241 Systematic Investor Series ft. Alan Dunne – April 29th, 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 Alan Dunne and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global markets through the lens of a rules-based investor. 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 the past episodes that you may have missed, like last week’s episode with Nick, where we among many topics discussed a couple of academic papers that were critical of time series momentum as a strategy, but also a paper that discussed how volatility can actually be used to define the direction of market moves.

Also, I would like to encourage you to listen to the midweek episode where Cem and I had a wide-ranging conversation on the current state of the global macro environment. Cem has some very strong views on where we are heading and he does not rule out an explosion in volatility as a consequence. So you probably want to listen to that episode in the not too distant future.

Of course, lastly, I would invite you to enjoy the CTA mini-series where Alan and I have had the privilege of speaking to many of the decision-makers of most of the largest CTAs in the world. We dive into the most pressing topics and have gained unprecedented access to these industry leaders who share some exceptional insight to the CTA world. So head over and check it all out after you’re done listening to me and Alan today.

Alan, great to have you back on the podcast. How are you doing? How are things in Dublin?

[00:01:53] Alan

All is good here, Niels. Good to be back. Interesting to be back on this side of the microphone this time, but plenty to talk about.

[00:02:04] Niels

Plenty to talk about. I’ve kind of started asking the people I’ve spoken to this week if spring has arrived because it hasn’t really arrived in Switzerland. What about Dublin?

[00:02:14] Alan

It has a bit. March was like the UK. It was the wettest in decades, but April has been a little bit warmer. Yeah, I’d say that certainly Spring has arrived, but not quite feeling very summer-like yet. I suppose a bit early for that.

[00:02:31] Niels

Okay, good to hear. Anyways, I can’t wait to dive into some of the topics we have planned. It’s a pretty good lineup, even if we did it ourselves. Since we are recording on an unusual date, which is two days earlier than normal, and that is, again, I’m to be blamed on that because of traveling. I don’t really have a good market wrap at this point in time. Instead, I wanted, as we did last time, touch on some global macro observations instead.

So why don’t we just start out with hearing your current big-picture macro framework as you see today, and maybe if there’s been any changes since we talked about this, I don’t know, five, six weeks ago?

[00:03:13] Alan

Yeah, it’s interesting. Obviously, we had a lot of volatility in March since I was last on. That kicked off immediately after we were on. The big focus has been around the banking sector and what is the economic impact of that going to be. From a big picture macro perspective, it seems like we’re still in a bit of a holding pattern, I would say.

If you’re looking at the economic data, economic growth in the US has slowed a bit or continues to be showing that moderate, maybe slightly below trend trajectory. There are certainly some signs of weakness there in terms of ISM manufacturing new orders, and the services sector has slowed as well, and signs in the labor market of cooling with jobless claims picking up.

I think we’ve got GDP numbers today. The Atlanta Fed nowcast is pointed to Q1 growth. That’s just above 1%. That’s consistent with a slow-ish economic growth picture, but not dramatic, not a major slowdown yet. On the inflation side, the numbers of late continue to show inflation being stubborn and coming down. If you look at the core PCE on a three-month or six-month annualized basis, you’re still looking at core PCE at 4.5 to 5%.

That picture was so consistent with the Fed thinking in terms of doing 50 basis points in March, but then obviously, what we had was the issues in the banking sector. This has really very much clouded the picture now, because I think there is some anecdotal evidence some people are pointing to of that impact in credit conditions. I would say it’s pretty tentative at this stage and we’ll have to wait and see what the economic impact of that is going to be.

Obviously, there was a lot of stress over a couple of periods there. We had Credit Suisse as well, but things by and large have stabilized across the board. Obviously, some banks, First Republic, are still under strain, but I would say probably too early to say what the impact of that is. One of the things I’ve been looking at from a market and macro perspective is the spread in the US three-month T bill rates and the 10-year rate. Obviously, everybody has been focused on the yield curve and people tend to focus on two to tens a lot, and obviously, that’s been inverted for a while.

It’s interesting, if you look at the three-month 10-year spread, it’s 1.73%, and that’s the spread to the constant maturity tenure looking at the Fed data. That’s the highest level, the most inverted since 1981. I think it’s quite an interesting statistic that we’ve had this constant expectation that rates would go up but they wouldn’t be able to stay up, and that market continues to price in lower rates pretty soon. It’s interesting that that expectation is much higher now. The difference between the three-month and two-year spread is much greater now than, say, at the peak of the cycle in ’07 or in 2000.

We’ve got this ongoing expectation that something dramatic is going to happen that caused this reversal in policy, but we haven’t quite had it yet. It looks like we may have had it with the banking sector, but we haven’t seen the real economic impact of that. I think this comes to the point that I’ve been talking about before. Obviously, monetary policy operates with a lag. Those lags are variable and uncertain. What you get with higher rates is, at some point, you’re going to get a nonlinear response.

Obviously, some sectors of the economy respond in more of a linear fashion. As rates go up, borrowing costs go up, and that impacts people fairly linearly. The nonlinear impact is when rates get to some point and it’s a tipping point, and it tips the economy into a major issue, and that’s when you get a big response. I think that’s the challenge that the markets are seeing at the moment. There’s this pervasive sense that, okay, rates might go up a little bit more, but they won’t stay here too long.

Probably the pain trade for the market is if rates go higher and stay higher for quite a bit longer. That’s probably the scenario that people are not anticipating. I think from a macro perspective, I would still be of that view, that at some point monetary policy will bite, but we don’t know when that will be. I think from a market perspective, it’s interesting. Your conversation with Cem in looking for an expansion of volatility that I was just looking at, 20-day S&P vol down to its lowest level since basically the levels it was at when equities peaked out here. We’ve had this real compression in volatility, in equities.

If you look at the S&P, it’s fluctuating around 40, 50, 40, 100. It traded there in March and February, in December, November, last August, September, July, May. It traded there back in April 2021. The market has been just up and down in a broad range basically for two years now. There is a bit of a sense of this kind of coil compressing and that we may get a breakout on one side at some point. Certainly, I think that’s interesting and very mixed.

When you look within the equity sector, a lot of the sectors in the US are technically starting to look less bullish. I was looking at the Russell 2000 as well. That’s only 4% or 5% off its lows. But equally, on the European side, European equity is trending very nicely higher, so quite a mixed picture there. In some, I think markets do seem to be setting up for bigger moves at some point in the next while. I think the higher rates are going to bite at some point, but it’s uncertain as to when that will be.

At the moment, you’ll have to say cash looks attractive at 5%. Aso, we’d add cash plus strategies, because obviously, trend following managed futures benefit from higher cash rates. I think that’s pretty meaningful at the moment. I was just looking at it. If you think about it, short term rates in the US at 5%, you’re basically picking up 40 basis points every month in terms of return, just more or less obviously, probably a little bit less. It’s a pretty nice tailwind in terms of returns.

Yeah, all in all, I think there’s a lot going on. No sign of the major downturn to my mind yet, but I do think that we will see a reaction to these higher rates at some point, but the timing of it is a tricky thing.

[00:09:56] Niels

Yeah, you make some great points, Alan. Just on the last one about the CTA side, I think that’s a really interesting one. I think people completely forgot that there is a benefit within the CTA strategy, or at least within a fund, when it comes to the cash earning some interest after 20 years of it probably not earning anything. That is a nice pickup, for sure. Now, just a few things, you mentioned a lot- and I’ve kind of probably forgotten some of it, but there’s a couple of things that I just wanted to also test with you.

I think the Conference Board came out this week with consumer confidence which came down in April to the lowest level in 2022. But consumer’s assessment of the current conditions actually improved, but their expectations worsened. It may go to some of your points about there is perhaps some pessimism about inflation still, as well as concerns about the banking crisis without a doubt. Maybe people are feeling a little bit optimistic from the fact that the labor market is still pretty strong and that’s the one that everybody seems to be just waiting to give way to this. By the way, you mentioned the lag of a Fed policy.

As far as I can tell, I came across someone who had done some analysis, and correlation, and studies on lags and they came out with about 18 months as the usual lag, which is actually still quite a few months away because it’s only been a year even though rates have gone up by quite a while. The other thing, which is one thing I don’t think you touched on but something I picked up this week from Ray Dalio in one of his latest writings. He wrote something like the debt ceiling increase will not go as smoothly as most people expect and will likely become a big election issue that will split the country because both sides will fight for victories and will be less willing to compromise.

Do you even in your wildest fantasies think that the US could default? I think a lot of people will say, oh, yeah, we’re always going to get it done at the last minute. But this time around, there are some real political obstacles going on at the moment. So, how do you see that?

[00:12:26] Alan

I think the general view is that, yeah, the more likely scenario is it does get resolved, but it’s not obviously 100% certain that that’s the case. I think the concern is that the level of brinkmanship in Congress is greater now than it has been. We had Barry Eichengreen on the macro series and that was the one thing that he really pinpointed around risks, possible risks to the US dollar and how this might undermine confidence.

I think the Republicans did pass a piece of legislation to their plan last night. They approved in the house, I think, that would be an approval for an increase in the debt ceiling, but linked to that, obviously, spending cuts. That’s kind of the opening salvo in the negotiations. The Republicans themselves are not a unified group as well, so that’s another dimension to it. It does seem to be a bigger issue this time around. We’ve had these before, 2011, 2013. It’s gone into where we’ve had shutdowns.

You would say that’s the more likely scenario, but I do think you will definitely see headline risk around that, around this over the next few weeks as each side kind of establishes their bargaining position. Whether we actually get a technical default or not. Yeah, who knows? I think markets are on alert for this as more of an issue for the next month or so.

[00:14:08] Niels

Yeah, absolutely. It’ll be interesting. Yeah. A great conversation you had with Barry. On that topic, actually, in 10 days’ time or so, we’re going to publish a conversation we’ve recorded this week, where Kevin spoke with Martin Wolf, the well-known Financial Times editor, I think he is a columnist, editor. Thought-provoking for sure, and probably he’s also going to divide the audience a little bit on some of his thoughts, but I think he also was quite concerned about the political situation as we head into this debt ceiling negotiation.

Last point I just wanted to hear, it’s not something I know a lot about really, but we tend to always look west, right? We always talk about the US, etc. But if we look east, there’s another big country called China. Yeah, from an economic point of view, people might think that okay, maybe they’re having the best growth right now and there’s going to be some headwinds in the second half both from a geopolitical point of view, maybe some tougher sanctions. Who knows?

I don’t know if this is something you’ve noticed or picked up, but I’m curious about it. That is, suddenly we’re seeing China, and to some extent, Saudi Arabia showing up in slightly different roles than before. Suddenly, they are part of making peace with certain countries that never seemed to be able to make peace. They’re making deals with other countries. It probably ties into the bigger discussion about the dollar and the de-dollarization, all that stuff.

But anyway, I’m just curious whether when you look at a global macro framework, whether you factor in changes from the East, and not just things that are going on in the West?

[00:15:59] Alan

Yeah, I think there’s a couple of things. Again, it did come up in the conversation with Barry Eichengreen, around the US dollar and how more and more of these countries are organizing themselves. For example, I think it was between Saudi agreeing to accept renminbi for payment for oil, not necessarily pricing, but in renminbi as a new way of accepting payment. Obviously, in the last few weeks, we’ve had a big amount of discussion around de-dollarization, and is that a theme or not, and different views on that. But, I think certainly there is a movement around China.

There seems to be movement to promote greater use of the renminbi amongst, I suppose, friends of China, or trading partners. It doesn’t necessarily have to be in Asia, but nations who are sympathetic to that view of it would be favorable to have an alternative to the dollar. I think that’s part of the dimension, and that’s coming from the likes of Brazil and Argentina, as well as much as China and Saudi. Obviously, China has been promoting their international role for a number of years with the Belt and Road Initiative. They had kind of retraced a little bit, I would say, but it’s interesting picking up a more prominent role.

I think the other thing is, where does it stand between the US and China and the disengagement? There seemed to be a little bit of an olive branch from Janet Yellen recently around that in saying it would be detrimental to have a complete disengagement between the US and China. That does seem to be the trajectory of travel at the moment. It will be interesting to see that dimension how serious. I think Yellen has plans to travel or will be traveling to China. I think that’s certainly a key thing to watch.

These things evolve slowly, and people tend to forget about them because they’ll impact more the supply side. Obviously, that would be quite a significant supply shock for the global economy if we would see ongoing disengagement and realignment of global trade flows.

[00:18:17] Niels

Let’s hope for the sake of the conversations between the countries that she doesn’t make a stop in Taiwan on the way. I think that might stir up a few things. But actually, on the whole point about the relation between US and China, I really would encourage people to go and listen to the episode we did about 10 days ago with Stephen Roach, the former vice chairman of Morgan Stanley in Asia. That was fascinating. He actually brought up some ideas as to how you could improve the dialogue between the countries, which he believes is quite critical at this stage.

Anyways, let’s jump back to something we hopefully know a little bit more about, which is kind of what we talk about every week on this channel, and that is trend following. Now, we’re only a couple of days away from the end of April, so naturally, we have some idea of how CTAs have fared after a soft Q1, not a disaster. A little bit of soft Q1 caused by the banking debacle in March. From what I can tell, things look okay as we head into the end of April. Of course, there’s still two days left. Anything can happen. I suspect that some of the themes driving performance in April so far, at least as of yesterday, are things like commodities, or at least some of them. We have seen a very sweet uptrend in sugar, where the price has gone up by about 16%, 17% so far this month.

In terms of other big moves, I think trend followers probably have been enjoying the downtrend in things like wheat, which is off by about 8% in April in terms of price. Of course, that has not made the environmental activists from Greenpeace, who a couple of weeks ago criticized CTAs for making about $2 billion, (according to them), from the food crisis of Q1 last year. They have not come out applauding CTAs for quote-unquote “forcing down” the price of the grains at the moment, a down move that has pretty much started at the middle of March last year, where they were pinpointing this food crisis caused by CTAs. Actually, some markets like wheat have dropped more than 50% by now.

Now, of course, the truth is, they should not write a new article applauding CTAs because we didn’t drive the price up in 2022, and we certainly haven’t driven the price down this year. That’s just not typically what happens in terms of how CTAs or trend followers are trading. I just want to remind people who may have seen the article but may not have heard us talk about it a couple of weeks ago, CTAs were most likely selling in Q1 of 2022 because of vol expansion, so they weren’t pushing prices up putting more exposure on. Most likely they were reducing positions based on that.

Anyways, another sector that may have helped a little bit in April is the equities. As we’ve seen, many markets grind higher, as Alan mentioned, based on low volatility. But what does that mean? That means that some investment banks come out and talk about this. So in the latest news, I think this morning, I saw that trend following commodity trading advisors snapped up more than $170 billion of global stocks over the last month, according to Goldman Sachs Managing Director, Scott Rubner, now leaving the contingent with the highest exposure to equities since the bull market crested in early 2022.

He’s probably right that CTAs have increased their exposure to equities, so I’m not blaming that. I still think it’s weird that the investment banks are so obsessed with what CTAs are doing, especially those who don’t get it right when they talk about it. Anyways, currency and bonds, I think we have been pretty flat for many trend followers. Also energies, mainly because I actually think exposure in these sectors are pretty low at the moment. At least that’s how I see it.

My own trend barometer, it closed yesterday at 43, which is still pretty neutral, although it’s towards the higher end of the range that we’ve seen in the last few months, where it’s been neutral at best and very weak during a large part of this year so far. It has been sitting between 20, which is really some of the lowest reading you’ll ever see on the low side, and then briefly touching 50 on the high side, which is not even really positive in terms of expected returns.

As of yesterday, CTAs were in the BTOP 50 Index up about 62 basis points, still down about 3% for the year. SG CTA up about 1.18%, down 4% for the year. SocGen Trend, up 2% for the month, down 5.4% for the year, and the SG Short Term Traders Index down about 76 basis points and down 2.75% so far this year. Certain replication funds down about 9.25% so far this year, and yeah, equities down a little bit, both on a world basis, but also the S&P and bonds are pretty flat so far this month. Anything trend following April thoughts, observations?

[00:23:42] Alan

I think you’ve summarized it pretty well. It looks like on average, a positive month. A little bit of dispersion within it, but not enormous. As you say, probably the more interesting moves in commodities within major markets. Obviously, we’ve had a weak dollar trend that has continued to grind with the euro grinding up above 110. So I think that’s certainly been a source of opportunity.

As you say, European equities have been up on the month as well. Gold had been trending higher at the early part of the month but peaked out, and then as you say, the grains and also cattle prices have been going up quite dramatically. Particularly in the early part of the month. So certainly opportunities in commodities, but probably more rangy in bonds and equities this month, I would say.

[00:24:39] Niels

All right. Well, let’s jump into the questions and we go to the topics that are actually somewhat linked to this question that came in from Lawrence. Lawrence writes a general couple of questions I have and then he asks if we can fit it into the Q&A. Of course we can do that. He talks first about, “We here on many of the podcasts people talk about trend percentage allocation within an overall investment portfolio. I have 20% allocated via UCITS, including some of the names we know here on the channel, to CTA trend, but I’m approaching retirement drawdown. The question is, do you think the allocation should remain the same or differ when drawing on investments to provide an annual income?”

[00:25:24] Alan

Yeah. Obviously, anything we say is not advice. We have to say that straight off. All of these things depend on the individual. To be honest, a lot of these things, it is very individual-specific in terms of what else you have, what income sources, all of that stuff. The one thing I would say is that it kind of depends on the overall strategy for the pension. Within my experience, I’ve had more experience with dealing with institutions that have had similar situations around this.

What you tend to find with large institutions is they often very much have an allocation to CTA and managed futures as a diversifier to their equity portfolio. If they’re getting more funded in the overall pension and they have less need for growth assets, they might have less need for diversifying assets to hedge that equity risk. I would say it depends on- if the portfolio still has an objective of growing over time, I’m not sure where the person is from, but I get the impression possibly the UK. So obviously, you’ve still got high inflation in the UK, so presumably still wants to try and protect against inflation and grow the portfolio over time.

To the extent that you still have that equity allocation within the portfolio, then it would make sense to have diversifying assets that could profit should that equity allocation suffer a meaningful drawdown. So from that perspective, using the template of what I’ve seen with larger institutions, I would suggest, yes, maintaining it in that diversifying capacity.

[00:27:23] Niels

Yeah. I’ll keep my comments to the end because there was a follow-up question on this and that is, Lawrence asked that if you receive a state pension in the UK, that would effectively be viewed best as a bond with regular income. Again, does that affect the percentage to trend in a nominal 60/40 equity bond holding portfolio? But I gather from your answer that probably that doesn’t change anything.

[00:27:48] Alan

No. You can view it as a bond. It’s bond-like in terms of you’re getting this income in perpetuity basically. If you have bonds and the way people use bonds within a 60/40 portfolio is often that the bond value would go up in periods when equities go down. That was the whole philosophy around that. Obviously, you don’t have this because you don’t hold a bond in the same way. You’re just getting the income in the form of a pension. Yeah, I would nearly treat that separately to the existing portfolio as a source of income and then manage the retirement pool separate to that.

[00:28:28] Niels

Okay. So my observation, just to round it off, is that I think if people had been asked this question, say, three years ago, they might have thought, well, as you get older, as you go on pension, maybe you should increase your bond part of the portfolio because quote-unquote, that is “safer” and so on and so forth. I think 2022 told us something and that is that that may not be the case. Even a 60/40 portfolio can run into some severe turbulence. So my overall take, I’m very much aligned with Alan here.

My overall take, and I guess it’s always been that, and that is that, one, having an allocation to trend following kind of allows you to own equity, and that’s just simply from the long-term correlation benefits you get. Now, I think we can add that to bonds as well. I think the fact that we long-term had no correlation to bonds is very important because I’m not so sure that bonds will behave the way they did in the last 40 years. In fact, I’m pretty sure they won’t behave that way.

That goes back to this 40-year interest rate cycle that may well have turned a couple of years ago. So I think, Lawrence, from where I sit, I would say I think trend falling is incredibly important in all portfolios. Actually, in a few minutes, we’re going to talk a little bit about some of the ways consultant institutions think about these strategies in a wider portfolio. Before we do that, you did come up with an additional question, Lawrence, and that was more about how can smaller investors benefit from having an allocation to CTAs.

Specifically, again, you’re looking at this from the European perspective in terms of UCITS. I’m not sure we in Europe have ETFs, but of course, in the US, we’re still getting a few more ETFs that give us exposure to these kinds of strategies. I think, from my perspective, again, this is more like a product. It’s not so much a strategy. Generally speaking, we don’t get too much into the weeds about certain products. We see more and more managers have UCITS funds, we see more and more managers in the US have ETFs or mutual funds.

Unfortunately, I think it’s just a matter of just following that market and finding out which managers you can get access to through these products. The problem with some of these products are of course that they’re a little bit more expensive, and so you need to weigh up the expense, you need to weigh up the exposure you get, meaning the leverage you can get, because there are restrictions in terms of leverage within say UCITS, and so on and so forth.

I’m as frustrated as you are probably, Lawrence, in terms of the fact that we can’t give everyone access to these strategies because I truly believe that they should be part of every portfolio, for sure. But I think I’m going to leave it at that in terms of the specific product discussion. Just follow the space, and hopefully, it’ll change in the future. All right. Staying on this topic of risk and how to assess it, we’re going to move on to a question about risk mitigation or mitigating risk in a portfolio sense.

Initially on the trend side, Alan, you’ve been looking a little bit at the current drawdowns that we’ve seen in the trend space just to kind of help us better understand from a historical context what it looked like, so to speak. So I’m not entirely sure where we’re going to go with this, but I know you will guide us through this.

[00:32:04] Alan

Yeah. I think there’s a couple of things we were going to talk about risk mitigation. Maybe before then, it’s, I suppose, more in relation to I guess current performance. Obviously, Q1 was a tough quarter, not an enormous decline. Obviously, there was a period in March where we had slightly more difficult performance. It’s interesting how managed futures trend following has gone from being in a very good period last year as we all know to being back in a drawdown.

We all know drawdowns are part of life in CTAs and managed futures. It’s just interesting to look at the current drawdown in terms of size of drawdown and how does that compare versus history. Can we infer anything from history? Probably not is the answer because we’ve got a small sample of drawdowns, and at any point in time, we don’t know whether we’re going into a more prolonged drawdown or whether this is it in terms of drawdown.

Just to put it in context, the SocGen trend hit a drawdown of about 15% towards late March. That’s obviously sizable enough. Looking at the data, it’s the eighth largest drawdown since the index came in, in 2000. In terms of an index with volatility of about 13% or so, that’s not enormous but it is meaningful. I think it was interesting to look back and say, well, were there similar periods? Of course, you can find periods that are similar, but as I say, we can say whether it’s going to be a more prolonged drawdown are not.

What I would say is if you look back at the period between 2000 and 2010, which was a very good decade for trend following, the SocGen Trend Index annualized 8.2% over that decade. There were 10 drawdowns that were 10% plus, and there were 6 drawdowns that were 15% plus. Meaningful drawdowns like this are still not unusual, even within a period of very good performance for trend following. If you were to look at similar periods in the past, if you go back to the 2000 period, there was a drawdown of this magnitude back in 2000, and it was a kind of similar type of period.

Equities were up and down in a broad range. There were a couple of others. November ’01 was a big reversal month and we had a meaningful drawdown in the index back then. That was a little bit similar to what we saw in March in terms of rates had been trending up and then had a very sharp reversal to trend down. We saw something similar back in 2007, July/August 2007. Obviously, August was the quant crisis. Even July/August, in terms of macro markets, there were reversals, and again, related to bond yields. So we’ve seen this kind of thing before.

You couldn’t say just because we’ve seen similar ones before, that’s it, that we can be confident that we’ve seen the worst of it. Although I’m sure it can be frustrating for investors who maybe came in towards the end of last year or the start of this year, it can be frustrating. In terms of the size of the drawdown, I would say it is very much comparable with what we’ve seen historically so far.

The other thing that was noteworthy when you look at the index is how low volatility had got for trend following managers towards the start of March, and then the huge expansion of vol that we saw recently. That’s very evident if you look at 20-day vol, but less so if you look at something more smoothly, like 260-day vol. So yeah, you can build narratives around these drawdown statistics, but as I say, we don’t know what the future holds except to say what we’ve seen today is very normal and very typical, even in a period of very good performance for trend.

[00:36:15] Niels

Very true. One thing we can also say for a fact, and that is, so far historically, CTAs have come out of every single drawdown they’ve been in. Of course, we don’t know about this one, but at least that’s what we can say from the data. All right, good stuff. Now, I mentioned before that these strategies, and Lawrence also in his question alluded to the fact that they are really good to have in a portfolio to mitigate risk. Of course, they can play a very meaningful role in this provided that you allocate a reasonable part of your portfolio to it.

You dug out a paper from Meketa, I think they’re called, that I would love for you to talk about. I think that’s probably going to be our main feature today.

[00:37:08] Alan

Absolutely. Yeah. It’s an interesting paper. It’s all about what I called risk mitigation strategies. For people who are maybe not plugged into the public pension space in the US, this is a terminology that has become quite widespread. You’ve got crisis risk offset or risk mitigation strategies, and I think CalSTRS use the term risk mitigation strategies.

It is interesting. I was at a conference in London last week, a volatility educational event, basically, from a lot of volatility traders. There was certainly a very strong sense of this philosophy coming through that a sensible way of managing portfolios is to have growth assets and then manage the downside risk of those growth assets with either volatility strategies or trend following because they will benefit from different types of equity drawdowns.

There’s within that community nearly a universal acceptance that that’s a sensible approach. Then obviously, you go outside of that to more mainstream investors and I would say that’s not universally shared. So an interesting disconnect. The theme at the conference was very much aligned with this idea of using risk mitigation strategies. The Meketa paper is quite good on a number of fronts.

Firstly, straight at the bat, they highlight a problem with many institutional portfolios in that a portfolio might ostensibly look like it’s highly diversified, but actually, it might have a lot of the one type of risk of it. So they have a chart in there showing a portfolio consisting of private equity, global equity, US, international real estate, high yield, hedge funds, commodities, TIPS, investment grade bonds. By their estimate, that portfolio might have basically 93% exposure to economic growth risk and 7% exposure to other things.

Bridgewater has done some research on this before highlighting the same thing that a lot of institutional portfolios basically are attuned or biased towards stronger economic growth and lower stable inflation, and do well when that’s the macro scenario, but do badly when you get the opposite of that. I think that makes sense because this has certainly been a theme that we’ve picked up on in the Allocator Series with a lot of allocators that it might look like a portfolio is highly diversified and you can have lots of different buckets to give you comfort that you have lots of different things, but ultimately, they might be just different shades of the same type of risk.

Specifically, a lot of strategies would benefit when economic conditions are favorable, or liquidity is ample, or rates are generally falling and inflation is stable. What happens when that’s not the case? I think that’s the first point and they presented that well. The solution to that is obviously to have more risk mitigation, so growth mitigation or growth management strategies. Their way of thinking about this is in terms of, I suppose, splitting those strategies up between what we call first responders, second responders and diversifiers.

I guess the idea of this is to have different strategies that can benefit from different types of economic downturns and equity downturns. First responders are duration, long vol and tail risk strategies. Before we go into that, second responders are largely trend following, and then diversifiers are a range of unrelated alternative risk premia or hedge fund strategies. The reason for this is that you’re managing your portfolio for different types of equity drawdown.

If you have more of a March 2020 type equity downturn, which is very short, sharp, what kinds of strategies will do well? Fast trend maybe, but if you have slow trend, that could struggle. Obviously, in that kind of shock environment, disinflationary shock, duration will tend to do well, at least initially it did do well. Obviously, we did have such a sharp that we had some challenges in the treasury market in that scenario, but you can see the logic for this.

For a very short, sharp, growth shock or disinflationary or capital market shock, generally, there’s a flight to quality and that’s why duration might do well, and that’s why volatility strategies, particularly if going into the period, volatility was low, you could understand why volatility strategies. They differentiate between long vol and tail risk. Long vol, to my understanding, tends to be more relative value trading, has a convex return profile, but not as pronounced as a tail risk is obviously designed to generate strong returns in particularly extreme events.

Two types of approaches there. So that’s your first responder. So they’re there to help the portfolio for that first initial shock. That could be just that it could be a Feb 2018 type scenario or a March 2020 type scenario, then, obviously, from the perspective of a more prolonged equity downturn such as 2008 or 2022, that’s where trend following has that role in the portfolio. Obviously, if volatility gets elevated within that downturn, it could be more challenging for volatility strategies.

Having that blend between first responders, as they call them, and second responders, I think it makes sense and I think that’s the direction of travel for a lot of allocators. Interestingly, they also include diversifiers as this kind of third bucket. Diversifiers can be things like global macro, alternative risk premia, they mention insurance linked strategies, arbitrage strategies, equity market neutral, multi-strategy. I guess with all of these, they’ll tend to be uncorrelated with equities but not necessarily have that convex return profile that you expect from volatility strategies or from trend following. These are partially to deliver uncorrelated returns.

Also, there’s a strong behavioral element to including this in the interest mitigation bucket as well from the perspective of trying to deliver absolute return and effectively smooth out the return from your risk mitigation buckets. Because if the risk mitigation strategies bucket has that positive skew which you would expect, it’s going to have periods where it’s not delivering performance, and that can be challenging obviously in terms of investors’ ability to hold these types of strategies.

At the conference I was at, it was referenced, I think, that CalPERS exited these types of strategies in 2019 exactly at the time when you didn’t want to be doing that. I think we have to be cognizant of the behavioral challenge and that there are investment committees and that people have these biases. I do think it is reasonable to factor that in as you are building that portfolio. That’s the broad framework of risk mitigation. I would say the general philosophy around this is moving away from equity bond portfolios to equity risk mitigation strategies.

I think generally what you see is these tend to be maybe a 10% allocation. Maybe it will be growing over time as this kind of gathers more momentum I think in the community. I suppose the last part of the Meketa paper is just saying the precise mix of those strategies and the balance between growth and risk mitigation will vary depending on the portfolio. I think it was a good paper. I think there were other things you could go into as well.

Obviously, within trend following, there’s lots of different types of trend. We’ve picked up on this, you have more defensive trend, like we talked to the guys at PIMCO about, and then you’ve got considerations around capping equity beta. There are additional layers you can think about with respect to individual strategies. But at a high level, I think the framework is helpful and I think we will hear more about this.

[00:45:54] Niels

Yeah, great summary, Alan. Thank you for doing that. It’s interesting. You mentioned CalSTRS, and actually, CalSTRS were very early in terms of using the term risk mitigation and actually setting aside a sleeve of their portfolio. I think it was 12% in the early days that they wanted to get to. I interviewed the CIO of CalSTRS, Carrie Lo, many years ago on the podcast. Back then, she was explaining that the portfolio at the time was about 40% trend following, 35% long bonds, and then some other hedge fund strategies and stuff like that.

Now, of course, it kind of would be interesting to hear whether that has changed, meaning since interest rates were so low, could you still justify having such a large allocation into treasuries as a risk mitigator? Of course, last year, we found out that they’re certainly not always a risk mitigator. That will be one thing. The other thing that I was thinking of when you were talking about this, Alan, is that from my understanding, and this is just one pension fund (now, albeit, it’s a big one) but because they are so big, their allocation into the managers that they have chosen, I don’t know, 5, 6, 7 trend followers, they’re becoming a very large part of each of these managers’ overall AUM.

Again, this is just one pension fund. You may know this better than I do. I certainly hope you do, and that is, how many other US pension funds would you say adopt this? Do you know of any European pension funds that have gone down this road? Frankly, if 10 big pension funds say, yeah, this is what we’re going to do, they’re going to fill up the whole trend following space with just their allocation so to speak. How do you see that dynamic?

[00:48:00] Alan

Yeah, it’s a good question. I saw somebody talking about recently how more and more US pensions have been increasing their leverage a little bit and using that to allocate to diversifying strategies, which is kind of on the same theme. It’s not exactly the same. Within the US, I would say certainly in the public pension space, I guess there’s more than 10. I don’t have the numbers, but certainly, it’s not a small number that would have something with this label on it. I think in Europe, I haven’t come across the label as such.

Obviously, I think some institutional investors allocate to these types of strategies and think about the same framework, but I haven’t heard the same label being applied. I think with the very large institutional investors, the sovereign wealth funds, a lot of them don’t tend to. You’d probably know more. The likes of the Norges Bank Investment Management don’t tend to have much external allocations to hedge funds, whether they do this stuff internally or not, I don’t know. That is part of the unknown that we’ve talked about before, how many large institutions are running these types of strategies in-house.

Obviously, some of the Canadian pensions have done that historically. So it’s a good question. I think it’s one that there remains the behavioral challenge of convincing people of the merits of these strategies and well, as I said, it was kind of the consensus view at this niche conference I was at. It’s not the consensus view more broadly in the market. So I think we’re a good bit away from that capacity consideration yet, and we may never get there because the reality is holding risk mitigation strategies is not necessarily an easy thing to do.

[00:50:06] Niels

Yeah, I think you’re right there on that. Anyways, there’s always hope. Now, the only thing I thought of the paper when I read it is, I always find it curious when they talk about these diversifying strategies, right? Okay, global macro, I’ll agree that’s diversifying. But then they mention all these risk premiums, alternative strategy, equity market neutral, stuff like that, and I’m thinking, a lot of that stuff, you’re kind of investing in the same underlying you’re trying to diversify away from. You’re just calling it something else.

We know the correlations are pretty high anyways with the underlying market you’re trying to get away from. So I’m always a little bit curious about why it’s called diversifiers because I wonder how much diversification you get from it. But leave that as it may, the paper also talks a little bit about correlation hedges, structural hedges, and explicit hedges, and I thought that’s also very useful for people to be aware of now.

Now, you talked about how they think about these things and I kind of wanted to ask you, given the fact that you’ve interviewed quite a few allocators in the Allocator Series, how would you think about doing it if you were suddenly given the magic wand by a pension fund saying, “Well, Alan, we need to have an alternative investment portfolio here,” what would your argument be in terms of how it should be fitting inside the overall portfolio, and how would you go about actually structuring such a portfolio?

[00:51:32] Alan

Yeah, it’s something that I talk to investors about all the time. We kind of get the same answer as well when we do the CTA series that a lot of this stuff comes down to objectives. Largely speaking, by and large, the objective with an alts portfolio or even specifically a liquid alts portfolio, generally, the objective is diversification to equity risk, plus absolute return. That’s what most investors are looking for. Obviously, you can get protection against equity downturn by buying puts, but that comes with a high cost. So it’s what’s the most effective, low-cost diversification, and executing that in a liquid alts portfolio.

I say liquid alts because I think using that expression, the types of strategies that we’re involved in do lend themselves to this much more than the private. A lot of investments in the private are labeled alternative and they might be alternative in terms of their construction, but the risk you get is not necessarily very alternative to the risk you get from public equity markets. So focus on truly diversifying strategies. I think a few things to think about. One, in the first instance, focusing on those strategies that deliver that low correlation and potential of that convex return profile.

Specifically, trend following is obviously the one that probably has the greatest historical reliability in that respect, but as we know, won’t work in every single environment and particularly short, sharp inflection points in equity bull markets. There is that case for possibly short-term strategies filling that potential role alongside other types of long volatility strategies. Outside of that, I think it is balancing that behavioral element with the pure portfolio element in the sense that, I think if you just wanted a pure diversifier, maybe a trend-only portfolio would be sufficient.

But can an investor, whether it’s a wealth management group or a public pension plan, can they stay invested with that in a prolonged drawdown? That’s where I think there is a merit in including other strategies in the same vein as Meketa. Things like global macro, quant macro, specialists in commodity trading, it could be relative value trading, foreign exchange trading, all of those things, will tend to have an uncorrelated return profile but won’t necessarily have that convexity and that expectation of very strong returns in periods of stress but should have positive return expectations over time.

I think it’s interesting to think about what not to include, what to exclude. So certainly, things that are short vol, either explicitly short vol or short vol in characteristic. I think things that have an inherent equity beta, particularly things like credit strategies. If you think about what you often see in markets as some assets or strategies may have a low correlation to equities in an equity bull market, but in times of stress, they’re benefiting from the same condition. So there could be either economic growth or liquidity.

What happens in an equity downturn is they become more positively correlated. So the phenomenon of correlation is going to 1 and the volatility picks up. So you can see that their equity beta actually increases in an equity downturn, which is the opposite that you want to see. You saw that type of thing with, say, for example, credit in the US, like the LQD or HYG kind of ETFs here in March 2020 had three moves on the downside. So credit type strategies, short vol, strategies with inherent equity bias, they would all be things to exclude.

Very low vol strategies as well tend not to work well because you’re going to be taking up some of your risk budget or your capital budget with something that’s not going to give you a lot of bang for your buck. I suppose there’s a few principles that I would believe in, from my background, obviously, multi-manager philosophy, even within strategies, so even within trend. Obviously, we know that there are many flavors and ways of approaching trend, not necessarily one right way. I think you can get benefits from multi-manager. I think you have to look at, from a portfolio construction perspective, volatility adjusting is very important.

For people in our industry, it goes without saying. But once you move outside of the CTA experience, I would say, talking to people in wealth management firms, that sometimes gets overlooked, that you have to take account of that volatility. That sounds like an easy thing, but it can be a little bit trickier when you’re dealing with managers with a more erratic volatility profile. A manager who generally has a stable vol but then can go through periodic bouts of very high vol. So do you penalize them, from an allocation perspective, because of that volatility profile? I think that’s the second thing from a portfolio construction perspective.

I think the third thing is you also then have to look through at the individual manager and strategy level to get a sense of the mix of strategies you’re getting within that manager. A lot of the managers we seen in the CTA space would be diversified trend in the sense that they might be 70% trend plus 20% or 30% in either relative value strategies or quant macro. In constructing a portfolio, you have to account for that and weight the underlying components according to the volatility of the program.

Beyond that, it’s a matter of looking at the stability of the correlations, thinking about what level of volatility does this portfolio want to run at, and then that will dictate how leveraged or not the portfolio will be. Then obviously, looking at things from a fee perspective as well. Again, you have to adjust for the volatility to get a sense for how much bang for your buck you’re getting when you’re allocating to the manager.

That would be the approach, starting off with the overall objective of the portfolio, figuring out what kinds of strategies can help meet the overall objectives, thinking about what strategies to exclude, and then getting more into the portfolio construction and manager selection process and building that portfolio to the specific mandate.

[00:58:40] Niels

Yeah, super interesting. Very comprehensive, Alan, as always. I really appreciate that. There’s one thing. I think we’re probably going to wrap up, and maybe you have a couple of points you want to make on one of the papers. I think Aspect came out with a paper, but I will leave that up to you. One thought, as you were talking about these things and portfolio building, maybe this is just me seeing something that is not there. But maybe in our wonderful community of people listening to the podcast, there are people who have studied this. If you have, feel free to let me know, email me.

I don’t know if it’s just me observing this but I’m kind of thinking that some of the shorter-term strategies that are meant to do this risk mitigation, as you say, the first responders, I’ve seen less response from them, so to speak, and maybe a slightly higher correlation to equities than I’ve noticed before. I was kind of wondering whether that’s because some of these managers that we know well (and are in part of the series we’ve just done actually), some of them at least, whether it’s changed by size or that they’re less nimble to take advantage of some of these things, but that’s just my gut feel. I could be wrong. Maybe it’s just too small a sample size anyways. But if anyone has noticed the same, done a study on this, feel free to share that.

Alan, as we wrap up, did you want to say a few words about the paper from Aspect?

[01:00:16] Alan

I’ll just give it a shout-out. Aspect produced a paper just called, Trend: Adaptive, Agile, and Resilient. It’s a short paper but worth a quick look. Interestingly, within it, they go back to the 1970s showing how a representative trend system would have done and it’s just interesting how you had a bunch of very positive years in the 1970s. The main thrust of the paper is around what is the outlook for trend following and answering that question, which is a really good question that I’m sure you get asked a lot, Niels, and I certainly get asked and have gotten asked a lot over many years. It’s always a tricky one to know how to answer.

You can allude to the macro environment and say, well, we’re seeing more volatility and higher inflation and more dispersion across rates, etc. That should be good. You would have said that last October and we’re still in a 15% drawdown for trend following. That’s just the reality of things. They take a slightly different approach to trying to answer that question based on the kind of adaptability of the trend strategy. Really, I won’t go into it all, but it is worth reading.

It really comes down to, I suppose, trying to get investors to think more probabilistically. Whether that is reasonable or not, I’m not sure. What they show in your paper is that trend should be able to adapt to multiple environments and that the return expectation would be positive over time. They actually simulate; they feed their trend system lots of different scenarios using Monte Carlo simulation based on actual price data that we’ve seen. What they found was that in I think it was 85% of the one-year periods, they were positive, which seems high. Obviously, these are gross returns.

I think there was certainly plenty of food for thought in terms of trying to answer that question and get investors to think differently as opposed to just saying, Oh, the outlook is good or bad. Well, the outlook is always positive but with a risk of an unforeseen drawdown. I’m not sure if I convince you with that, Niels, but anyway, maybe read the paper to draw your own conclusions.

[01:02:55] Niels

Yeah, I’m easy to convince about these things. But what I will say is that it’s a question that I find kind of interesting because sometimes I come across people. We don’t show our full 48-year track record, we show 38 years of track because there was a change of the program, etc. But still, even with 38 years, and even if, as you say, the ‘70s were pretty good and they were for us as well, so when you look at the 48-year period, you will think, okay, that probably includes as much change, you can imagine it will be different change in the future.

But this was pretty radical change from going to the ‘70s with very little technology to a world like we live in today. I mean, that’s pretty extreme, and yet people will still say, “Do you think trend following works?” That’s what I find interesting about it. I do think that the best way to answer the question that they raise about the outlook is actually looking at the long term evidence we have. I think that answers the question because our whole premise is that we don’t know what the future holds and we didn’t know that, certainly when we started in 1974. We had no idea.

We still have no idea what the future holds, yet as Aspect puts it, and as you just talked about, it is an adaptable strategy. I think that’s one of the critical advantages that the strategy has. As Katie Kaminsky talked to us about, it has that opportunistic style. It’s not captured in one asset class. It’s not only long-only, etc. It has so many things going for it. So as you can tell, Alan, when you trigger me like this, I go straight into finding all the positive adjectives I can think of, which probably people know already.

Anyways, this was fun, Alan. Thank you so much for all the preparation, all the hard work that you put into today’s conversation. If you enjoy these conversations and all the work that goes into preparing them for you every week, perhaps we can ask you a favor, and that is to go to your preferred podcast platform, leave a rating and review because it does matter, it does help us. If you don’t know how to do it, you can go to toptradersunplugged.com/review and there you have all of the instructions.

If you have questions for us, you should send them to info@toptradersunplugged.com because next week, I will be joined by Mark, he’s back. So I’m sure there’s going to be some interesting topics that he’s going to bring. But as always, we find it interesting and I think it’s useful for the whole community to hear what’s on your mind. So do send in your questions and we will do our best to address them.

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.

[01:05:58] 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.

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