235 Systematic Investor Series ft. Mark Rzepczynski – March 19th, 2023

[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 Mark Rzepczinski 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, for those of you who are regular listeners, this podcast series is all about voicing our differences on the one topic that brings us together, namely, systematic investing using the often overlooked but very robust strategy of trend following.

Now, we hope that today’s episode will trigger your curiosity to learn more by diving into the back catalog and listen to all of the past episodes that you may have missed, like last week’s episode with Rob where we discuss lots of different topics like market and parameter selection and also what happens if brokerage firms fail and much more.

But also, I would encourage you to listen to the midweek episode that we published on Wednesday where this week, we caught up again with Rory Johnston of Commodity Context to discuss the SPR, the Strategic Petroleum Reserve, that has been actively deployed by the Biden administration over the past year or so. With crude oil hitting this week, the price level that has been mentioned as the level where it would start to refill the SPR, this was quite a timely conversation.

So if you missed any of these conversations, I would really encourage you to go and listen to them as soon as you’re finishing listening to Mark and I. Of course, if you have more time on your hands, you should definitely check out the episodes I’ve done with Alan where we’ve spoken to the largest CTA firms in the world and I think where we are, probably for the first time, bringing them all together more or less at the same time. So lots to dive into.

But today, Mark, it’s just you and I after a (I wouldn’t call it) quiet week, would you?

[00:02:09] Mark

No, not quiet at all. We’ve got a lot of event risk going on and a lot of intervention by governments. I think that we’ve got a lot of surprises that have occurred and I think we’ll see more in the next week. I believe that this is, I’ll call it the cockroach theory of blow-ups. Usually, there’s never just one. If you turn on the lights, you might see one but there’s a lot more lurking behind the baseboards. There’s a lot more surprises that may be lurking right around the corner.

[00:02:45] Niels

Absolutely. It’s one of those weeks where markets humble you as they do from time to time, and I think that’s probably a really good reminder when these things happen even if they don’t feel very pleasant at the time. All right. So let me try and give a little bit of context to what’s been going on, and Mark, I’m sure afterwards, you might have some comments. But I know, Mark, you have children, although they’re not really children anymore, but I’m sure you remember the concept of the participation trophy. This is where organizers of a game or a competition want to make sure all participants feel good about themselves, so everyone gets a trophy.

For the younger kids, quite often, the parents discourage keeping score or even declaring a winner, and this week kind of felt like it was a trophy day for the banking system. Let me explain. The first trophy went to Silicon Valley Bank for their mismanagement of their hold-to-maturity book by establishing a duration that suffered a significant loss of value from the Fed’s draconic rate hikes to date. The FDIC, which guarantees deposits up to $250,000 in the US, on Sunday evening announced that the guarantee would be extended to all depositories regardless of the size of their deposit.

As has been communicated, many of the deposits were the working capital of promising, albeit not profitable, startups; startups that should break through and prove successful hold a winning lottery ticket for the founders to hundreds of millions, maybe even billions of dollars. So as to ensure that all financial institutions were treated fairly at trophy time, the FDIC effectively offered the same guarantee to all banking institutions, large and small. Deposits in the US banking system total approximately $20 trillion with a T.

Not to be outdone by the FDIC, the Federal Reserve implemented the bank term funding program, which commits the central bank to lend to financial institutions for a term up to 12 months valuing their collateral at 100 cents on the dollar despite the current market value of the collateral. In other words, if you pledged a 1.125% August 2040 long bond which is currently valued at 67 cents, then the entity that does that can borrow at 100 cents on the dollar. Arguably, this could be the third iteration of quantitative easing. Then on Thursday, a consortium of banks pledged to deposit $30 billion at troubled First Republic Bank in an effort to avoid what happened at Silicon Valley Bank.

First Republic, in similar fashion to SVB, had extended its hold-to-maturity portfolio and was facing a deposit run that they couldn’t meet. One can only guess at the arm-twisting that Yellen and Powell applied in getting the usually quite competitive banking industry to support a competitor at a time of need. Now, of course, no one is served by the massive run and potential collapse of the banking system. I get that. But that leads to the question of why this happened, and the blame falls mostly squarely on the Federal Reserve.

After years of suppressed interest rates and irresponsible monetary policy, the Fed went in the opposite direction and yield starved investors, both institutional and retail, pounced on the rising rates. As a result, bonds of all stripes registered losses month after month in 2022. It was headline news, at least weekly throughout the entire year. One would think with that backdrop, the regulators would be extra sensitive to the hold-to-maturity accounts at the banking system with regard to investor confidence and liquidity of the banking system. But this was missed entirely.

Anyways, next week the FOMC meeting is likely to be an interesting gathering. Will the Fed continue with their inflation-fighting rate hike or pause? Many now expect the latter. Less important is how Powell will be treated at the press conference. The entirety of the mess should, to a large extent, be laid at his doorstep. The press call has historically loathed pinning him down on difficult topics, but Powell himself should offer an explanation. The Fed is, after all, the central bank.

All right, Mark, let me bring you in here. I imagine that some of the things that have caught your attention, at least the things you remember since we last spoke, would have been linked to what happened the last week or so.

[00:07:45] Mark

Absolutely. Let’s start with the overall theme. I think you framed the banking issue very well. We’re in a period of what I call the great bond repricing. We’ve gone from zero interest rates up to 4.5% and maybe going higher. We don’t know how much higher now. That’s in doubt. But think of this as a great repricing. When the great repricing has occurred, that means all of the assets are going to have to have a change in value and those values are going down. So, the discount rate goes up, the price of bonds goes down.

It doesn’t matter when you hold it, those losses are going to have to be realized. You can attempt to hedge but hedges don’t eliminate risk, hedges just shift risk to somebody else. So somebody is going to have to pay the price of the repricing and this is what we’re seeing. If there is a systemic problem, it’s across all asset classes. It’s starting at banks, but I think we’re going to see it in the REITs market, which are obviously very interest rate sensitive. We’re going to see it in insurance companies, which are also very rate sensitive. We haven’t seen it to date not because this repricing hasn’t been occurring, it’s because accounting rules allow for frictions.

That means that losses don’t have to be realized immediately as you would if you mark to market all of your securities. So the great part about the futures markets has always been that all of the assets are marked to market every day. You don’t see that in other institutions and that’s where the problem really comes in.

[00:09:33] Niels

Yeah, I completely agree. I wasn’t sure whether this thing about not having to mark to market was a European thing or a US thing or maybe it’s both, but that, I think, is just the canary in the coal mine, that we have no idea really what the unrealized losses are. There’s one group of investors that you didn’t even mention, which I think is a really big issue as well, and that’s the pension funds.

Now, being Danish, I follow the Danish press as well and the largest public pension fund or the largest pension fund in Denmark had some extraordinary losses last year, mind-blowing losses really, and definitely linked to rising interest rates. So probably, as we saw in some of these other institutions that blew up this week…

[00:10:23] Mark

Well, the work is being done. That’s the interesting part. Because even on our level with my partners, we went through all of the banks. You can actually find out exactly how much of the assets are held in held-to-maturity accounts. You can find out how much of their deposits are insured versus uninsured and you can calculate exactly what would be the unrealized losses for banks. Let’s go back to swan thinking.

Oftentimes, some people might actually start to say, glibly, this was a black swan event. In reality, it wasn’t a black swan. It could be a pink flamingo and the sense is that it was right there, or you could use other zoo animals. It’s a gray rhino or it’s a leopard. The sense is that the risk was out there, we just didn’t see it. So that’s different than a black swan where it was an unknown event that no one really handicapped. The information is all available. It’s a question if now people are realizing.

So you have the great repricing of bonds and now you have market participants starting to realize what is the impact of the great repricing. This is why when you think in terms of trends, this is what is going to cause a trend. This is not just one isolated event that’s going to end here. It’s going to continue because we see bank one, clearly, there was some bad management here in their asset and liability mismatch.

So then we go down to the next bank, you say, well, there could be bad management here. Then we realize that it’s not just bad management and a few of those might be extreme. Now we sort of see that there’s a whole set of banks that have held to maturity in treasuries, which is not a credit risk problem because it’s of the highest quality, but it’s a duration mismatch problem. You’d say, well, if they have it, the next person has it. If we actually mark to market and we have to take those realized losses, then we can actually determine what would be the loss for each individual bank.

I’ll throw out a word that I haven’t heard for a while that I think applies here, which is financial disintermediation. It’s a word that’s fairly come out of use. If you go back in time, what’s really occurring (in terms of financial disintermediation) is that banks have not really given competitive rates for their depositors. The great part about it is that in th short term, rates have gone up. You don’t pay the depositors the same. You could actually increase your net interest income because you got a better gap.

Now, money market funds, they’ve been actually becoming pretty competitive. Their cost is a lot less. There’s not bricks and mortars. They don’t have to pay for FDIC insurance. The great part about that is that they could go to the Fed and they can do reverse repos in treasuries. We’ve seen that increase to $2.4 trillion. So the money market funds are going to be able to get cheap funding at a very high rate. Depositors see that, they say, well, I’m not getting money on my deposits at the bank, I’m pulling it out and going into money market funds.

For example, the Fidelity money market fund, their biggest one, their weighted average maturity is seven days and they have a tremendous amount. Over two-thirds of their exposure is in reverse repo. So in some sense, they’ve allowed money market funds to be able to get cheap funding, which causes financial disintermediation, which is leading to the problem. Because if nobody, if no depositors leave the bank, then the held-to-maturity account, securities never have to be sold.

If they never have to be sold, well, then you don’t have to realize any losses. So the financial disintermediation leads to deposit outflows, which means that now you’ve got to sell the securities that are at a loss. Part of that is associated with the fact that the Fed allows for higher rates somewhere else through reverse repos.

[00:15:05] Niels

Money market funds, they’re obviously (I imagine) not insured in any way, shape or form. Is there a risk in that part of the financial system?

[00:15:16] Mark

Well, that’s really interesting. This is the law of unintended consequences. Money market funds in 2008, a lot of them invested and reached for yield by buying into corporate commercial paper. The thought was that, well, if they buy commercial paper, they may break the buck, which means the value of that commercial paper may be less than a value of one, which means you may not get one for one for every dollar you put into your money market fund. So the government said, look, you have to have a certain amount of assets that are liquid.

What we’re going to do is we’re going to say that we’re going to increase the amount that you have to hold in the non-risky assets in treasuries. So now, by doing that, they increased the demand for Treasury bills. If you increase the demand for Treasury bills for all these money market funds, what are they going to do? You’re going to bid up the price for Treasury bills. You’re going to drive interest rates down to close to zero or actually to negative rates. So then what happened? They said, well, we can’t have that happen.

So now what we’ve got to do is set up this reverse repo facility so that we can be able to allow, for money market funds, a place to be able to put their assets. By doing that, they say every time we raise rates, the rate on reverse repo increases. So therefore, we allow for higher rates in money market funds. If deposit rates don’t increase in lockstep, you’re going to create the disintermediation from banks to money market funds.

We also see it even just in household treasuries. Households are buying hundreds of billions of dollars of Treasury securities, especially in the short end, it would be 90-day bills, one year bills, which they didn’t before for the simple reason they get a better rate than what they would on their banks. So you have financial disintermediation on that side. That means that eventually, all of those assets they hold, those losses are going to have to be realized, and that’s where the problem comes in. So it’s not over yet.

[00:17:36] Niels

It’s not over yet. In fairness, we’ve talked about the US banking system so far, but unfortunately, close to my home, we have a slight problem with the second largest bank in Switzerland called Credit Suisse. I don’t know the details of that but I did notice someone mentioning that the share price of Credit Suisse, since 2008 when the banking crisis began, is down, or was down, at some point this week, 97%. That’s a loss that will take a little while to recoup.

[00:18:12] Mark

Even from a modeler’s point of view, what you find out is as stock prices get lower and lower, then the volatility gets higher, because just a small change causes a huge increase in volatility. It’s harder if you’re a long-short investor. Then that means it’s harder to short, it’s harder to borrow that stock. In some sense, in our firm, we put in certain exclusions. So if the price goes below a certain level, we won’t trade it at all. What happens is the dynamics change as those prices get lower and lower.

But when you think about it from a European perspective, you had negative interest rates, now you’ve got positive interest rates. ECB just raised rates 50 basis points and so you’re having the same problem in the US. Again, it may not have been realized yet because of accounting rules, but the losses are accruing across the board for all of the financial firms. It’s just a matter of when they’re now going to be realized.

[00:19:20] Niels

Speaking about volatility, speaking about losses, we do need to talk about trend following, Mark. Let me give a little bit of context. We did have some extreme moves in the markets, especially in the short end of the yield curve this week. Maybe to put the size of these moves into perspective, the US 2-year yield on Monday declined as much as 60 or 61 basis points and that’s the biggest one-day decline since I think late 1982. So in other words, the move was larger than anything we saw during the 2007 to 2009 financial crisis or the 9/11 or even the 1987 stock market crash, just to put things into perspective.

Now, CTAs saw, also, a quote-unquote “historic drop” in performance on Monday. The SG Trend Index, as far as I can tell, registered its second largest daily drop of about 5.6%, which is only surpassed by a 7.3% drop in performance on September 4th 2001, and that goes back to the year 2000 when the index started. Now, what’s interesting, of course, is that only a couple of days ago, a couple of days before this started, some managers, certainly one I know pretty well, were making new all-time intra month highs. So, again, just putting things into context, it was a rough week, but go back a few more days, and everything looked pretty good.

Now, to me, this feels a little bit like, actually, a lot like the Thanksgiving 2021 correction where we saw trend following strategies also have a pretty significant correction in performance between November 26th and November 29th. Of course, this particular correction in late November 2021 was (we now know) the beginning of one of the strongest performance periods for trend followers in many, many years. I’m not suggesting that this will play out the same way this time around, but we just need to put things in historic perspective.

Now, as we know, trend following strategies are adaptive, and therefore, many programs this week would have decreased the portfolio risk exposure. Of course, specifically, in the short fixed income area, positions would have been cut significantly, as well as maybe some of the long equity positions. Now, I know this might open a debate about using dynamic position sizing or not but that’s the point I want to make today. I have no idea what static position size strategies would have done. But as we know, there’s definitely room for both of them.

So, to some extent, I think for the longer-term trend followers, I think positions overall may have remained directionally the same as before the crisis but with a much smaller position size. Therefore, it will still reflect some kind of inflation trade to some extent, and therefore, it will be somewhat interesting to see if the hand of the Fed shakes a bit next week and they go away from fighting inflation, which could lead to much bigger problems maybe later this year or next year. Who knows?

Now, if the past week turns out to be an overreaction and the prevailing trends that have been strong for the past year or so are reengaged, well, trend following performance will remain directionally as is and exposure will calibrate according to current market conditions going forward. Alternatively, if the past week turns out to be the beginning of a transition period where there is some follow through on trend reversals and that we see some sustained price action against current positioning, well, then strategies will simply exit and the posture of their positions will change.

As a trend follower, our process is free from making decisions about what the markets will do next. We simply apply a reactive process that follows price across a globally diversified portfolio in recognition of the fact that the majority of our alpha will be delivered in those times when predictors get it so wrong. Maybe I could just give people a bit of context in terms of the numbers. My own trend barometer, yeah, it’s at the lower side. It’s a 34 and it was lower during the week for sure, but we’ll see.

In terms of performance, yeah, it’s not pretty, but it’s not too bad either. BTOP 50 is down 5.18% for the month, down 4% for the year, but again, it was up 15% last year. SocGen CTA Index down 6.5% for the month, down 5.3% for the year, but it was up 20% last year. SocGen Trend down 7.8% for the month, down 7.4% for the year, but it was up 27% last year. The Short-Term Traders Index I think is down 1.91% for the month and down 2.26% for the year. Now, it was up 11% last year, but one of their selling points is kind of this thing about well, we can make money if there comes a big short-term event, etc., but not this time it looks like.

MSCI World is down about 2% for the month, still up 2% for the year. Government bonds obviously had a great run. The World Government Bond Index is up about 3% for the month so far, and the S&P is down 1.3% for the month but still up 2% for the year.

All right, that was a lot of information, Mark. Before we get to the various articles, what are the key takeaways in terms of trend, in terms of this week, in terms of how you see it with all of your decades of experience from this space?

[00:25:40] Mark

Well, what we’ve seen, in one week, is the ability to differentiate across managers, which might take years, has all been compacted in about one week. So, let’s try to look at this. If you’re a long-term trend follower, long-term trend followers, in some cases, have not changed position. They’ve taken some big losses, but they haven’t changed positions. If you just look at a chart, you could run a longer term moving average and you’ll see that they have what appears as very longer term averages. Short-term people reversed. So right away, you’ve got a difference between short and long term.

Stops versus non-stops. If you had a stop, you probably got stopped out of your positions. What does a stop really do? It says there’s something wrong with my model or there’s something wrong with the environment that I need to take a rest. So a stop is saying, here’s a time to say, let’s regroup. So you’re going to see that between the managers. Third, you’re going to see the difference between how you adjust positions to increase volatility.

Given the increased volatility and what we’ve seen in the marketplace, some people took off exposures significantly which seemed to make prudent sense. The people who say, no, we keep static position sizes through volatility, you’re going to see that they’re going to take bigger losses and they might see bigger gains if we see a reversal again. Finally, you’re going to see whether people are interventionist or non-interventionist. You would say that there’s a spectrum of behavior. One would say, I always follow my models, I never change. Others might say, well, I don’t know what’s going on so maybe I should cut back my exposure overall.

I don’t think that there’s anything wrong if you say that there’s a high level of uncertainty, you say I’m going to override some of my models that I’m just going to cut exposure or cut risk. Finally, you’re going to see that there’s a difference between those people who are purist about a strategy; so you say maybe I only follow trends, versus those who say I follow an ensemble approach – I’m an ensemble modeler. So I say, look, you want to have a number of different models because if you have a changing environment, you want to be able to allow for profits in different ways given that market changes in different ways.

So if you say I’m only a long-term trend follower, you’re going to have a very different profile than if you have someone who’s an ensemble modeler. All of the discussions that you’ve been having on this podcast for years, all come to fruition and all come together in one week to differentiate who’s making money, who’s losing money, and what are the sizes of those gains or losses.

[00:28:38] Niels

Yeah. A couple of interesting thoughts on this. One is that to some extent, okay, maybe for this week, there’s going to be somewhat of a difference in performance. But I bet you, if you vol adjust performance, maybe there isn’t that big of a difference in performance. Even between the other big discussion that we have from time to time, and that is, even if you trade 300 markets versus 50 or 60 markets, did you really see (on a vol-adjusted basis) a massive difference in performance? I’m not sure. I don’t know what the numbers are, of course, so far.

The other thing I think it really brings out is something that Rich and I wrote about in the monthly performance; trend following performance report we just published on the website, on the Top Traders Unplugged website under the blog posts. We talk a little bit about the lifting power of trend following and how it helps a 60/40 portfolio. Again, I haven’t run the numbers because there’s not enough time in a week like this, but again, we always say to people that trend following, unless you are a trend follower like maybe we are, okay, maybe we would put (and do put) a large part of our liquid net worth into trend following. That’s fine.

For most investors, this is part of a diversified portfolio of stocks and bonds and then trend following, for example, just like Dr. Lintner wrote about in 1983. I’m thinking, just looking at the numbers, just thinking about the numbers in my head, if you had a portfolio of say 40% stocks, 40% bonds, 20% trend following, a week like this wouldn’t even be something you would notice probably because performance wise, when you blend it, it’s probably not that bad. Stocks were up a little bit in the US, bonds were up strong. Okay, trend followers were down, but it has a smaller allocation usually.

So I just think as you rightly say, it kind of summarizes, in many ways, what we have been talking about for the past nine years on the podcast and why all portfolios or all investors really should have an allocation. This is another point I wanted to raise and I’d love to hear your thoughts. What’s interesting about this is that most trend followers, even someone like DUNN, we’ve been doing this for 48 years, we don’t have an event in our research data like this. Maybe from ’82 to because we traded from the ’70s. Okay, maybe you could say it’s in our data.

But most managers, most trend followers, don’t have a move in fixed income like we’ve just seen in the research data, and yet, the strategies are perfectly capable to deal with them. Yeah, sure, we’d lost some money. We’ve given back a bit more than we made in February and certainly not as much as we made in 2022. So it’s not, in the bigger scheme of things, it’s not a big deal. I think that’s the beauty of what we do. I think that showcases the robustness of what we do, that even when things that are completely out of what we’ve seen before, these models are able to cope with them.

I’m not saying the drawdown in performance is over. It could continue for sure. But big events like this where some banks blow up and so on and so forth is not usually what kills a trend following strategy.

[00:32:23] Mark

Right. Well, a couple of things to unpack. First, going back to the idea where we said this is a microcosm of everything compacted in a very tight one-week window. I will say that we could see the ordering of performance based on some characteristics maybe one way this week. We could play this forward in two weeks and that ordering and performance could change radically. So the people who are the long-term trend followers who didn’t get out of positions this week took large losses. They may be the top winners in two weeks’ time.

So we’ll say that while we say this is a microcosm, that doesn’t mean that one strategy is better than another in terms of your choice set of what you’ve done, because in two weeks, they could be reversed the other set. That’s what volatility is all about. Now, the other point you made is really good.

Whenever you build a quantitative model, you don’t say, I’m building a model that will take into account events such as a bank run. You can’t do that. Well, one is that there are some events you don’t have in your backtest, but you try to backtest as best you can. But you have to anticipate, as a model builder, that there will be events that I have not included in my backtest that I have to anticipate may occur and should be accounted for. What do I mean by that? In a broader thinking, this is what I like to call anticipatory thinking.

Anticipatory thinking is coming out of the work of Gary Klein who’s into naturalistic decision-making. The naturalistic decision-making often talks about what we call heuristics. Heuristics say that often one way to describe them is that they’re fast and frugal decision making. How do I make fast decisions with a frugal amount of data or information? The sense is that there are events I don’t know about, say, a bank crisis. So what it means is, how do I make sure I have a diversified portfolio? How do I make sure that maybe I have different time frames (so it could be a short-term as well as a long-term model)? How do I make sure that I have different styles or approaches?

We often talk about trend following, but it also may mean that you may want to include other strategies. So as a change point technology person looking for change points, you say, how do I also have models that can handle reversals? In terms of what we say, always look at three dimensions – how do you diversify across style, timing and markets? Since there are events I don’t know about; there are events I can’t handicap, then how do I have a broad portfolio that can be able to work through some of those events even if I can’t describe them?

The difference between anticipatory thinking and predictive thinking is that a predictor says that, given this event, what’s the probability of it occurring? Anticipatory thinking says, I have to now describe what are the events or I have to think about the events, and some events I don’t know whether they will occur, so I just have to stay diversified.

[00:36:15] Niels

Yeah, absolutely. Now, you brought along a few topics but before we dive into those, we’re going to talk about another topic which relates to CTA replication and hoping that next time Andrew is on, he will also have some views on this, because yesterday, there was an article posted on Seeking Alpha, specifically about his product, but also mentioning the other couple of large CTA ETFs that are around.

But specifically, the article talks about the headline DBMF: Driving Through the Rear View Mirror. Of course, some of the things we’ve mentioned on the podcast, and I’ve been voicing, are that perhaps these replication products, at least the ones that are not based on models but based on linear regression, might be challenged when trends are not smooth, when big stuff happens. You could certainly say that big stuff has happened in the last 10 days or so. So it will be interesting to see how they perform towards the mandate they have versus, in this case, the SocGen CTA Index.

As far as I can tell, it’s underperforming so far this year, but actually, I think that started even before this week’s events. I haven’t checked the relative performance in the last couple of days, but it is interesting how these different ways of doing “replication” are going to handle this. I think the author of this article certainly suggests that it could be a challenge. When trends are relatively stable, then doing linear regression, according to the author, is probably fine.

But when you get uncertainty and you get lots of reversals, etc., estimating the exposure of managers, because obviously, a lot of the managers in the SocGen CTA Index will be adjusting positions quite aggressively since they are, for the most part, dynamic position strategies, then it might be more difficult (especially when you trade only once a week) to just get that right. But we’ll see. I don’t know.

You probably saw the article that I emailed you. What are your thoughts on these things? I guess these are the periods where, as you said in the beginning, it’s a good period to evaluate the pros and cons, both for managers, but I guess also for strategies.

[00:39:10] Mark

Let’s first talk about looking through the rearview mirror. Every model, every quantitative model, and we’ll say almost all analysts are always looking through the rearview mirror. We always are just going back in history. We’re looking at the past data and our assumption is that this history, looking at the past, we can be able to then do something that’s extrapolative, that if I do this today, then that will tell me something about tomorrow. So it’s a false argument when you say, well, a modeler is like looking through a rearview mirror.

The issue with replication is that you’re trying to replicate something that has already been looking through the rearview mirror. It’s a copy of what has already been done. There is an old movie I talk about. Someone said, I’m really busy, how do I do all my work? I’ll make a copy of myself so that there’ll be two of me so that I could get more of my work done. The first copy was a little bit off relative to the original and he said, well, I’ll make a third copy of myself. So he made multiple copies, but each one was a little bit further off from what the reality is.

So if you’re trying to replicate trend following or replicate a model through using linear regression to try to say let’s try to find a way to figure out the factors that drive a trend following model and then we’re going to use that to be able to replicate it, you’re just getting a close approximation. So if there are turning points, if there are stop losses, if there are adjustments in sizes, you don’t always catch that with your linear regression if you’re trying to do a replication of a trend following index.

So you’re going to have a little bit more error as you move forward with some of those models. The idea is that, well, I know I’m going to have more error, but is the cost cheaper than going direct, and that could be it’s a vehicle that’s cheaper, the cost is cheaper in terms of actual costs of managing the fund. So they’re saying I accept that there is error, but the costs are going to be cheaper so that’s going to offset the error that I’m going to have in my replication.

[00:41:46] Niels

Yeah, absolutely. It’ll be interesting to see. It kind of reminds me of when you were talking. It kind of reminds me if you have to look at yourself through a mirror but you have to see something say on your back or on your neck or whatever, you take a mirror to look at a mirror behind you. It’s not that easy, actually, to do.

[00:42:07] Mark

The real issue, I think, when you look at that article and I think what he talks about it, is I think there is the view that, well, you’re looking through a rearview mirror, and just because we had great performance last year, well, that doesn’t mean it’s going to be replicated in the future. You should anticipate or get out of trend following programs, get out of some strategies, because they’re always looking in the past. Somehow, if you can look into the future, you would see that these aren’t good strategies.

So this really enters into the question of how often should you change your portfolio? How often should you adjust your portfolio when you see different market events? I think that this, for example, goes back to when you talked about the 60/40 versus adding in trend following. You get 40/40/20 type of exposure. Let’s look at what you are really trying to buy with a trend following program.

Ultimately, when you think about it, you’re trying to buy some convexity. Let’s say if you had a trend following program that just was looking at stocks and bonds and let’s say you had your 40/40/20. Well, if stocks are doing very well relative to bonds, that trend following program should start to have skew or have more exposure in equities. So in some sense, your overall equity exposure would be higher than 40%. So you’re starting to tilt more towards equity.

Similarly, if, let’s say, bonds are doing better on a trend basis, then that convexity component for the trend following will give you more tilt to bonds. I’ve often talked to pension funds who often might have quarterly investment policy committees or they might set their investment policy on an annual basis. The real value for a trend following program or for a quantitative program in general is that the reaction time is much quicker than what would be for an investment committee.

The quicker reaction time means that you could be able to gain exposure in different asset classes faster than what you would do, as a committee, if you wanted to put a tilt into the portfolio. Now, let’s look in particular for this event. The trend follower might have said we’ve seen interest rates going higher so I’m going to be short bonds because the price of bonds are falling. That’s where the trends are going to be so I’m lightening up the exposure.

Now, given there was a flight to quality, your core bond portfolio should be doing better right now. Your managed futures will be doing worse because of the reversal. But the net effect actually could still be fairly positive because what you were doing with that trend following is giving you some positive convexity. In the short run it worked against you but the flight to quality effect has been positive. So, the two of them have sort of balanced each other off.

[00:45:26] Niels

Yeah, absolutely. By the way, just a quick thought on that. Now, because of the correction in performance that we’ve seen in the trend following space in the last week or so, it kind of will be interesting to see whether all the investors who might have had too little exposure and realized that last year, or no exposure and also realized that that’s not a good idea last year, whether they will actually take the opportunity and say this actually gives us a little bit of a free get out of jail card and buy into some of these strategies at a time where you could say a rebalancing, if you already had it, you probably would need to rebalance now to get your exposure back up in trend and take some of the gains off you’ve seen in your fixed income portfolio in the last week or so because the moves have been relatively big.

All right. Now, Mark, you brought along a topic about SVB bank and trend following. So I don’t know if you already touched on that. But also, the other thing we wanted to talk about was just that okay, we’ve seen a bank run. That doesn’t happen very often. But then we also need to realize that bank runs today are very different from bank runs that we may imagine how they were back in the ’30s and ’40s, or even in 2008 when people were queuing up outside their banks in the UK and in many places in Europe for sure to try and get their money. But anyways, on that topic, go where you want. I don’t know if you already feel you talked about it or not.

[00:47:11] Mark

Well, I think that what we’re really seeing is a higher level of uncertainty on two levels. One is that there’s uncertainty because you don’t often see what is actually happening. A bank run will be silent this time as opposed to the past. What do I mean by a silent bank run? We usually think of a bank run and people are lining up at the branch banks waiting for the doors to open and they’re fighting to get to the teller and then they’re withdrawing money from their account. You could actually see people lining up or you could sort of see the effect of a bank run.

Now with a click of a button, you can be able to withdraw money. You can go to your ATM and pull money out. If you’re a corporate treasurer, well, you had to call up your banker and you had to then be able to send a fax and then you had to sit and write some paperwork (the frictions of the clients), so we could sort of see money flow out much faster than we’ve had in the past. So that creates more uncertainty across it, which means that you have to be more careful from a portfolio manager’s perspective to look for the signs that events occur.

Look at SVB, a lot of the institutional money there, something like $40 billion flew out in one day. Nobody would say, how did you see that? How do you recognize it? Well, you heard it in the news, but you’re not going to see the visuals of that. So that has a big impact on what the market might do and react to. So I think that there’s a higher level of uncertainty concerning the bank crisis because we don’t have the visual information of what is going on in the institutions. So that’s one. Second is that since we’re talking about quantitative models, systematic modeling and trend following, what does this really mean for that? Why should I care? Okay, it’s interesting news. We see the effect on performance. But how do you translate this into actual trend following behavior?

There are a couple of things we want to talk about. One is that, as we’ve talked about before, the cockroach effect. You don’t just see just one event. Usually, there’s a series of events. So if you really are a trend follower, what you’re going to see is that there usually isn’t just one event. It’s going to be a series of events. So that means that there’s likely to be more dislocations across financial firms.

Two, we see that there’s flight to quality effects and we know that the flight to quality effects can last for a while. It can be very abrupt in the short run. You can go back to March 2020. There was a dislocation in treasuries, Fed comes in, offers a lot of liquidity. There was also a flight to quality out of stocks. It reversed fairly quickly. But you have flight to quality effects so you have to think about what that means. Three, you have to say that there is an adjustment process. I always go back to, why does trend following work? Trend following works because the human decision process is often slow to adjust to phenomena. So you have a main crisis like that.

Some people say, what should I do? They start saying, well, where do I keep my deposit money? Maybe I should do something. Well, maybe I’m not going to do it on Monday. But I want to think some more and they say, if this is still around for another week, maybe I better go to the bank and start to move, or I sort of set up another bank account at another bank and then I start moving my cash. So adjustments, speed of adjustments are often slow and the speed of adjustments is often slow when you think about financial decisions.

People will take time to make asset allocation decision changes, and because of that, that’s going to lead to trends in markets because the flows may adjust slowly over time. Clearly, we’ve had an immediate shock, but at the same time, adjustments will slow and that’s what a trend follower is trying to exploit or trying to take out the slower adjustments.

[00:47:52] Niels

Yeah, it’s kind of like being an entrepreneur, I imagine. Probably many people will relate to that if they’ve tried it. You have all these fancy plans, in terms of building your business, at least this has been my experience, and you just realize that things just take a lot longer. Even in your most conservative strategy planning and budgeting and what have you, it just takes so much longer. So I think that’s another way of visualizing this process and maybe why longer-term trend following just seems to be more profitable than shorter-term trend following.

[00:52:25] Mark

I will say that absolutely, everything, from an entrepreneurial perspective, takes longer than what you think. But I also think of the comment by Mike Tyson. He said that everybody has a plan until they get punched in the nose. So this is a nose punch.

[00:52:48] Niels

The other thing, Mark, that was really interesting about this particular situation, is not just the speed of it. Because I think nowadays (I wouldn’t say we’ve gotten used to it), but things do move very quickly sometimes for sure. But also, what was behind it, as far as I can tell, this thing that, here’s a bank, maybe it has a thousand corporate clients, but maybe they’re all controlled (in some way) by 10 venture capital firms. If these venture capital firms call up all their companies that they own stakes in and say, I don’t think you should keep your money with SVB anymore, then gone is the money in 48 hours, right?

I guess this could be said for private equity as well, because we now have some companies that are so big, and control so many smaller companies, so to speak, and therefore, the dynamics to some extent in the financial world, banking world maybe specifically, has certainly changed. That’s something that I don’t think we maybe thought about, frankly, a lot before last Friday, that maybe a few, a handful, two handfuls of people have this kind of power.

[00:54:09] Mark

Well, let’s always go back to information because ultimately, when we build models, any type of quantitative models, even a trend following model, it’s actually the fight of dealing with information. So in the SVB bank, in some sense, if you go back to their 10 Q’s, you go back to their financial information, all the data was there. We saw that information. So there the data is there, we just didn’t look at it or we didn’t spend enough time looking at it or processing it.

The other sense is that there’s also the opaque information. That would be from private equity where there’s a lot of firms that are not public firms so you don’t have a 10 Q. You don’t have quarterly information on the firms because they’re not in the public domain really because they’re in the private equity world. So that’s opaque because we don’t have all of the information yet there are private equity managers making decisions of what firms are going to be closed, what are going to get more capital, what their profits look like that we don’t have that information.

I think that this is an ongoing area I spend a lot of research on is talking about what other people have called rational inattention. I want to use a quote from Herbert Simon, a great economist. He goes, “In an information rich world, the wealth of information means a dearth of something else: a scarcity of whatever it is that information consumes. What information consumes is rather obvious. It consumes the attention of the recipients. So wealth of information creates a poverty of attention and a need to allocate that attention efficiently among the overabundance of information sources that might consume it.”

So ultimately, it says that we are overloaded with information. We have so much information that there might be information about banks like SVB that we don’t even see. It’s right in front of us. Our attention span or lack of attention doesn’t allow for it. When you think about it, a trend follower is trying to solve the information problem or their rational inattention problem. What they’re saying is that I can’t focus my attention on all of the details of every financial asset. I don’t know all the supply and demand of every situation, hence, I’m going to focus on prices.

Prices are primal, prices are fundamental. The one thing I can focus my attention on is prices and that’s what I’ll do. At the other end of the spectrum, would be the fundamental analyst. He says, no, I don’t care about prices. I’m going to do valuation. I’m going to look at all the details. I’m going to gather all the information. I’m going to be just a Hoover vacuum of information and I’m going to hoover it all up and then be able to assess what that means.

On the other hand, at the other end of the spectrum would be the index investors. Those are like, well, I don’t really know what to do with all this information. I suffer from overload. So what I’ll do is I’ll just buy the index fund and say, give me the market.

So everybody’s trying to deal with the same problem, which is the overabundance of information and trying to figure out, what do I pull in to use and what do I discard or ignore? So when you think of that, you should always think of trend following as a way to deal with this information overload problem. Some might say, how do I deal with the information overload? I’m going to look at only short-term information. I’m going to discard all the long-term information.

Others might say no, I’ve got to look further back in time because I want to gather a lot of the information. Maybe what’s happening in the 200-day moving average 200 days ago is still important. Other people might say like, well, if I’m looking for change points or if I’m looking for market reversals, well, then I’m going to look at how I Z score that information and say, is it out of line with everything else in the past? That’s the way I’m going to deal with this information overload.

So it’s a long answer that this gives you an opportunity to think about what trend following is trying to do. When you see all of the news that was coming across about banks, all of this where you’re getting bombarded with new information about what’s happening in SVB, what’s happening with Credit Suisse, what’s happening to the Fed, what’s happening to the ECB. Well, one way to deal with that is to say I’m just going to look at prices, follow the trends, because I can read all the newspapers but it’s hard to assess. So tell me what the prices are doing and how I’ll make my decision.

[00:59:22] Niels

Yeah, all very good points. Another thing that I think we can be a little bit proud of, in some sense is (but then yet again, also admitting that this was probably not what we thought about when we talked about it), we have, for quite awhile, discussed on the podcast this concern about liquidity. The natural reaction is to think about liquidity in terms of, can we just buy and sell our futures contracts as efficiently as we normally do? I don’t know. I don’t follow the markets that closely to know whether there were any market liquidity bid-ask type situations during the week that we would normally say that that’s what we think about.

We also talk about this, that we have to imagine the unimaginable, and I think actually this week kind of highlights both of these concerns. One, liquidity, but it showed up in a different form, namely, in a bank run. There just wasn’t enough liquidity at the bank. But also imagining the unimaginable where who would have imagined that a bank, the 16th largest bank, and another bank, I think two of the largest bankruptcies, would happen within a week in the US and with the speed that it happened? Probably not many would have put that on their top whatever list they have.

So I think a lot of these discussions that we have ongoing, they may feel a little bit abstract, in the now, when we talk about them, but I don’t think that makes them less important and less relevant. We are living in a world that is changing dramatically. Our financial policies, our fiscal policies are changing, monetary policies are changing. We have a war that just seems to be escalating over here in Europe, now with countries sending fighter jets. That was unimaginable six months ago. Nobody wanted to touch that. Now we’re doing it, have done it, in fact.

So it comes back to this thing about being an investor in a world filled with so much uncertainty and so little lack of clarity because those who of us who sit in situations where we are involved in the investment community, most of us, even those of us who have a few gray hairs, have not really experienced anything like the change we’re seeing right now in the world.

For me, it always comes back to this thing about as you just rightly said, well, maybe it’s just better just to look at the price. Because what am I going to do with all this information? Most of it’s something I have no idea what it’s going to do. If people had said a week ago, we’re going to have two bank failures in the US but the S&P is going to be up by 1.4% during the week, I’m not so sure people would have taken that bet. But yet, that’s what we got.

[01:02:45] Mark

That’s another argument for why you always want to follow the price action. I always play this experiment with a lot of people. I say, if I told you X, what do you think would have happened? So I give you perfect foresight. I say I’m going to tell you that these two banks… that the 16th largest bank of the United States, fails, it has to be taken over by the government. Tell me what you think that you would do with the stock market. So I’m giving you the perfect info, I’m giving you the headline, but I’m not going to tell you what the market did. Tell me what you would do as your reaction. Would you buy or sell the stock market? People would probably say, I’ll sell the stock market and I say, okay, you would have lost money.

So it’s almost as though you play the game of, let’s say, I could time travel into the future, I get the headlines, but I don’t get to see the market price page. Would I still be able to make money? I could still lose money, because you can sort of see like Amazon loses again in terms of negative cash flow, and Amazon stock goes up through the roof.

Now, the liquidity issue is really important because coming from Chicago and being at the exchanges is that you always have almost this base view that there’s free markets for free men. But at the same time, I think we need to address the question on the liquidity issue. Would we be better off if, let’s say, that they just gated some of the withdrawals of banks. Say you stop some of the large bank outflow from deposits, you limit the amount of money that a depositor could take out at any one time. So you put frictions into the system, and you see this on hedge funds.

We hate these, in terms of from an investor’s perspective, that they’ll have gates or they might say that you have to have a lockup or you can’t get daily liquidity. You have to have monthly or quarterly liquidity. Everyone sort of bristles at the fact that there’s going to be some limitation on my behavior. But from a liquidity perspective, if the assets don’t always match the liquidity of the terms of the contract, whether it’s a depositor or a hedge fund, those don’t perfectly match up, could you create bad events for everyone?

In some sense, even a futures fund, there’s no reason why you shouldn’t have daily liquidity because the markets are open, they’re marked to market every day. At the same time, if everybody was able to pull their money out on the close, at 4 o’clock, and then you have to adjust all of your positions before the next day’s open, would that always be good? Is that in the best interest of the investors who pull their money out? Is it in the best interest to the investors who still keep their money in?

There is a problem when I pull out my money today but the impact may actually be affected because it’s going to cause a rebalancing of the portfolio and it may be that the liquid assets have to be sold out and then the remaining investors are stuck with more illiquid assets. That has an impact for all the other investors who stay in. The question comes in, are frictions sometimes for the public good? Are frictions good for the individual when you have high uncertainty?

[01:06:35] Niels

Yeah. Actually, it does open up certainly an interesting topic to keep an eye on, and that is to see what are the flows going to be in some of these CTA ETFs that have daily liquidity. When you give people daily liquidity, are they going to use it sensibly or not? Time will tell. I have my worries, but we’ll see.

[01:07:05] Mark

Because you often bristle to say, well, do you want to give investors daily liquidity and say, are they going to be “smart enough” to know when to pull or to hold? Yet at the same time, I bristle at the whole idea that we want to impose our thinking on an investor. Investors should have the freedom to be able to make the choices they have, either good or bad. But at the same time, is giving liquidity, daily liquidity, a good thing for them? Or if you put some frictions in there, is that in their best interest?

Those are big questions that I think have to be touched on because if I’m building a model, and I give people daily liquidity, in general, I’m going to have to stick with more liquid markets to begin with. Someone said, even if I have monthly liquidity, quarterly liquidity, some form of lockup, some kind of restrictions, then I can say, well, I can do things that are a little bit more complex, I can build strategies that might be a little bit harder to unwind because I know I could play those through.

Let’s go back to anybody who does quasi or arbitrage-type strategies, sometimes the arbitrage isn’t going to be profitable until you hold it till some terminal date. So in some sense, are restrictions a good thing? I think that in some cases, they are, but you want to have restrictions that match the strategy you have.

[01:08:39] Niels

Well, there’s always private equity. No volatility. Now, Mark, have we touched on all the topics you wanted to touch on? Is there anything left?

[01:08:53] Mark

I think we covered all of it. All I can say is that next time you have me on, the topics or the events may change, but our topics oftentimes will stay the same. So we’ll have a new set of events, but we’ll still be talking about what type of model you have, how do you risk manage, whether you have stops, whether you have variable position sizing. So the questions and the topics will always be the same, that the events may change.

[01:09:28] Niels

The other thing I would say this highlights and I guess maybe also inspired a little bit from the conversations Alan and I have had with some of these super large, very successful CTAs. For most of them, I would say, where they have two, maybe three (in DUNN’s case, almost five) decades of experience, I think that’s the other thing that is important that I take away from it, and actually how important experience is when you go through a period like this.

If a manager today has never seen the performance change, over a week, that we’ve just gone through, let alone the fact that, as I mentioned earlier, for the CTA index, Trend Index, it was the second worst day in the last 22 days. Personally, even after more than 30 years of doing this, I never feel great when we go through periods like this mostly because I care about the investors, meaning, I feel sorry for those who may have only come to trend following in the recent month or two and then they get this. This is kind of their starting experience.

I feel bad about that because I know how great it is if they just stick with it. Hopefully, they do, so to speak. But I will say, and maybe, again, this has been very humbling experience once more, but I do think there is some comfort in knowing that for those who’ve been around for a long time, even if they’re down double digits this month, which quite a few managers will be, they will have had many double digit down months in their track records going back. I know certainly we have.

So there is this sense of I think comfort is the word (and one should never have, hopefully, false comfort), but comfort in the fact that the strategies are designed to deal with this kind of stress and these weird, crazy, unexpected events. That’s just how trend following is. I think that, hopefully, we can turn the conversation around. I’ve seen it in the press. The press right now, in the last couple of days, it’s all about how CTAs are being absolutely, in their words, kind of killed, whipsawed, or whatever the word they’re using in the markets. So they always want to focus on that.

What I’d like to do is to change the conversation to focus on, wow, we’ve never seen this before, it’s not in our research data, and we’re all fine, and we live to invest another day even though we may have given back a few months of performance over a short period of time. That’s the conversation I would love to see happening. So hopefully, we can be part of that.

[01:09:29] Mark

We’ll have that in one month’s time. As we said before, there is a tremendous ordering of styles in the last week. I will put this out as a bet, that the ordering for those styles will be significantly different the next time we talk. Ultimately, this argues for why you want to have an ensemble of strategies. This is why you want to have more than one quant manager in your portfolio. This is why you want to think through what you’re actually buying in the approach that a given manager has and that you want to diversify across approaches. So we’ll see the ordering change in one month and you should plan accordingly.

[01:13:35] Niels

Absolutely. Well said.

All right. Well, if you enjoyed this conversation and all the other conversations we have on the podcast, perhaps I could ask a small favor and that is for you to go and leave a rating and review on the preferred podcast platform that you use, whether it’s Amazon, Apple, Spotify. We would love it if you would just take five minutes of your time. If you don’t know how to do it, you can go to toptradersunplugged.com/review and it gives you all the instructions that you need.

Of course, keep sending your questions. I have a feeling that there might be a few coming in this week because next week, Cem is back on the podcast. He’s had obviously to take a couple of months off doing other stuff but now he’s back and we’ll be tackling some interesting topics, I’m sure, especially in the given volatility environment and actually also based on some of the conversations we had a couple of months ago in terms of his expectations. So make sure you send us the questions. As usual, info@toptradersunplugged.com is where you would send them.

I think that’s about it. I will encourage you to go to the website, check out the latest blog post, the monthly report that Rich and I just posted. Hopefully, that will be of use to you and interesting as well. I think that’s about it. From Mark and me, thanks ever so much for listening. We look forward to being back with you next week. As usual, take care of yourself and take care of each other.

[01:15:05] 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.