259 Systematic Investor Series ft. Katy Kaminski – September 2nd, 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 Katy Kaminski and I, Niels Kaastrup-Larsen, where each week, we take the pulse of the global market through the lens of a rules-based investor. Katy, it is wonderful to have you back on the show. How are you doing? How are things where you are today?

[00:00:40] Katy

Things are good. Fall is starting up. You can feel it in the air here in Massachusetts, a little bit chilly. It’s starting to feel like school starting, which is good for me.

[00:00:51] Niels

Yeah, it’s funny you say that. This year is only our second year where our kids are not starting school because they’re in university now, so it doesn’t feel quite the same. But I remember fondly the difference between having them home all summer, and then suddenly, school starts and everything quiets down. So I feel you on this one.

[00:01:12] Katy

It’s a nice time of year.

[00:01:15] Niels

Exactly. Now, Katy, we obviously have some topics that we want to talk about, and I think it’ll be enlightening to see what you’ve been up to. But I always like to ask in terms of other things that have been on your radar, things you’ve been monitoring slightly or kept an eye on, is there anything going on where you are, in the US economy or in the world, around the world? It’s not that there’s nothing going on in the world right now. So anything you’ve been keeping an eye on?

[00:01:48] Katy

Niels, this year has been so hard to figure out what’s going on. I think that’s the general theme for me. It’s just, there’s different stuff going on in different places and we had such an extreme event last year that people just haven’t really… It’s like sorting out the tea leaves. Nobody has sorted them out yet, and that’s how it feels. I don’t know. I’m excited to talk to you today because I think maybe you’ll have some insights too. It’s a hard one. It’s been a very particular year, this year.

[00:02:24] Niels

Exactly. Actually, I think it’s quite interesting what you say even then, and that is, I think we often struggle a bit when asked. I guess a lot of people look at you for answers, maybe they look at me for answers. The thing is this answer where we say we just don’t know, it’s something that is quite hard and people might sometimes get a little bit disappointed when you say so. But I think you’re absolutely right in describing that this year is just all over the place.

[00:02:54] Katy

Yeah. Everyone was convinced in the beginning of the year that the recession was coming and now nobody’s convinced it’s coming. Now everybody’s convinced that we’ll have rate cuts, which I disagree with, we can talk about later. I think everybody’s ready for everything to go back to normal and that’s not happening. Everyone was excited that China was going to reopen, everything was going be great, and that hasn’t happened.

I think we’re just kind of stepping back and going, where are we? We’re standing on this tightrope. Do we step right? Do we step left? Do we fall if we do? Do we fall in a pit of fire? Do we fall into a feather bed? So it does really feel like that kind of situation where we’re not sure which way we’re going and are we going to step in the wrong direction. It felt that way all year this year.

[00:03:38] Niels

Absolutely. Well, lots of things to talk about no doubt in our conversation. Before we dive into all of that good stuff, let me just quickly, because we are recording on September 1, so we just finished the month of August. Actually, it was a little bit of a, I think, down month for the industry, although there’s going to be some dispersion in returns.

But I would consider it as a pretty uneventful August, at least compared to some of the Augusts that I’ve experienced in my career with some crazy stuff going on. So I think we can have a sigh of relief saying, well, nothing too crazy went on in August at least. From a performance point of view, probably what decided if people finished in the black on the red is most likely a little bit of trend speed, I would imagine, especially in stocks and bonds where we saw most of the losses from what I can see.

Also, of course, this is a month where for those managers, and this is probably not the big managers I would imagine, but a lot of other managers that have exposure to smaller markets like orange juice, they might have had a slightly different experience in August than most of the big managers have just because again, talk about a crazy trend going on there which is quite fun. Other than that, I would say commodities generally did okay for trend followers in August and that’s probably where some or most of the profits came from.

My own trend barometer finished at 30, so that’s still suggesting kind of a downward drift to performance for trend followers. So that’s so far at least from what I see in line with the indices. The indices as of August 30, so one day before month end, down 0.5% for BTOP 50, down 1% for the year; SocGen CTA down 0.25% for the month, down 1.3% for the year; SocGen Trend Index down 62 basis points for the month and down 2% for the year; and the Short-Term Traders Index down 48 basis points for the month and down 3.5% for the year. Equities of course also struggled in August. Down 2.55% for the MSCI World, but still up 14.75% for the year, and the World Government Bonds down 0.25% roughly, and the S&P 500 down about 1.77% and still up 17% or so for the year.

All right, Katy. With all the admin stuff out of the way, now it’s time to dive into some interesting topics. The first one I wanted to ask you a little bit about, and of course, some of what we’re going to talk about today is based on some of the amazing research that you and your colleagues write about. So we should of course encourage people to read all of the papers that we’re talking about today. We’re not going to read them for them today, we’re going to talk about some of the bullet points from these papers.

But the first one I think is very interesting because for many, many years, I think a lot of critics of trend followers probably said, well, trend followers for the most part have made all their money in the last 20-plus years just being long bonds, and it’s true. We made a lot of money from being long bonds. So I wanted to ask you a little bit about this topic because you’ve been writing about, well, maybe from the fact that markets did move generally in one direction in the bond markets, could certain biases have crept into the way we design our systems, etc.? So why don’t you talk a little bit about these things and the challenges?

[00:07:20] Katy

Oh, I love this topic. We wrote this paper, it’s called Beyond Bond Bias: Perspectives From a Systematic Trader. The reason this came about is that we work with a lot of institutions and we’re very pure trend. So a lot of institutions started coming to us and saying, not all the trend followers are taking reasonable shorts in fixed income this year during 2022.

When we started to look across the board at the positions and estimate them, we started to see that not all trend following systems were willing to necessarily take shorts in fixed income after we had spent decades descending the exact argument that you just said, Niels. So we started to ask the question like, oh, my gosh, it’s really quite reasonable that you can build in a long bond bias in your system just in multiple different ways because it’s always better to be long bonds throughout most of history as a trend follower. It’s actually pretty much good to be long bonds in most scenarios for the last 40 years for anybody.

So what’s fascinating to me, and we have this conversation with all sorts of investors, is that so few people have this concept. When you say short bonds, they say short duration. I say I’m short bonds, and they look at me they say short duration. The reason is they’ve never thought about it. I actually had someone in the media, someone said to me recently, I said I’m short bonds, and they say short duration. They said, how do you do that? They didn’t know how. The reason is because it hasn’t worked.

So we decided to try and think about let’s try and examine this concept from the concept of somebody who’s not supposed to be biased. A systematic trader is supposed to measure opportunities and size positions as a function of their opportunity set. So if you bias your system to reduce exposure to things that you don’t like or that haven’t worked in the past, then when the world changes, you can tie your hands. So that’s kind of something that was fascinating to me last year because when we looked at the data, it was possible that some people might have tied their hands.

So when we did this particular paper, we started off by doing some empirical studies and looking at the bond betas for different funds. We did see a large variation in terms of beta exposure to short fixed income across many different funds. Last year, the biggest differentiator in performance, hands down, is how large was your bond short. Ironically, the bond short was in notional terms not that much larger than any sort of long bond notional that you’d ever see. So it’s not like this was an outsized position or outsized beta. It was just a normal short beta that you would see in any asset class like commodities or dollar.

So to me, that was fascinating because it is in our psychology that if something hasn’t worked in the past, we don’t want to do it. Last year was a perfect example where something that has never worked, worked really well. So that to me was just such an interesting thought experiment for me to think about. How do you build a bias into your system?

[00:10:58] Niels

Yeah. When you looked at these different managers, were there certain clues that came out of it saying, well, this is probably most likely for why it’s occurred? Is it timeframe? Is it other things or is it just the data they look at, they choose to look at, that ends up creating this perhaps unintentional bias?

[00:11:19] Katy

I would have loved to call them all up and ask them that question to be honest with you, Niels, but I didn’t have the inside to the inside box. So instead, what we did was we said, okay, so we do see some differences, and then we stepped back and we said, okay, so we see some differences, let’s do a thought experiment. What are some of the ways that bias creeps into your system both intentionally and unintentionally?

In the paper, we divided that up and we actually looked at how these different approaches might actually leak into reducing your bond beta. So one of them would be you could include some constraints, for example. So you suddenly add some constraints on your system which say, well, we’ll just shrink the position or cut the position when it gets big on the downside because we don’t like that. Another is that you can add other strategies or other things that might actually have that long bond bias, things like carry, or other things as well into your system.

Finally, which was really fun in this paper, is we looked at machine learning. So if you look at data from the past, you can learn, oh, this is how I used to respond to trends. If you use data in the past, which particularly we tend to use data that’s available from the last 40 years, you can learn how to respond to trends and how fast and how slow, and that will tell you how to treat those trends going forward. That particular approach will also include a bias more unintentionally but data-driven.

We found using these approaches, we can explain that both constraints might explain it, but you could also have data or the way that you design your system even using machine learning could easily learn a bias that might cause you to be reticent to actually take a short position even though a very simple trend model like your moving average would be screaming, “Short the bond,” your machine learning model might say, “Watch out, don’t do that.” Or your constraint would say, “Don’t go there.”

So I think that was very fascinating is that we couldn’t actually ask managers that question so we asked ourselves the question; if we’re building a system, how could you build in this bias into your system?

[00:12:43] Niels

You know, it’s funny when I hear you say that, Katy. Of course, you’re absolutely right. We’ve come across this certainly in one other sector, and that’s equities when people or certainly investors would say, well, I’m long equities generally speaking so I don’t really need a trend follower to be long equities. Then some managers have actually then responded saying, well, we have all these building blocks, you can take the equities out from the long side or whatever it is.

But interestingly enough, I’ve actually never really come across that discussion when it comes to bonds. Nobody has ever called me up saying I don’t like you being long bonds. Is this something you’ve come across?

[00:14:36] Katy

No, because bonds always worked. The reason they say that is that bonds are… I love that you asked this question because in another paper we’re going to talk about later you wanted to ask about, the frequency on bonds is just different. Most of us have not been working in the financial markets during a period like the ’70s or another period in history where bonds were upsetting. I think the other challenge with bonds, and this is something that puzzles me to this day, is that bonds have fixed cash flows so people always perceive them as unrisky.

There’s this concept too and I’ve been scratching my head about this all the time recently because (we can talk about this more later because it’s so fascinating) it’s this idea that you can get 5% for a 2-year and you can get a 4% for a 10-year, to me, it’s confusing. You ask people, why would you buy that? It’s fixed. Something about the fixed nature and the yield of those assets, it naturally lends itself on a longer time horizon to make sense, but it’s something about that fixed nature and the fact that it already has a yield that people don’t think about NPV effects.

So when yields go up and you own a fixed cash flow, guess what? You lost money, but as long as you don’t talk to your neighbor and realize you have a worse mortgage, you don’t care. That’s kind of like an intrinsic bias that people have that is there in fixed income that we haven’t thought about because we’ve been in a falling rate regime for 40 years, and I think people don’t think about it. It’s interesting.

[00:16:23] Niels

It is. It’s fascinating. One of the things that I think a lot of investors may not know is a course, and this doesn’t necessarily have a huge impact (you would know this much better than I do), but people may not realize that actually, futures markets (which is what we predominantly as an industry are focused on), they were really commodity-only up until the ’70s, early ’80s. Of course, since the early ‘80s, we’ve had falling interest rates so all the data we can get on futures for fixed income is kind of in more or less one direction.

Now, I’m not saying that necessarily influences a lot, but I’m curious. You may not know the answer so it’s a little bit unfair for me to ask you perhaps. But if you’re a manager that generally wants to trade universal parameters or treat all markets equal rather than having specific parameters for certain sectors, etc., I think it’s fair to say that most of the big managers have probably more bond markets in the portfolio than any other sector. Maybe currency, some people have a lot of currency, I don’t know.

But how much does that actually influence if you want to trade universal parameters? Does it tilt a little bit towards it will end up picking (I say picking but that’s not what I mean), but we end up having parameters that tend to work quite well for what we’ve seen in bond for the past 40 years yet still works okay for other sectors?

[00:18:00] Katy

Well, I think you’re asking a question that’s actually universal for all hedge funds. I think that’s an issue. I got this question the other day because someone said to me, yields are higher so your funding rate is higher. I said, well, that’s not how futures work. Actually, it’s good for us because we’re going to carry on our collateral and we can short bonds. So we’re actually shorting bonds right now and earning collateral. He was like, what? It’s kind of funny.

But no, it is true that I think everybody right now has to go back to the drawing board and ask themselves the question, how much are your strategies that you’ve developed dependent on a falling rate regime? Because if we move to a new regime, it could be the case that a lot of strategies and approaches, whether its value, whether it’s anything that you’re using in your portfolio, if it’s dependent on more of a falling rate regime, you can have a very different result.

I think that’s where this long bond bias is so fascinating is that we’re so used to this particular regime and you go to the dinner table and you talk to your parents or something and they complain about mortgage rates in 1978. You kind of listen to them and go, okay, okay. But the truth is that they were different regimes. I’m not saying this is the ’70s. But if we are in a higher rate environment, and we do actually have higher rates for a longer period of time and we’re no longer in a falling rate environment, some strategies don’t work as well in the same environment.

[00:19:35] Niels

There’s one thing you said also early in our conversation that I thought was quite interesting when we talked about that this year feels a little bit strange, and that is this thing about that people expect things to go back to normal and they’ve defined normal as pretty much zero interest rates and 2% inflation and all of that stuff. But of course, I certainly couldn’t say it about UK but for myself who’s been around long enough to know that that is not normal, and again, maybe based on some of the conversations you have with people.

But when we interview people on some of the other series on the podcast, they don’t necessarily expect us to go back to “the way it was” for the first two decades of the century, and I kind of share that. In particular, I share also what we recently discussed with Neil Howe about the fourth turning and how these periods tend to be very disorderly that they’re often associated with high inflation, high interest rates, etc.

Now, as systematic investors, we don’t make any forecast whether that’s true or not, but we do look at historical data and we tend to think that markets I wouldn’t say repeat themselves, but it certainly rhymes with what we’ve seen before. So I’m not sure where I’m going with this as a question, but I am puzzled about this thing people expect things to just go back to the way they were. I’m not sure they will. Where does that leave investors really, so to speak?

[00:21:15] Katy

That’s the conundrum for me too. I think sometimes, and maybe this is me having my own bias because I used to be an MBA teacher. I remember we had negative energy prices in one year and then we also had negative interest rates. I was teaching a class and I was like, think about that. I just stopped and I was like, think about that. And then the students looked at me and they were like, what do you mean? They’re thinking back and said, I don’t understand, and I said, neither do I.

So what I’m saying right now is what’s puzzling me is we’re in this world right now where short-term rates are high, longer-term rates are low, inflation is high, and the whole world is expecting that we’re going to go back down to zero, which means they’re expecting rates to get cut and everything to go back to where it was. Whereas the MBA teacher in me is saying, where’s the term premium? We needa term premium, and if there’s stress and risk in the world, there’s inflation, then we need to have a yield curve that looks logical and people need to be paid to hold risk over longer horizons.

If we have all this dislocation and supply chain issues and waves of cycles of valuations of commodity prices, then we’re kind of more back in a normal economic cycle, which doesn’t necessarily mean a disruptive cycle, just a more normal economy than when I’m sitting there going, okay, so what does it mean when you have a negative oil price? It’s more like a normal supply-demand mismatch sometimes. So to me, I think that’s where we’re trying to go, at least in my head.

We’re trying to go to a normal economic scenario where you have economies that are disjointed, like sometimes, China’s trying to figure out how to get back going and the US is figuring out if they’ve slowed too much or not, you have some inflation. That, to me, I know that it’s upsetting when you’re used to zero interest rates, sounds pretty much like a textbook economic scenario. So if that’s the case, I feel like it’d be better if people tried to think about that as the new normal instead of trying to see how we can get back to where we were.

[00:23:36] Niels

It reminds me of one of the things. You’ve been first a couple of times talking about certain concepts. I think certainly for me, you must have been one of the first ones who kind of had a really nice way of visualizing convergent versus divergent strategies. I think in a sense, what you’re painting a picture of here is just to say, well, actually, for the most part, markets are divergent, but we’ve had this convergent period of extreme carry where central banks were in control, economies were synchronized for about 20 years, inflation was not a problem so we could keep interest rates to the floor.

But that’s just not how the world normally operates, and now we’re slowly or maybe we are fast moving towards a world that is more normal but that normal world is divergent in nature. This also is why I think you and I sit back and we look at this year and we’re thinking, we have no real sense of a theme. There’s been so many things going on at the same time, and of course (and sorry for this to be such long-winded), people have in the past often talked about trend following as being a long volatility strategy. But you always came out saying, well, it’s actually long divergence. So can you talk a little bit about that because I think it’s a good refresher for people at this point in time.

[00:25:04] Katy

Yeah. I’m glad you bring that up because we haven’t talked about convergence and divergence in a while. This is a great new paper. Now I’ve got to come back and write another paper. I think convergence strategies are really looking for things to converge back to something, whereas divergent strategies are following things that are breaking out. In a world where things are changing and breaking out, it definitely feels like that was last year. This year feels a little bit of both. I think as somebody who trades a divergent strategy, this type of environment is more interesting, a divergent world.

So a world where all monetary policy is converging actually is not great for the active trader because everything’s kind of converging to the same thing. It’s more about the long-term investor and it’s about buy and hold and it’s about risk premia. But I guess you’re right, that hasn’t been sustainable over centuries. If you think about it from a long-term perspective, it’s not necessarily the best strategy over centuries. It’s worked really well for a short period of time.

So I do think that that’s a concept to reconsider and think about again. I’m going to go back to the drawing board on that. You just gave me a good idea for a new paper. Thanks, Niels.

[00:26:31] Niels

My pleasure. Speaking about new papers, I do want to talk about another paper that you wrote. We can always come back. We’re going to mix and match this conversation because there’s just always so many great things to talk about when we get together. But you did write another one that caught my attention certainly because it is another thing that is really very close to your heart but also what you’re known for, and it’s the word crisis, but then again, you raised the question, well, is it a crisis, is it a correction, and an all the challenges that come with that simple question. So I’d love to spend some time on this and maybe you can talk about some of the things you found and you wrote about.

[00:27:17] Katy

Yeah. So let me tell you. The name of the paper is Crisis or Correction? Managing Expectations for Managed Futures. Yeah, that’s the end. That’s long enough. The funny part is this paper was published in 2018, and if you remember 2018, we had the vol apocalypse on I think it was February 5, and then we had a really tough day on October 16th which were these really sharp V-shaped recoveries. Many of the clients that we worked with started coming to us and saying, the market is down, you didn’t make money, what happened?

It was really hard because they loved the term crisis alpha, let’s just be honest. It was something they loved. So we said this is a correction, it’s not a crisis. Let me explain. So we wrote this paper, and it’s called Crisis or Correction? We wanted to really differentiate the difference between a crisis and a correction to help our clients understand expectations for the strategy in these types of environments. So a crisis is a sustained period of losses which does not recover quickly. A correction is a period of losses which recovers quickly.

The key difference there is if you think of something like the vol apocalypse, yes, it was terrible, but it was gone within a week or two. The same thing in October of 2018. It came and it went. When you look at more severe drawdown periods, those are more of a crisis than a correction. So what we did in this new paper and what was really fun about it is we started getting a lot of questions last year. Are we in a crisis or are we in a correction? What’s happening? Where are we in the cycle?

Another really interesting thing came out and we just talked about bonds. Are we in a bond crisis? It was the first time I heard that ever in many years. So this time, we actually updated the paper and examined crisis periods for both fixed income and equities and examined managed futures performance during crisis and correction periods as well as recovery periods of crisis to understand expectations of what typically happens with a strategy during these.

So if you look at the results from the paper, it’s very interesting. We have some nice bubble charts. I love bubble charts with color, red and green so you can see good periods and challenging periods. What you see there is managed futures really likes a crisis. Managed futures can struggle in a correction, whether it’s fixed income or equity. This makes total sense because the correction is when the world is standing somewhere and it moves quickly in the other direction and then it moves back.

When you’re a systematic trader, you’re following where the market is moving, and if it moves quickly against you, you don’t have time to go with it. You don’t have time to pivot. Whereas a crisis happens, unfolds, and you have to move with that crisis. You have to find those opportunities in the wake of something very volatile. Corrections, unfortunately, they’re sort of like pops of volatility. This is why we’re not necessarily long volatility. It’s basically pops of volatility that sort of shutter against your signals and then go back to where you were. That’s never good for a system about detecting direction.

So this paper was really helpful because it helps to give a nomenclature of when you’re in a correction, it’s not necessarily clear. It depends on where we’re standing in that correction. If we’re standing in the right position, we might do well in a correction. If we’re on the other side, not necessarily. If it’s a crisis, we have the time to actually pivot to try and capture what happens in the wake of a crisis to potentially capture that crisis alpha that we’re trying to capture in market trends.

[00:31:26] Niels

What makes these things even more confusing, Katy, is that what may for some feel like a crisis, it doesn’t actually show up in the data as a crisis, meaning it can be very orderly yet it can be very painful. The way I would visualize that of course is also just how the appetite for long vol strategies goes in and out because they tend to come back in flavor after a situation like COVID. Then you have a year like last year, where actually, stocks were also down a decent amount and yet long vol strategies didn’t do so well.

I have a couple of questions about these things. I’m personally curious about whether you found anything about this. First of all, I’ve noticed, and this could be like the famous last words where you say, I’ve noticed that crises, “corrections” are becoming shorter and shorter in time, and then as soon as you say that, you have a major long crisis ahead of you. But since we don’t know what’s ahead of us, I have noticed that there are more corrections than they are crises, it seems like. Do you think that has anything to do with just how the world is, I wouldn’t say operates, I think you know what I mean. Why are we seeing shorter and shorter crises compared to 20 years ago?

[00:33:02] Katy

I might actually disagree with you a little bit.

[00:33:04] Niels

Oh, by all means. That’s great.

[00:33:07] Katy

I felt that way in COVID. I really did. Because that was so fast and it moved so fast back. But if you look at the data, because I’m such a data person, you know that. If you look at the data in this paper, that’s what’s kind of fun, is there’s not a lot of like major crisis event. There’s only a couple of really big ones, right? Last year was pretty bad and pretty long. So it was pretty long and pretty bad for equities, and pretty long and pretty bad for fixed income. So it was very long. That’s what amazed me.

Let me give you an example. Last year, at the beginning of the year, I asked all the people in the room and an audience probably 100 times last year, do you think rates are going up, and everyone said yes. I said, what are you doing about it? They said nothing. I said, anyone here short bonds, and they’d say, no. That trend was so long and the Fed came out every day and said, we’re going to fight inflation, pay attention, and it was so slow.

So I agree with you. There has been some really fast ones I think in equities, but some of them have been pretty slow. Actually, that trend in commodities that we saw, and that’s not like a crisis trend, but the trend we saw in commodities related to inflation, that was also super slow. That’s kind of related to the stress of inflation. I think the the long energy trend started in the spring of ‘20 and stayed until the spring of 2022. So it was a two-year long trend that was relatively positive.

So I do agree that I think especially equities, I think that might be true. This could be the case in equities because people are paying attention. People are actively involved. There’s retail trading, there’s all this stuff. So what do you think about the hypothesis that that could be true for equity markets, but for some of the other markets, people are just not as actively involved? So like commodities or fixed income.

I still think there’s definitely trades that are slower. Equities definitely do feel faster and more corrective and hard to trade, but they’ve always been hard I think too.

[00:35:33] Niels

Oh, yeah. For sure. I think from a trend following perspective, it’s a very difficult sector, and this is what is so (is the word) disconcerting for me, that you see a lot of advertising for, “Oh, you can become the next trend follower, you just buy this course,” and it only talks about trade equities. But actually, equities is not necessarily the place you want to be a trend follower and people don’t understand the importance of diversification, which is another whole conversation maybe for another time. But you’re right, I was referring mainly to equities.

You’re also right that last year was long. But I think this is what I referred to earlier saying it didn’t feel so much as a crisis. But you’re absolutely right. You could say it was a crisis in many respects and a lot of people, institutional investors, lost a lot of money in this situation. So maybe we need to come up with another name than crisis alpha because we need to include the correction as well. I don’t know. It’s a challenge, Katy, for you.

[00:36:38] Katy

Yeah, it’s hard. I think for me, I think about the way that I define a crisis is how much return is your client losing. If they lose above a big enough amount, then that’s a serious issue. I think what was particularly hard with fixed income is I think a lot of people, like I said, they have a money market fund or something and they just don’t think about that it can lose money because they think it has a yield so it can’t lose money. But I’m like NPV.

I think that’s what was hard last year is I’ve talked to a lot of retail investors that say that to me too. Their financial advisors put them in these funds, and I said, when rates are going up, you don’t want to buy bonds. I think that’s where it just always has been easy to do that. Just do it and you’ll be fine. Last year showed that that’s not the case always, and I think that’s hard to conceptualize for a lot of investors who are used to that.

[00:37:40] Niels

Yeah. Before we move on to the third part of our conversation which is more maybe market-related and stuff that’s going on right now, given what we’ve talked about so far, I am curious, because again, you speak maybe to a lot more financial advisors than I do. I’m always fascinated about how to position(for lack of a better word), or how to visualize for people how they should use trend following in a portfolio.

Of course, I come from the school of thought that you should have it as a core location, it should stay there forever, etc. I’m also facing a lot of resistance in that thought because people like to time things and maybe they don’t necessarily agree, etc. Do you think that part of the conversation, do you think that’s changed? Based on what happened last year and maybe earlier this year as well, is there a different narrative or is there a different understanding of the role of trend following in a wider portfolio among the people you come across?

[00:38:49] Katy

I hope so. I think it’s hard because anything new or different, as always, there’s a learning curve. I do think that part of what our goal is is to help people understand what they’re investing in so that they know when it works and when it doesn’t work. But I think the key thing is really making sure that people add different things, so diversification. We all talk about this so much.

But I do think, I really do, that since I started in the industry, there has been at least a lot of progress in the sense that people have learned about these things. They’re starting to understand that it’s important maybe to have exposure to other asset classes, that it’s important to have exposure to alternatives, to things that might work in a different year.

A year like last year helps us. It just helps us. Of course, it doesn’t help us when somebody expects last year to repeat itself. But it does help us to realize that there are proof points. There are environments where the 60/40 isn’t there, and that gets people to go back to the drawing board and say, oh geez, I need something else or bonds were my best friend for 20 years, what do I put in here instead of bonds? I always loved bonds, they were my tried-and-true investment. They probably will be again soon if we could get a stable yield curve.

So no offence, I’m not dissing bonds. I’m a short-term trader. They’ll probably be fine in a year. It really goes back to the drawing board and says, hey, maybe we need some different things in here, at least that’s what we are hearing from people that they’re open-minded to think about things, which is good.

[00:40:32] Niels

Yeah. Which also actually leads me to ask you this question somewhat related, and that is, for the longest time at least, I remember talking to people about trend following and it’s inspired by your writing and your wording about diversifying during crises. But we were always relating that to equity crises, right? That was always the understood crisis we were trying to diversify away from.

You raise a good point. Last year was a wake-up call for many investors that actually, a crisis doesn’t have to be in equities anymore. Does that make it easier or harder for us because now there could be two different types of crises that people should diversify away from?

[00:41:24] Katy

Oh, that’s a good question. I think it’s both easier and harder. It’s an easier word for us from a divergence center in that the world is more chaotic right now. There’s a lot more stuff going on. So it’s an interesting time to be a trend follower and to be trading actively, I think now, because there’s just a lot of- in any type of more chaotic society and environment, there’s more opportunity, there’s more turbulence.

But the challenge is for the traditional investor, the simple solution doesn’t work as well, and I think that’s hard. So the simple just buy your stocks and your bonds and you’re fine, if that doesn’t work, it is hard because it means kind of explaining, well, if this happens, then this might happen, and then it becomes a bunch of common rhetoric, and that’s hard. I personally have always had that view. Everyone comes to me and says crisis alpha is equities. I actually wrote a paper a couple of years ago in P&I which was called Crisis Alpha Everywhere, and I loved it because the idea was exactly what you asked me.

It was this idea that crisis is really about something disruptive, whatever it is. Let me give you a good story for this. I remember being I think it was in the Middle East on a trip at one point in 20’… I can’t even remember the year; a couple of years ago, maybe 2016. I was there and oil prices had been down and people were just so upset. It was just such a different thing because it felt like a crisis there, whereas in the US, the equity market was up so everyone was fine. The truth is a crisis is in the eye of the beholder. It depends on what you do.

So if you’re dealing with oil prices, then that’s your crisis. If you are exposed to fixed income, then that’s your crisis. So the truth is, what’s interesting to us is we like things that move a lot, whatever it is, and any crisis is really a moment where there are trends. Hence, we like crisis whatever type of crisis it is. Some crise are not disruptive everybody and others are. I think the bond crisis is a perfect example of that. People kind of ignored it and pretended it would go away and tried to not pay attention to it.

Whereas in equity crisis, what do they do? They go and they look in their Ameritrade account or their other account or some other account that they have, and they go, “Oh, my gosh, my 401(k) is down, this is terrible,” and they didn’t think about probably their bond fund or what that meant as much. That’s where it’s all about how people think about it and whose perspective it is. Somebody who owned all bonds probably might have felt pretty bad about it. So I agree. It’s complex. It gets complicated. That’s why I said complexity.

[00:44:30] Niels

Yeah. No, it does get complicated. Actually, I think that your last sentence about people who may have been more exposed to fixed income, which I think of as being Europeans in particular, and European pension funds specifically, maybe for the longest time, they didn’t really pay a lot of attention to what we were doing in the trend following space because they didn’t really have to. Everything was hunky dory, it was fine, and the small part they had allocated to equities even if equities had a rough time, it didn’t make a big difference. Well, last year, it did make a big difference.

Obviously, being Danish and keeping an eye out for the Danish headlines, there were some pension funds in Denmark that lost significant amounts of their assets, which also makes me a little bit concerned because yeah, of course, bond prices can correct and we can have a period of time. But if the cycle has changed, interest rates might go higher for the next two or three decades. Of course, we don’t know that. It’s not a prediction. But I’m just saying, I think a lot of things could be helped by structural diversification, as I think we both agree on.

Anyways, in the last 15 minutes of our conversation, Katy, I’d love to pick your brain about global macro stuff, what’s going on. I know you have been in the media a lot lately talking about things that are not necessarily just trend following. So give us a taste of what you’ve been talking about, what you’re finding interesting in the global markets. We’re talking on a day where payrolls have come out, so what better than to talk about economics and markets?

[00:46:32] Katy

To be honest, it’s been a little bit of a difficult August because the first part of this month, I really felt like we started to see a flatter yield curve. The bond shorts were starting to work. We started to see the flattening, which I was hoping for, the steepening, the soft landing and everything’s going to be good. It’s been such a weird summer because we started off the summer with what our head of trading calls pause mania. So everyone was like, oh, with the pause, everything’s great, and then we stayed short. We’ve sort of seen short signals.

I guess the biggest conundrum is bonds. I’m sorry to go back to bonds again. Bond signals, from a trend following perspective, have been short all year. That particular signal, it got really in trouble in Q1 and it hasn’t really worked much but it has been correct to some degree over the summer because if you look at the yields, look at the yields for the 10-year, you can see that the 10-year yield has come back. You can look at the 30-year, you can see that the whole curve has steepened and it’s flattened out a little bit. So in some sense, it’s correct but I’m not really sure where we’re going. I think that’s what’s the challenge for me.

Then August came and the equity markets got spooked. Liquidity is always low in August, so who knows? People had been concerned about China, and equity markets were being spooked about everything and then we started to see correlation similar to what we saw last year. So we saw positive stock-bond correlation. So stocks and bonds were selling off, the dollar started to rally, and energy started to rally and then puttered out a little bit with the China narrative.

So from a technical perspective, we started to look like last year, and of course, I got excited because that’s very similar to something that was working really well last year. Then the last week of August came around and we started getting softer data. Some softer data came in. As you know this week, we had the gilts data, we also had some private payrolls, we had an on-par PCE number. So all these numbers came in and they were kind of soft, a little soft.

So then the market got exuberant again, because like, I told you so. It was kind of like an “I told you so” moment for the market and that is not very fun for trend following because basically, you talked about the returns this month, it’s not a great environment because we started to see a good trend and then the market kind of reverted again. So you can tell it’s kind of like a back and forth. We can’t figure it out. Are we going into this direction or that direction? So this last week has been a day of reckoning kind of moment. Are we going to go to this narrative of, are we moving into the data is looking weaker and softer?

Let me ask you a question. Good news is bad news. I hate that. I don’t know about you. Everyone’s excited. Yay. We have worse data in the labor market. I don’t like that. I don’t know about you because people don’t understand if that keeps going, then that’s bad. Do you know what I mean? I don’t know. How do you think about that, Niels?

[00:50:10] Niels

No, it’s true. It is weird. What’s interesting about this to me is actually the equity-bond correlation to a large extent. Of course, what kind of tricked a lot of stuff out this year was really the SVB event in March. It’s certainly has taken the shine off some of the profits that would otherwise have been from being short fixed income. Actually, and this is what’s interesting to me, is maybe the US futures have not made new lows compared to October last year, but actually, I think the German bunds did this month.

So when I hear people say, oh, yeah, bonds are going up, I’m looking at the data I’m seeing, I just don’t see that. So there is a lot of emotions around this theme right now for sure in the narrative that we see. But as you and I know, price tells its own tale and that’s what we’re going to be following. But it does feel like a little bit of a fight going on.

I don’t know if it’s a transition just yet because I actually think that there might still be higher yields to come before we get there, because of course, nothing goes in a straight line all the time. There will be a point in time where yields will have a period of time where they go lower without a doubt. We just don’t know when that is.

[00:51:39] Katy

So, Niels, I agree with you. That’s why this week has been frustrating because it’s sort of like a head fake. Because my general view, and I liked how you put it, you kind of said, everyone says bonds are going up, and if you actually look at the price chart, take a look. No, they’re not. That’s why the technical signals say short, and that’s why I keep saying that. I feel like I’m the only person saying that. I got excited in August because some of the fundamental guys got up there and said, hey, we agree with them. We’ve been alone this year saying that.

So what we’ve been saying too is if you look at recent commentary from the Fed, they focused on their potential upside risk to inflation. If you think about this, inflation is still coming in much above target. So the fact is, yes, we have cooler data. So that might mean no further hikes. It doesn’t mean we’re at target. So we’re not at target, then we’re just going to sit here in no man’s land and wait until we get to the target. So it’s kind of like you’re coasting in with a boat hoping that you kind of get to the right dock.

What I think people underestimate or at least feels to me that the market underestimates is the amount of time that that could take and how many missteps and potential ups and downs we might have on that trajectory that could cause rates to be higher for longer, which would mean that those long-term bonds are actually mispriced. That’s kind of what I’ve said, but I keep saying that and then people just kind of go, what? I don’t know. Maybe that’s the technical, because we look at the technicals.

So we’re looking at what does the price tell us is happening. We’re not saying what do we think should happen, and the price keeps going down for now. So I think that’s a very interesting dichotomy that price is going down but people keep saying it’s going up. What does that mean, Niels?

[00:53:51] Niels

Yeah, there’s a big disconnect about the narrative and what actually is happening. We kind of started our conversation today talking about biases and I think this shows very clear bias among investors in general, that they just want things to go back to what they perceive as being normal, meaning lower rates. But actually, if we think back 50 years, well, normal is probably closer to where we are now. It could even be a little bit higher rates that would be normal. So it’s all in front of us. Time will tell, so to speak. But it will be interesting.

The other thing is I think generally speaking, after a strong year like last year, another narrative of course at the beginning of the year came out about, well, probably a lot of that profit will be given back by trend followers because it was such a good year last year. But actually, the industry is doing pretty well. Yeah, we always will give back a little bit of what we made and that seems to be happening, but we may be setting ourselves up for some new interesting trends.

We’ve had to go through quite a big downward move in energies and now as things have turned around, and I would imagine a lot of exposure is now going to the upside. If this inflationary story comes back, and if a lot of that may be driven by say energies and other the commodities, at least in some commodity markets, trend followers will be well-positioned for that. But we’ll see.

The base effect is certainly coming out. I don’t know what the right narrative is, but we’ve taken out a lot of price drops now and if energies and other stuff starts to go up from here, that’s going to show up in inflation numbers. It’s just the way it works.

[00:55:38] Katy

Yeah, that’s why when people have asked me, “What are you watching?” I’m like, well, let’s watch where the cycle starts instead of where it ends. They’re always looking at the end of the cycle. I’m like, let’s look at oil prices or things that are going to cause a new wave. I was actually very shocked watching oil prices in August because that to me was interesting. It started to move up and I’m thinking, okay, if that starts moving up, that eventually pushes into things.

So if we start to see something that is a problem in supply or some geopolitical issue or something, that has the ability to start a cycle of that as opposed to thinking about the result of it. I think those are important. But most of the time, these things, I think that’s why inflation is so interesting. At the beginning of this whole thing, I remember our head of trading saying to me, he goes, Katy, once inflation leaves the station, it’s really hard to stop it and it moves around in many places and it’s really hard to figure out where it’s going.

I think that is really the truth. So I think that’s where we are right now. We’re kind of in the aftermath of last year and trying to figure out where are we now. So I think this year, we’re going to look back on this year and say, it’s all obvious now but it was clearly not obvious at the beginning. If you took people’s forecasts for this year, they’re all going to be wrong.

[00:57:05] Niels

Yeah, and actually, that’s another great point you bring up there. I think that what the world benefited from in the last 20 years before, say 2020, thereabouts, was not only low inflation, it was predictable inflation. I think what we’ve definitely come into this period is unpredictable inflation, meaning it can be low from time to time and it can be really high from time to time, but as you rightly say, it’s going to change.

Of course, the great thing about what we do is that our systems do adapt, they just don’t adapt over a week or maybe over three weeks or four weeks. But I think that’s the strength of it. When asked, I’m always fascinated by the fact that some of these strategies have been around for 40, 50 years and how different the environments have been, how different the technology has been and all the “technological revolutions” we’ve been through, like people talk about AI now as the next great thing. Yet these more “simpler” strategies have just continued to adapt and thrive really. So no doubt they’ll continue to do so.

[00:58:22] Katy

Well, Niels, I’d say people are people. The strategies work because people are people. Human behavior persists throughout centuries no matter how much AI or how much advances we get in technology. We have our biases and we take them with us. That’s what I would say.

[00:58:47] Niels

Exactly. So we kind of end where we started meaning with biases. Katy, is there anything else I forgot to bring up today or do you think we’ve covered what we wanted to cover?

[00:58:59] Katy

No, thank you. Thank you for the suggestions. I’ve got some good paper ideas and I look forward to our next conversation.

[00:59:05] Niels

We’ll be reviewing them every time you put out a new paper, we’ll talk about them on the upcoming episode. Anyways, the good news for everyone is of course that Katy will be back in a few weeks. In the meantime, if you love these episodes, head over to your preferred podcast player, leave a rating and review. It does help the podcast to grow, and of course, press follow so you can make sure you get any new episode that we release.

Next week, I’m joined by Andrew Beer, so we’re going to be tackling some questions about trend following again, but maybe from a different perspective. We’ll see what’s been going on in the replicator space and the ETF world where today we saw the announcement of another big name CTA that has joined the ETF world. The name will be withheld by me until next week when I speak to Andrew.

From Katy and me, thanks ever so much for listening. We look forward to being back with you next week. Until next time, as usual, take care of yourself and take care of each other.

[01:00:07] 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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