think there is some commonality for sure. If I was going to sum up how a lot of these things relate to the markets, I would say that it feels to me like the markets are pricing for some kind of perfection, that we somehow magically get around a lot of these issues and we have this soft landing, rates will go down later in the year, etc. But I think you said something that’s very, very important in dealing with all of this because there’s no doubt that government plays a much bigger role in how we will come through this period. You mentioned the point about, well, can they even agree?

I actually think that’s a really important point because when you have crises, then there is obviously a need for people to work together and to essentially find solutions across the aisle, if we look at the American system. But it doesn’t strike me that there is that will to work together in many countries, frankly, to find the solutions. So I’m concerned about whether this perfect picture that the markets are laying out ahead of itself might get derailed just from the lack of cooperation between policymakers. So I think that’s a very interesting point.

I also think that, are the other markets really listening to what the ECB saying? For example, they’re not saying anything about low interest rates anytime soon. I’m not sure even the Fed is saying anything about it. They might say we’re slowing down, but I don’t think they’re saying anything about low interest rates anytime soon. I think there’s actually building up a fair amount of risk of disappointment in the markets, both in bonds and in equities. Just based on my own observations having been involved in markets for 35-plus years, I’m not so sure that what we saw last year was the bottom of the bear market.

I think what we’re seeing now could as easily just be a big correction in a much bigger bear market where essentially disappointment with earnings, we’re obviously seeing layoffs hitting as well. But disappointment with earnings or whatever it might be could easily change sentiment once more. So that’s sort of some of those things.

I also think about the inflation front. I was talking to one of my friends in Denmark the other day, and as you were saying, yeah, it’s great that inflation is coming down, but it’s still 9%. You’re thinking, “Oh, shoot, it’s 9%.” Interest rates are far below that. So yeah, it’s going to take some time for it to get down to something like 4%. So at the moment, you’re hoping that inflation will come down to interest rates, but at some point, maybe interest rates have to come up to the inflation rate to get to that point.

Then there’s, at least for us here in Europe, another thing that I think we can’t ignore, and that’s the fact that the US and Europe are now sending tanks to Ukraine. What does that mean? Does it mean that Russia at some point will say, “Actually, we can cut half of our oil exports, and so you’re going to get 4 million barrels less than you normally get.” So that’s just probably going to drive up prices by a significant amount so that they won’t necessarily financially lose out too much. But inflation is going to come back on the agenda, that’s for sure.

I hear from many different people and some of them, obviously, guests on the podcast, about some of these constraints you have in the commodity space, not least, with some of the metals. I’m thinking, I don’t know if people are aware of it, but a lot of the metals that go into production of weapons and the shells that they fire thousands of every single day, all of that metal, a lot of it comes from Russia. It’s not like we have metals all around the world. So that’s another thing I’m worried about is that maybe there comes a time where we just simply can’t get the metals we need.

I’ve certainly heard Peter Zeihan talk about companies, like Airbus, are going to run out of the metals they need to build the planes in the not-too-distant future. So I have all these different conflicting messages in my mind, which suggests that there’s a lot of uncertainty ahead of us and therefore I’m a little bit surprised about the calmness. VIX is very subdued, and of course, there have been some pretty big market moves this month so far. But still, it all looks a little bit too rosy for me.

[00:14:32] Alan

Yeah. It’s interesting. If you go back to maybe last August in Jackson Hole, we talked about it at the time, the themes that came out of there were all around supply-side challenges that we will have going forward. We heard the same from Bill White when we had him on. Anybody who’s looked at that side is saying, yeah, we’ve got deglobalization, we have nearshoring or friend-shoring or whatever you want to call it, and you’ve got all of these structural shifts.

I suppose, the thing about the supply side is it evolves slowly. It’s not like there’s a monthly release like you have with payrolls or inflation highlighting where we’re at with supply side. So it’s still there in the background, but it just hasn’t been to the fore in the last few months and the market seems to have pushed it aside as an issue and is more focused on the favorable news we’ve been seeing on the inflation side recently, I guess. But I agree with you. None of these issues have gone away.

[00:15:35] Niels

Yeah, and favorable on the inflation side when you exclude food and energy, which is very hard to exclude if you’re a family of four or five. So we’ll see. I think PC comes out this week, doesn’t it?

[00:15:48] Alan

I think it was out earlier today, but I haven’t had a chance to look at it.

[00:15:52] Niels

Okay. Well, neither have I. Good stuff. All right. Well, no doubt there’ll be more to talk about as we move forward.

In terms of a trend following update, sure, there’s been some corrections in some of the trends in January. Maybe it already started in December, so there was a bit of dispersion in returns in December. Some of the managers who probably lost a little bit of ground in December, I think they’re doing somewhat better this month compared to the managers who had kept the positions on during December, and therefore, benefited from some of the longer-term trends resuming for a little while, and now they’re certainly being turned in January. So yeah, there’s going to be some more pain for those managers either through the markets they trade or the timeframes they use.

But of course, things like bonds and stuff like that have had a good month and that’s against the longer-term downtrend that they were in last year. But it’s not bad. Overall, for the industry, it’s not really that bad at all. I was looking at the numbers as of Wednesday night, since we’re recording a day early, and the BTOP 50 Index is down like 20 basis points, so nothing to write home about. SocGen CTA Index down about 1%. Trend Index down about 1.7%. The Short-Term Traders Index is flat, slightly down. So nothing at all really to be concerned about.

Also, my trend barometer’s last reading was 45. That’s completely neutral. So plus-minus a couple of percentage points for the indices is what it looks like even though we have a couple of days left for trading in January. That is, of course, in contrast to as you were pointing out, equity doing really well this year. MSCI up 6.75%. Even the World Government Bond Index is up this month, up 2.5% thereabout, and the S&P up 5.75%.

So with that out of the way, that allows us a little bit of time, extra time this week, to talk about some other topics. You have very kindly provided some as I have been on the road. So, happy to let you lead current markets and asset allocation. Obviously, we talked a little bit about some of the themes that’s going on right now. But where do you want to go with markets and asset allocation?

[00:18:32] Alan

Yeah. We touched on it a little bit in the intro. We’re at an interesting juncture. We’ve had all of this pessimism in the last year, a big sell-off in equities and now, as you’ve said, a big rebound. So is that it? Are we seeing the bottom or not? Jeremy Grantham had an update piece out recently, which I thought summarized quite well some of the issues. A year ago, he published this piece saying he thought markets were rogue. Obviously, he’s been saying it for a while. But he came out in January saying he felt that timing was good then and was pretty accurate with that call. But obviously, we’ve had the rebound. Now the question is, is it still looking bearish?

Overall, in his piece, he was still pessimistic, I would say, a bit more cautious. One reason for the caution is that there is a bit more pessimism generally. He did highlight how some of the sell-side strategists in Morgan Stanley and Goldman are calling for earnings recessions this year. So being a contrarian, that’s maybe a concern.

The second thing which I found very interesting, and he does often talk about this, is the presidential cycle. He’s looked at it historically and the presidential cycle being that where you are in the four-year electoral cycle can influence economic policy.

Actually, what he’s found is a period in the second year of the four-year cycle from October to April has been historically very positive for the equity market. I think I’d have to check but something like the return you get in that period is equal to the return you get in all of the other periods, which is statistically very unlikely. I don’t know if it is something that any of our managers have ever looked into and whether the sample sizes is big enough, probably not to have any conviction it. I’m a bit skeptical, I have to say. It seems odd that that period in the second year is so critical. You would have thought maybe a little bit closer to the election would be the time you’d see this boost. But anyway, we’re in the midst of that period now.

[00:20:53] Niels

If I can interject here a little bit, Alan, it could have nothing to do with the presidential cycle. It could just be a four-year cycle where it just happens to coincide. Actually, personally, if I take off my trend following hat, I think markets do have cycles. I completely believe that. But whether you can pin it to a president or not, I don’t really know. But probably, I would doubt it, frankly. But is there a four-year cycle or is there a 40-year interest rate cycle? I truly believe there is. So it’s an interesting thing. We’ll come to this a little later when we talk about some of the early observations we’ve done in the CTA mini-series. But I do think that some managers talk about doing seasonality and stuff like that, so maybe.

[00:21:42] Alan

One of the interesting features of it is it’s good for the US equity market. But historically, it’s been even better for the UK equity market. Why that’s the case, I’m not sure. maybe it could just be random, but that’s one of the factors. Obviously, he does touch on the other parts of the bullish narrative at the moment: China reopening, inflation coming down, etc. But equally, and he touched on it in his piece, is the issue that we were talking about earlier about these periodic shortages that we’re likely to see going forward in relation to the metals required as part of the greening of the global economy.

It’s something that I wrote a piece in December around as well, about the long and variable lags from monetary policy. We have had this excess cash in the system that everybody saved during the pandemic, and you had stimulus checks so money supply growth was unusually high. Money supply growth has collapsed but the stock of money, the stock of savings are still in the economy and gradually being depleted. So that’s one reason why monetary policy may not to-date have been that effective. But you could have a scenario in the second half of this year, as those savings get depleted, that the higher rates start to have a bigger impact on the economy.

So his baseline case is still looking for S&P to go back down to about 3200 and slightly below, and that would bring it in line. It would be about a 45% to 50% correction in real terms overall, which would be in line with past similar episodes. The other point that he does make, which I think is a good point too, because as you said, we’ve been hearing about, are central banks going to pivot, etc? Everybody assumes that once the Fed pivots, that will be great for the equity market. But there have been instances in the past, in 2007, 2008, 2000, 2002, and other ones where the Fed did start a rate-cutting cycle but the economic downturn was so severe that that wasn’t enough to save the equity market as well.

So, I think that’s another factor that people are not acknowledging amid all of this expectation about an eventual Fed pivot and how that will save the market. So yeah, it’s another perspective to add to the mix. I thought it did summarize quite nicely the current bullish narrative, but also put in context the relevant factors that may still be headwinds for equities going forward.

[00:24:27] Niels

Yeah, I’m pretty sure I’ve seen his charts floating around in social media land, where they show that actually, often, equity markets continue a bear market like 9, 12 months after the central bank starts to lower rates, which speaks to your point that it may not be a great sign for equity investors the fact that the central bank is going to change course. The other thing I was thinking about when you talked about the money supply, the thing I don’t think we can completely ignore is the fact that the Federal Reserve is tightening and reducing its balance sheet. I think we’re below 8 trillion for the first time since whenever. Although I don’t follow, it’s super, super close, but I think the pace is pretty healthy in terms of what’s happening on that front at the moment, and that probably has an impact as well.

I still think another thing we haven’t even talked about but that could also be a little bit of a dark horse here, which I guess our friend Cliff Asness has raised, and that’s private equity. If equity markets don’t really recover and we still have another leg down, for example, at what point do these funds have to mark to market, so to speak? How long can they continue to have their own set of prices, if I can be so blunt to say it like that? It’s something that I think we can’t completely ignore as a little bit of a risk factor. But I don’t know if that’s something you’ve come across.

[00:26:17] Alan

Yeah. It’s been an ongoing topic of discussion in our industry that we look at with a little bit of frustration. I think there’s a sense in some of these investments that because there hasn’t been transactions, you don’t mark the book yet. So it’s a bit of a sense of make-believe that, okay, nothing to see here, but in reality, everybody knows that the valuations have to be a lot less, particularly in the venture world. Look at ARK, Cathie Wood’s portfolio. That’s telling you that these high-growth stocks- and the most speculative end have adjusted massively in terms of value.

One thing that it often means, for our industry, is that rebalancing as investors for needed liquidity. Sometimes the ATM is often the CTA, so not always a positive when other assets aren’t doing as well for CTAs. I think it will be interesting to see what the investment impact is on investor groups like pension funds, etc.? What does that do to their asset allocation? They may still have commitments that they may still have to fund. But I imagine, for people in the space, there’s probably interesting opportunities in the secondaries market now because of all of this, but I’m not close enough to that to be able to speak on that.

[00:28:07] Niels

Now, the next topic you had slotted in was relating to our own wonderful industry, CTAs. There are a couple of papers, three papers, you wanted to discuss. I can safely say I’m not entirely sure I’ve read any of them. I may have skimmed over some of them so I will follow along as best I can. But it does relate to the CTA industry and so on and so forth. Why don’t you set the stage?

[00:28:37] Alan

Sure. Some of it is in relation to last year. We’re getting towards the end of January so it’s probably the last chance to reflect back on 2022 again. But there’s a couple of interesting observations. First one was just a paper from SocGen where they do an annual review. We’re at that point where a lot of firms are issuing their annual letters and probably just have them out by now. But there were a couple of interesting bits in the SocGen piece. They were reflecting on it being the best year ever for the SocGen CTA Index, up to 20% and SocGen Trend also up 27%, its best year, but interestingly, how volatility for the index wasn’t higher. So better in terms of risk-adjusted performance.

The Short-Term Traders Index also had a very good year, up 11%. Actually, you could say Short-Term did even better and purely from the perspective that the volatility of that index is very low, only 4.5% vol. To say it was better, you’d have had to lever up your portfolio of short-term managers. But it is interesting and it is something that came up in one of our conversations recently, how one of the managers; their non-trend had done even better than trend. It just speaks to what an interesting market environment it was last year, that not only did markets trend, but there was volatility that could be captured by shorter-term systems as well.

In the SocGen piece, they have a heat map of the individual markets and how different trends strategies of different lookbacks performed. I always find it interesting and really shows you how well or not you might have done depending on how you allocated risk. Basically, what it shows is for medium to long-term trend following, bonds were universally positive to trade. Actually, when you look into the commodity space, a lot of the markets weren’t that great.

If you look at things like sugar and live cattle and lean hogs, for a lot of the timeframes, you’re seeing their heatmap is blue for tough performance, red for profitable, and there’s plenty of blue in the commodity and in the equity space, particularly in the equities for a slower system. So, it is interesting. If you look at their performance in the industry, we’re talking about how 2022 was such a great year, but actually, for some managers, 2021 was an even better year. I think that’s because, in some of the commodity markets, there were even better opportunities in 2021 than in 2022 depending on how you’re allocated your risk.

I think the very best market was the eurodollar market, the 3-Month Eurodollar future. That’s an interesting one because I think in that market (and we’ve been talking about this as well), not only did you have a great trend, you had this huge volatility expansion. If you think about it going back one to two years, there was very little volatility in short-term interest rates. So, if you got onto that trend early, you would have had a very large position. Obviously, if you weren’t a manager that was vol sizing your position, you would have held that and it would have been an enormous contributor to performance. So that makes sense how well eurodollar is.

Euribor is slightly behind, but still very positive. But then obviously, Japan 3-Month hasn’t really moved yet so I’m sure a lot of people are looking at that as the next possible big opportunity. We’ll have to see if that plays out.

Interesting that, as I say, fixed income was really the standout currency but more mixed across, I would say, the commodities and equity side. Generally, in terms of the speeds, the sweet spot seemed to be in terms of their lookbacks, between 80 to 120-day lookbacks seemed to be where they found things to be the strongest.

[00:32:48] Niels

Yeah. It is an interesting chart they show about this. Now, correct me if I’m wrong, Alan, but I think this is based on their trend indicator, right? This is what they base this on. As you know, it may well have had a good year last year, but the trend indicator that they published is not…

[00:33:07] Alan

I think the trend indicator is just one system. I think that this is showing all of the different lookbacks so it’s not just one.

[00:33:18] Niels

Yeah. Different lookbacks. Exactly. So on that note, we also ran our [overview] where we look at a whole portfolio of markets, where we don’t look market by market, but at a whole portfolio of 60 different markets to see where the “best look-back period” would have been last year. It was actually pretty close to what I would say is the long-term cluster, which is around 200 days. The very best one was a little bit above 200 days. But, if I look at the lookback periods all the way down to 20 days, all the way up to 300 days, which we do in our calculations, all of those periods actually would have been profitable last year.

Well, of course, I would say that short-term trend following shouldn’t really be profitable because short-term, you don’t really do trend following the way you and I think of trend following. When you are a short-term manager, you do other stuff. You time-base exits, you use all sorts of other ways of getting out. You don’t wait for the trend to turn per se. Last year actually, you would also have made money from a trend following system using shorter-term timeframes. So it was a very broad-based trend year. But I agree with you.

Again, this is what shows the difference in how managers put these things together, which you and I are learning during our conversations with these firms. Because even though we’re talking about the same topics, the way they explain it, the way they tell about their own approach to this, you can tell there’s a difference. You can tell that they don’t necessarily see the same things and that’s great in many ways.

But yeah, a good year last year without a doubt, and maybe we can’t keep talking about 2022, but we will try a little bit longer as we go through our final, however many recordings we still have to do. You wanted to talk about another paper?

[00:35:26] Alan

Yeah. It was pretty much on the same theme, to be honest. They published on their website a review of 2022, key points from their letter. Again, they take a similar approach in terms of looking at different speeds, how they did in different markets, etc. Kind of a similar outcome there, I would say. In their models, I think they run at eight different speeds from five-day lookbacks to over 120 days. Again, slow was very profitable in bonds, also in energies and interest rates, not so in equities and not so in the credit state. They have that as a distinct asset class too. Agricultural commodities were very flat for the year too, across the different time periods, which is consistent with what we were seeing in the SocGen heatmap.

The other thing that I found interesting in this paper was that they talk not only about trend, but they also talk about some of the other, systematic investment styles and models that they have such as carry flows, macro fundamental seasonality (as we were talking about), sentiment slope curve, technical value. They looked at how all of these types of systems did in the different sectors last year. That was quite interesting in the sense that you might have thought, well, it was a tough year, say, for carry strategies. You might have dealt with a rising rate.

But actually, they found it was actually positive for carry across the asset classes, negative in some of them, but positive in things like equities, for example. So what’s carry in equities? Well, obviously, when rates rise and rates are higher than dividends, basically, the carry position in equities has to be short equities. We were talking about it our own year-end review, is it the end of carry or not? But you have different manifestations of carry.

Obviously, in currencies, the dollar was a carry trade last year as well. So interesting that that momentum and trend was their best system, but other things did work. Carry seasonality worked well for them, and sentiment. Again, just highlighting that it wasn’t just trend as what we’ve been hearing from some managers that trend and other strategies have benefited from this more, I suppose, dislocated market environment.

[00:38:10] Niels

Yeah, absolutely. I completely agree with all of that.

[00:38:15] Alan

Maybe we move on to the next topic, which feeds into what you were talking about just a moment ago, and that’s this whole issue of speed. Man actually had a paper out on this earlier this month, looking at the topic that you’re talking about, which is fast trend following and the benefit or not in a portfolio. What the paper presented was basically what you get by adding faster trend systems to a portfolio. If you look at the performance of fast trend systems versus slow trend systems, they do break it out in terms of before cost and after cost.

As you highlighted, the cost is obviously very significant when it comes to short-term trading because you’re trading so frequently. So on a pre-cost or before-cost basis, even not allowing cost, fast-trend hasn’t done as well as a medium to long-term trend. But it did have a positive skewness, so a kind of different risk characteristic. So, what’s the benefit of it? Tangibly, the benefit is (particularly in times of equity downturns), the faster trend systems will do better. So that’s one of the things. You get this favorable skewness, better performance in equity down markets.

Obviously, what’s critical to being able to capitalize on that is having good execution. This is a theme that we’ve picked up from the managers too. What was interesting within their paper was they then looked at how, if you combined a trend system with a 60/40 portfolio even after cost, which trend system would give you the best drawdown mitigation for the overall portfolio between 60/40 plus trend? They found that an equally balanced or equally blended one across the different speeds, so having some faster systems, was favorable in terms of mitigating the drawdowns in equities. Whereas if you were relying just on slow-trend, you would suffer a larger drawdown.

So, I thought it’s an interesting paper. I think it’s a good segue into picking up on some of the themes. Because really, when you think about it, it strikes me that this is the journey in the CTA world. You want to generate absolute return so that argues in favor of medium to long-term trend. Then you have to confront the fact that you’ll have drawdowns and they can be painful. So then people say we’ll add some carry or something like that or not. Then you’ve got the fact that people are looking at CTAs for crisis alpha. So you want to be able to deliver some kind of performance when equities turn down. That argues in favor of maybe should we add some fast systems or not?

Everybody’s grappling with all of these questions. People have had to come to different conclusions reflecting different utilities (to use that expression), or different tolerances for drawdown. But I think that’s broadly the journey and the trade-offs that people experience as they construct trend following programs.

[00:41:36] Niels

Yeah. I completely agree. It’s been fascinating to learn about how people look at these things, but then also have to put it in a business context, right? They have a business to run and they have clients. Well, some people might say, “Well, it shouldn’t be the clients who decide what systems we use. We should develop the best system.” But many people would argue, well, that doesn’t help if the clients can’t stomach it. So yeah, there are lots of things you have to take into consideration.

Maybe we’re halfway through our recording so far, Alan, and I can’t really think of two firms so far that have given us the same explanation. They’ve all been a little bit different in how they interpret this and how they’ve designed their strategy so far, which is quite fascinating. Feel free to go back and talk about some of the points you want to raise. But there’s one thing that’s still on my mind as we get through these conversations, and maybe we need to raise that more in the conversations we have left to record. That is, how does it still leave the industry in terms of compelling investors, more investors, I should say, to implement this?

Because I know part of the topics we discuss and that you bring up is the role of trend following in a multi-asset portfolio. But maybe we need to try and dig a little bit deeper into how the various firms try and get more people to take the step. It’s a big question mark for me still, after all these years, as to why it is so hard for investors to embrace a strategy that has so much evidence on its side. Maybe it’s going to be a little bit easier in the next 12 to 18 months to get people to focus on trend following.

I just came back from four days in Barcelona at a conference. Even though it wasn’t a trend following conference, trend following was on the agenda. It was talked about. Many people raised it as an area where they wanted to have some exposure, etc. But we still need to follow through, right? We can’t just say just because it’s been a good year and it’s on the top of the agenda for some people that that’s enough. It’s not. I still wonder what it takes for people to really embrace and internalize the value that these strategies provide.

[00:44:25] Alan

Yeah. As you say, that’s one of the important points that managers have made around making it digestible, and that’s part of the motivation for having not pure trend but trend with some other strategies to smooth out the return. Also, some of the managers said, it’s a painful ride for the manager if it’s pure trend as well. So it’s not just purely from the client’s perspective. I think that’s definitely valid.

It’s interesting. It was definitely commented, in one of the conversations, around people’s experience of time and how a one-year drawdown or a two-year drawdown doesn’t seem like a long time when you look at it on a chart of a historical simulation or whatever, but if you live through it, it can feel like a long time. It’s an interesting one. It’s just, I think, the randomness of outcomes as when the returns will arise and arrive. That’s the thing that I think people struggle with.

So I don’t know. It’s kind of one of those ones that CTAs capitalize on people’s behavioral biases, broadly speaking, but those behavioral biases mean that people are reluctant to allocate to CTAs, so there’s an irony to it. But will that change? I don’t know.

[00:45:54] Niels

No. The other thing, certainly, that I’m picking up on from just seeing the data coming out now, but also, I think some of the conversations we’ve had; I’ve seen some of the year-end letters the managers have been sharing, is that it’s a little bit counterintuitive when you think about how well this area did (or this strategy did) compared to anything else last year. But it looks like there were quite a lot of outflows from the industry. That’s what I’m seeing at least. At first glance, you could say, “Well, that’s weird. So people are selling what’s making them money?”

But actually, when you think about who’s invested in these strategies, it’s most institutional money, then it makes perfect sense because they have to do their quarterly or annual rebalancing. Therefore, they have to sell out of the things that are making money to buy the stuff that is losing money. The question will be, of course, are we going to see the reverse? If equities are having a great period now, is it then time to sell some of that and then buy into some trend following again, for example?

From memory, it never seems to quite happen at the same pace as the other way around, but maybe I’m a little bit too pessimistic here. Perhaps people have learned the lesson and they will be disciplined about that rotation as well. Time will tell. But that was another thing I picked up on. Then of course, we’ve also asked them a little bit about how they feel about being replicated, which of course, I might pick up with Andrew next week when I speak with him.

I would say the answers we’ve had so far, I think are very, very, like what I would expect from people in our industry, because I think they have been very constructive. It’s not like they’re sitting in the corner being upset about the fact that someone is trying to replicate what they do, but there have of course been different variations of that. One thing I did pick up on, and I don’t know how much I want to go into detail today about it, but one thing I did pick up at this conference that I attended is that there’s a lot of focus on trend replication.

So some of these investment banks, they must really think that either it’s a great strategy and all their clients should have it even though they’re competing with another set of their clients, or they’re just seeing an opportunity to make some money because trend is in favor again. I’m not so sure, even having attended a couple of presentations on how they do that trend following which, frankly, if I’m being very frank about it, I wasn’t impressed and I thought there were a few shortcuts that I didn’t like that they did not disclose in terms of cost and in terms of simulated data versus real data and all that stuff. But it’s certainly on the agenda from these big powerhouses, that’s for sure. You could say all publicity is good publicity, so maybe it is a good thing. We’ll see.

[00:49:05] Alan

One thing I wanted to touch on to close out was just that it struck me, listening to a lot of the managers (my background is obviously multi-manager portfolio construction), that you face the same challenges as a multi-manager allocator. The single manager has the same trade-offs in terms of, “Okay, let’s generate a portfolio, trend-focused, but then we’ve got the drawdown consideration, so will we add some non-trend strategies?” It could be quant macro, short-term, particularly from the perspective of delivering crisis alpha. So, I think just to touch on that.

Equally, one of the topics that came up was that now, the way the industry is evolving, for the institutional investors at the single manager and at the multi-manager levels, customization is becoming a much bigger and more important thing. So, it’s not just that managers have one fund and they go and sell it. Instead, they say, “Do you want pure trend, or do you want trend heavy, or do you want multi strat?” And they let investors decide. You’re seeing that on the multi-manager side as well. So again, you could have clients saying we’ll build out a trend-heavy portfolio or build out a diversified managed futures portfolio.

From a multi-manager perspective, the big case for multi-manager (and when you’re allocating to CTAs to go with a number of managers) is obviously the dispersion that we see across the industry and the low persistence. So I had a look at the managers in the SocGen Trend Index from last year, and I looked at their performance over the last 10 years and risk-adjusted all the managers to 15 vol. Actually, the average annual dispersion is by 32%. So, in any 12-month period, you would expect a 32% difference between the best manager and the worst manager out of the 10. So that’s pretty sizable dispersion.

This is a topic that’s come up a bit and came up in the context of the replication conversation as well. Do investors want to capture the industry return or do they want to get the best managers? Of course, the challenge is, very often what you see with managers is they might have a one, two, three-year period of outperformance and they attract flows (not that they do anything wrong), but they just experience reversion to the mean and suddenly they underperform. That can be difficult for an investor to hold. So, the basis for considering a multi-manager, it’s partially behavioral, I would say, in that sense in that it helps you overcome selling out managers just on the basis of a couple of years of underperformance.

Obviously, there is a diversification benefit (in the quantitative sense) if you allocate to 10 trend followers, you will get the level of volatility reduction in your portfolio. Then you can either choose to have a lower vol portfolio or lever that up. So, there’s that kind of quantitative benefit too. But I think that behavioral aspect is quite important and that’s been what you often find when you’re engaging with investors. “We had a bad experience with managed futures. We went into it once, we picked one manager, then they underperformed, and we exited.”

That can either be with a fund of funds or obviously, large institutions will often do it themselves. You get that benefit. As we’ve been learning, managers can make very different choices in how they execute trend following and because of those differences in choices, you get slightly different return profiles. So, with the multi-manager approach, you’re obviously blending to get the benefit of all of that in a portfolio. I think that richness, that dispersion, and that variety of approach is certainly something that’s coming out quite strongly in the conversations that we’re having.

[00:53:29] Niels

Yeah, absolutely. But of course, there’s just several sides to this, because of course, you could say investors shouldn’t really care about whether they’re underperforming or outperforming one year or three years or five years. It’s a long run. They don’t necessarily look too much at individual stocks on a year-by-year basis. So, I take your point, and I agree that there could be some comfort for people to not have to worry so much about that. But they’re probably paying for it somewhere.

But the other thing you mentioned that I thought was quite interesting is this idea of (obviously, we’ve heard it in some of our conversations) giving people more choice, saying maybe you can decide whether you want the equity beta being capped and this that, and you can do these building blocks. On one side, I can see the compelling argument for that. But on the other side, I’m also thinking, no, no, no, no, no, no. You don’t want to give people all these choices because they’re not equipped to make those choices. That’s what we are there for. That’s what our research is there for.

We should put our best ideas into one product and investors should rely on all the experience and the research, etc. But of course, we see that there are different approaches to this as well. So I was just curious where you sat on that, whether you think people should choose themselves or whether they should let the manager with all the experience do the choosing?

[00:55:12] Alan

I think it is something that has been on my mind this week as we’ve been having the conversation, and I think there’s two ways. You can give people certain things, but not necessarily everything. So, if a client said we’d rather if you didn’t trade dollar-yen or something like that, you’d probably push back and say that doesn’t make sense. Just because a certain market hasn’t delivered returns for a number of years, that kind of decision isn’t a good choice to make. But if somebody says I want trend plus non-trend, I think that’s fair enough.

So I think there are some things you can say, okay, yeah, that’s the kind of choice you can offer. I think it’s interesting, you have the larger firms who have evolved into these solution providers, whereas maybe the smaller firms have the trading heritage of the person who started it and they’re still thinking in terms of, “What’s the single best portfolio to deliver the strongest returns?”

So, I think it’s philosophically two different approaches. I can’t say one is right or wrong. The only thing I would say is you do have a duty not to give people things that wouldn’t be good for them in a sense. So in a portfolio sense, you don’t want to add short vol or something like that. I think you can give choices, but you can’t give people everything.

[00:56:41] Niels

Yeah, that’s fair enough.

Now, Alan, we also have to look inward, of course. I think the group of people who hear what I have to say now, they know who they are. But I did see, on my way back yesterday, a comment. He very kindly didn’t say which podcast it was but we’re happy to admit that it was on our podcast. I think where he felt that in one of the episodes, we haven’t been hard enough, we hadn’t pushed back enough on some of the statements that were made in the conversation. But all I just wanted to say is that we’re not here to call out managers and make them uncomfortable in these conversations.

We’re here to try and get the best we can out of the conversation. So even if we don’t necessarily fully agree with it, people shouldn’t expect us to get into a heated debate about certain things and certainly not comment on their performance, whether it’s been good or bad or whatever. So, I think the person who wrote that tweet will know who I’m talking to and I respect the view. It’s not that it hasn’t crossed my mind, but I hope he also understands what we’re trying to do with this.

As I said, I think what we’ve done and what we’re doing right now has never been done before. I think the value of bringing all of these brightest minds in our industry together in a series like this, I hope it makes up for the fact that we’re not necessarily wanting to get into a heated debate with them but actually just hear their thoughts. That’s what the series is all about.

All right, any final thoughts, Alan, from you before we wrap up?

[00:58:30] Alan

I agree with you. The idea isn’t to get confrontational, it’s to give managers the opportunity to answer and give their perspective on these topics. If there are some things that they don’t go into in as much detail as some people would like, I can understand. It can be a bit frustrating, but at the same time, we’re not here to try and interrogate or confront people aggressively.

[00:58:55] Niels

It has to be a safe place for people to come and voice their opinions. I think that’s how we get the most out of this and how we get them back and talk about all of these topics. We’re going to wrap up our conversation today. We hope as usual, that you’ve been able to take something away from it and we would very much like it if you would take just a few minutes to head over to iTunes or Spotify or Amazon, wherever you hear your podcasts, leave a rating and review. They are coming in on a regular basis, but we could always use more. It’s actually one of the things that Apple has come out saying this week, that that’s what helps their algorithms to put people higher up in the charts, that people are engaged, that they comment, etc. So if you wouldn’t mind, spend a few minutes doing that. We would so much appreciate that.

As mentioned earlier, next week, I’m joined by Andrew Beer who’s back, our resident CTA replicator. That’s going to be fun. Maybe he’s got some views on some of the topics we’ve already touched on with some of the managers but of course, you can also ask him questions. So feel free to send them to info@toptradersunplugged.com and we’ll do our best to bring them up. From Alan and me, thanks ever so much for listening. We look forward to being back with you next week. In the meantime, take care of yourself and take care of each other.

[01:00:19] Ending

Thanks for listening to the Systematic Investor podcast series. If you enjoyed 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.

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.