263 Systematic Investor Series ft. Mark Rzepczynski – September 30th, 2023

[00:00:00] Intro

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

[00:00:23] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Mark Rzepczynski and I, Niels Kaastrup-Larsen, where each week, we take the pulse of the global market through the lens of a rules-based investor. Mark, it is wonderful to be back with you this week. How are you doing over there?

[00:00:40] Mark

Very good. It’s starting to become fall foliage season here in New England, so we get some beautiful colors. We’ve had a wet late summer, early fall so we haven’t seen as much color yet. It’s maybe a little bit late, but I always look forward to this time of year.

[00:00:57] Niels

Absolutely. I’m actually heading kind of in your direction next week, but a little bit further north, and I’ll be interested to see how the autumn is playing out over there. Speaking of themes that are playing out, Mark, as usual, I’d love to hear before we dive into all of the nitty gritty, all the great topics that you brought along that we’re going to discuss and debate. I’d love to hear what’s been on your radar since we last spoke.

[00:01:25] Mark

Sometimes different phrases stick in my mind that you see in your reading. The one that has really captured my attention for the last two months and has been rattling around in my brain is the comment that changes are not permanent, change is. I think that we’ll talk about what’s going on in the world, but it’s something to really think about that any change is not permanent, but change is.

So that’s something that always just now resonates in my brain when I see the news and everyone says, let’s get excited about the latest event or the latest cloud that might be hanging over the economy. I just say, well, we’re always going to have a change, we’re just going to have to learn to deal with it.

[00:02:14] Niels

Yeah, very true. You mentioned a few clouds over the government in the US. I couldn’t help thinking a little bit about, obviously, we’re standing in front of a US government shutdown that seems very likely to happen by now since I think there was a vote yesterday on Friday that rejected whatever proposal was on the table. I think that’s an interesting thing that could have some impact on the markets.

I also find it interesting, and I don’t follow it that closely so I don’t know if there’s any resolution here, but I do find the whole UAW strike, so the United Auto Workers strike, interesting, and what kind of precedents that might be setting when it comes to wage and unionization and all of the things that I think might be maybe causing some challenges for investors in the years to come.

The third thing, and I don’t know if you follow this one, and that is there is more talk about now, and I saw this was an article in the Financial Times maybe from today or yesterday, talking about restricting leverage for hedge funds. I’m in particular thinking of how that might impact these wonderful multi-strategy funds that I believe need a lot of leverage to have all these teams of traders sitting around turning unpredictable market returns into a very kind of almost 45-degree return stream. So anyway, any of this been on your radar?

[00:03:53] Mark

Well, since we from our group, we have an allocation from a multi-strat.

[00:04:02] Niels

Did I step on some toes here, Mark?

[00:04:03] Mark

No, no. I follow the multi-strat area fairly closely and having a lot of discussions, just internally with some of my partners at Theme Analytics, we’ve been talking about how the market has evolved for different products. You used to have individual hedge funds, then you had fund of funds. What the fund of funds really did is that they said I could bundle a lot of hedge funds together.

But in the process of doing that, they actually, I don’t want to say, almost over-diversified. So the volatility got lower and lower as they diversified. But then they gave a good risk-adjusted return, but the returns got to the point that they weren’t very attractive after you take out fees. So when you think about then what happened, the multi-strats came in, and they said, well, look, we can build a better mousetrap.

We could take the idea of bundling hedge funds together, but when you find that you had all that diversification, you get lower returns. But if you have a good Sharpe ratio, let’s just start levering that up and then what we could do is we could lever it up to a volatility that’s consistent with what a lot of clients like, and then you also get a much higher return. So that’s what made it very attractive. Because it’s not the leverage that should bother an investor, it’s the volatility.

So if let’s say you could have, in the case for some on an unlevered basis, some of these strategies that might have a 3 vol with a 6% return. If you have a 3 vol with a 6% return, that’s a 2 Sharpe approximately. But right now, if interest rates are 5.5%, are you going to find that really attractive if let’s say that you’re only going to get 50 basis points over cash? If it was a 1.5 Sharpe, then you could say, well, that’s going to be like 5%. That’s less than what you could get on your cash account.

So what they’ll do is they’ll say, look, we’ve got a 3 vol, let’s, let’s lever it up four times, now get a 12 vol. But if we started out with that 6, now we’re getting 20 plus percent return. So that’s what makes it very attractive. You’ll say that a hedge fund structure, a multi-strat structure, could do that more efficiently than an investor. An investor couldn’t really say I’m going to manage a portfolio of hedge funds and now I’m going to go to a prime broker, I’m going to have cross margining, and then I’m going to lever that 2, 3, 4 times. It’s something that an individual investor or institution can’t do or can’t do easily.

So the structure, it makes perfect sense. Of course, as usual, if you have too much leverage, leverage can kill it in terms of strategy. What you find out is when you get high leverage, well, then you have to be very draconian in how you treat the managers. So if they don’t perform, you’re going to have to kick them out of the portfolio, which is what a lot of the multi-strats do.

[00:04:43] Niels

Just while you were speaking, I looked up on the Barclay Hedge website returns so far for the various hedge fund strategies, and one thing I do notice is that the multi-strategy index is only up about 2%. So it’s certainly not one of the highflyers this year of all the other strategies. Now, what I’m going to say now, I have to be careful because I’ve only heard it from other people.

You may know more about this than I do, but I’ve heard it from other people this week when I was in London and I was quite shocked, actually, also when I think about all the hoops that we have to go through to move to get allocations from institutional investors. But I was told this week that some of these multi-strategy funds, and I’m sure that definitely won’t be for everyone, basically pass through huge amounts of costs, meaning it doesn’t show up as a fee for the manager, it just passes through, including significant multimillion-dollar sign-on bonuses to attract the talent.

Of course, there were, and I don’t know if you would call Citadel a multi-strat, maybe it is, but of course, there have been Bloomberg articles and other articles about how they were paying interns, $19,000 a month, flying them business class and whatever. So I have no idea. These are just things I’m putting together as we speak now. But the information about these passthrough costs is something that I would say I can see or I’ve heard from other sides that this is happening.

If it is, I’d love to hear whether you think that is true. But if it is, I am surprised that institutional investors, who must be making up the bulk of these allocations, including pension funds, etc., who have been very hard on pressing fees down on other strategies, including CTAs, how that can even occur. Even with regulators, I mean, what on earth are you doing if you’re just passing through massive amounts of expenses like that? But maybe it’s because it’s offshore strategy funds or vehicles. I don’t know, Mark. But is that something that rings a bell?

[00:09:56] Mark

Absolutely. It’s an issue that people have been grappling with. We’ll say that when the model works, that might be a fair way to charge. Because when you think about it, if you had a fund of funds or if you had to look at a bundle of hedge funds, you’d have to pay an incentive fee for every one of them. So if you have 5, 10 hedge funds and all of them have an incentive fee, you’re going to have to pay for that. So if you bundle them up in a multi-strat, you’re still going to have to pay for some of those fees.

So what they do is they oftentimes will give an incentive fee to the pods, which are the different internal managers. They’ll pick up some of the costs so that they don’t have to pay the costs, which usually, if you bought it individually, would be the management fee that you’d have to pay. So some of those costs are passed through. Then if you have to say you were paying an incentive fee to that manager, that internal team as part of our multi strat, we’re going to also pass through some of those expenses associated with the incentive fees that go to the manager.

So when you think about it, let’s go back to if you had to do it yourself, you’d have to pay the management fee. Basically, if you have five managers and you built a portfolio, you’d have to pay five legal, five compliance, five fees for data, for Bloomberg, etc. So you still have to pay all those fees.

If you do a multi-strat it’s the same thing. They make an allocation to a commingled vehicle for another hedge fund, so you’re going to have to pay those fees. So multi-strat, they say, well, we still have all these fees even though the manager is internal, so we’re passing some of those through to the investors.

So I think that, by itself, is not a negative. It’s the same cost that you would pay if you had to go out and find those managers yourself. Now, that being said, some of the largest multi-strats have been able to do that and they’ve been doing it very effectively. Because they’ve posted very strong returns, then I don’t think that a lot of investors have complained about that fee structure.

On the other hand, if let’s say you have a very poor year where performance may be off such as this year, then maybe some clients are going to say I want to take a little closer look at those fee structures because when I look at the amount of fees I pay versus the amount of return I get, it might be out of whack relative to what I expected.

[00:12:46] Niels

I will say I probably disagree a little bit here, meaning I think there’s a huge difference between a manager charging a 1% or 1.5% (because nobody gets 2% anymore, let’s face it), but a manager charging 1% or 1.5% to a fund but then taking all the business risks themselves and then having to decide how much they can afford in terms of fees for Bloomberg or whatever, legal, whatever, to a strategy where the vehicle can just pass through the cost directly; where there’s no real business risk. It’s just, are we going to use the investors’ money to pay for all of this stuff, whether it’s 1% or 2%, or 3%, well, there’s no real transparency, I’m sure. I think that’s hugely troublesome, frankly.

But again, you could of course argue and say well, it comes down to the net returns and if they can continue to do really well, investors should be should not care. I have some sympathy for that, but I think there’s a limit. I think once you start passing through fees for signing on bonuses and what have you, I think there’s a huge red flag there. But that’s just my personal opinion.

[00:14:03] Mark

Well, there are two parts of this is. One, if it’s just the fees associated with running some of the business and these pods, because I think the pod manager or the managers within the multi-strat they’re taking a lot of risk. Usually, in some of the extreme cases, many of these multi-strats, if they have a hard stop, if let’s say you lose 5% or 7% or some number, they will just tap you on the shoulder, you’re done. You’re tapped out. You lose all of your money and you’re done.

There’s also talent that you can’t normally find because we’ll say that an investor wants to say if I’m buying talent, hedge fund talent, I want them to focus on the strategy. I want them to focus on generating return and not focus on the business. So the multi-strat structure allows the managers to focus in on the business, they pass around some of the costs. They still get also economies of scale. So if you’re buying certain types of data, if you’re looking at infrastructure, even though you’re passing it through some of that cost, you’re getting some economies of scale when you do it across a large number of pods.

[00:15:22] Niels

But really, I think they, the multi-strategy company, whoever they are, whatever they’re called, they should say, “Well, we’re going to charge a 1%, 1.5%, or 2% fee, and then it’s up to us to make sure that we can pay for these pods.” I kind of disagree also on this thing about well, these people who come into these companies as portfolio managers, they are taking a massive risk.

Well, they know what the risks are, and by the way, they’re getting massive upside because they will get a fairly high cut of the performance and they will get much more AUM. That I’ve seen from people that I know personally, where they go from managing a few million dollars to getting a $300 million allocation, or what it equates to in terms of risk, with massive upside. So as long as they don’t lose too much.

I mean, this was a little bit of me taking you down the rabbit hole, which I didn’t mean to, but it’ll be an interesting thing to continue to follow because as I said, there are some forces now out at least trying to figure out whether there’s too much leverage in the system, and that might have an effect not just on multi-strat funds, but on other hedge fund strategies.

[00:16:45] Mark

Well, this is an ongoing issue. I think that this might be more of an extreme because you have the pass through, but whether it’s 2 and 21, 1 and 20, 0 and X in terms of incentive fees, ultimately, the whole business is based on performance. So you could say like, well, if I charge 1% flat, but if I don’t perform, then that fee structure could be expensive no matter what.

[00:17:18] Niels

Well, Mark, you’re preaching to the choir here because you know I am not a big fan of flat fee funds, but that’s another discussion we should have.

[00:17:29] Mark

What would be interesting now is that I think that you could get, at some level, if you want an S&P 500 index fund, there are people who charge it for basically one or two basis points. So in a world where you have ETFs, you have index funds that are charging just almost say pennies, then I will say I’ve been there and I’m sure you’ve been there.

If an index fund is up double digit and then you come in and you come in with any kind of management and incentive fee structure and you’re not performing or beating that benchmark, even though it may not be an appropriate benchmark, you will have a lot of people say, why should I pay you anything when I can buy this index fund for nothing.

There is a lot of dynamics between fees and growth and the ability to sell in the hedge fund business. So I will say that it is dynamic so that if fees get out of line relative to performance, people will vote with their feet fairly quickly. Any of these multi-strats who don’t perform and pass through the fees, they will feel the wrath of investors if they don’t do their job, and that applies to all hedge funds.

[00:18:59] Niels

Yeah. That’s probably the good thing about what we do is that investors can vote with their feet. Absolutely. Anyways, I’m sure we’ll continue this discussion of that topic another time.

Now, it is month end. It is quarter end. So I thought maybe we should spend a couple of minutes if you have any thoughts on that. From my perspective, I would say the month of September was a little bit, I wouldn’t call it a massive rollercoaster in terms of performance. But certainly, for the funds that I track the closest, it was a little bit of a strong heart first half of the month and less strong, slightly negative second half of the month.

That’s interesting, but it’s also interesting from the fact that once again, we had positive correlation between stocks and bonds and they both went down. So investors that large, again, did not really enjoy any protection from a classical 60/40 portfolio or whatever relationship they have. So I think those were things that were interesting.

Of course, I’m sure many of the people listening to us today, Mark, will know that trend followers continue to enjoy trends in fixed income markets where, once again, they came under quite a lot of pressure in September and made new highs in terms of yield for 10, 15, maybe even 20 years. We haven’t seen yields so high. There were also some pretty good opportunities in the grains where wheat in particular was very weak. I think it dropped from about a price of $800, a couple of months ago, down to about $540, so a reasonable drop in a couple of months.

Then of course, we have the energies. Energies have kind of become this stealth, bullish trend that nobody talked about much in June but trend followers started to get reversals in their signals and went long, with the exception of course of the nat gas cousins (Dutch nat gas and the US nat gas), we’ve had a very strong rally in energy markets, up 30%, 35%, 40% in the last few weeks. So those are some of the takeaways. I just noticed here that, yeah, in the last three months, heating oil up 42%, so pretty strong.

Then of course there were a little bit of a struggle in some sectors, equities for one of course, with this weaker performance in equity indices around the world. Trend followers, I would say for the most part, probably still long, and therefore giving up some open profits. Currencies, probably also a little bit of a challenge. In particular, things like Mexican peso that’s been trending really well all year, but it certainly had a little bit of a correction this month, and so on and so forth.

The good news though, Mark, is that my own trend barometer finished the month at 52. That is probably the highest level we’ve seen I think maybe all year. So it could be setting up for an interesting Q4, even though I don’t want to jinx it, but Q4 could be interesting, as it has been many times in our industry as I’m sure you remember. So any thoughts from your side in terms of the industry, how it’s done in the last month, last quarter?

[00:22:35] Mark

Well, we started out talking about the fall and autumn, and I think that all of a sudden now, your evenings are getting cooler, it’s getting colder out there at night. Sometimes when you go outside and you say like, yeah, there’s some standing water and you splash yourself with that water that’s been standing outside overnight, it’s a little bit bracing. You get that splash of cold water in your face of reality.

I think that September, we’ll call it the splash of cold water with reality for a lot of markets. I think especially, what you take away from the Fed, you look at the Sep forecast, the dot plots, no matter how much we thought that we would say like we’re going to see, at the end of 2023, ’24, we’re going to see rates starting to come down and we’re going to “normalize” and get back to lower rates. The splash of cold water is that’s not going to happen.

Then you say, once that happened, while there’s been a decline in bond prices, the long bond I think was up 40 basis points in terms of the yield curve, so we got a bear rally in the back end of the curve and so we’re starting to get a steepening there. You could say that’s just the splash of cold water that we’re starting to hit reality. The other reality was, I think earlier in a month, the Russell 2000 year to date was negative. So take out all of the top 10 stocks in the S&P 500, you look at the rest of the stock market, it’s not doing very well.

I always look at the S&P 500 versus the equally weighted index, because equally weighted, that’s a good representation of what the overall market is doing. It’s more of an easy breadth index. Then we’ll say that there’s a huge divergence between those two. So if you say the average company return relative to those large-cap stocks that have been all concentrated in just a few names, that there’s such a divergence between the world going on there.

Then you look at even divergence between, you’ve got metals year to date, they’re probably down as a group, energy is up; you got agriculture is down, but you got precious metals being sort of flattish. So there’s much more divergence going on in markets. So it’s an ongoing theme. We’ll talk about it maybe a little bit later here on the podcast, the idea of divergence and what is the impact of that on trading? There’s more spread that we’re seeing in markets than we have seen earlier in the year, and that’s going to have an impact on the set of opportunities.

[00:25:48] Niels

Yeah, absolutely. Just talking about divergence, just talking about market moves, maybe not all our listeners follow the markets as closely as we do. We don’t trade that at DUNN, but orange juice up 97% this year, sugar up 49%, cocoa up 31%, NASDAQ still up 29%. But then to the downside, you have nat gas down 45% and wheat down 36%, palladium down 31%. There are some pretty big moves in some of these commodities year to date. So interesting times to say the least.

[00:26:25] Mark

This is the interesting part, and it’s a recurring theme about narrative and quant models or whatever. If you follow the narrative, let’s look at wheat as a perfect example. We still have war in Ukraine with Russia. We know that there have been, on and off there have been bombing of the grain export ports in the Ukraine. We know that there have been on and off grain deals. So if someone said we still have war in Ukraine, what do you think is going to happen for wheat?

You would come up with a strong narrative for why wheat prices should be the same or at least higher since the war began. Yet, here we have a tremendous decline in wheat prices. So you’d say the narrative would give you one different story, but then when you look at the model, if you follow just the trends and prices, you get a very different story or a very different answer to the same question of what should happen to wheat. Investments are driven by narrative, but the narrative is often false, and this is what a quant has to do. I always give an idea that I was going to check the weather earlier today.

When you look at, well, what’s the weather forecast? In some sense, it could be very cut and dry. Here’s what the temperature high and low is going to be. Is it going to be sunny or not? What’s the probability of rain? Now, I know in the United States, they spend an inordinate amount of time on the weather forecast in the news. They probably do the same in other parts of the country.

They spend a lot of time just giving you a huge narrative about what the weather will do and all of they answer is that is it going to be hot or cold and is it going to be rainy or not. Those are the only things you really are interested in. But they’ll spend a lot of time talking about the narrative to just wrap around the forecast.

[00:28:35] Niels

Transferring that to our little world, Mark, I mean, really, you have all these experts going on financial media talking about why they believe certain things happen. But if you ask a trend follower, well, the market is either going up or it’s going down, frankly, and that’s all that matters. So yeah, good point.

I will just run through… I don’t have the final performance numbers for September because we still have one day. We’re waiting for the numbers to come in on Monday.

But as of Thursday night, a good month for the CTA world. BTOP 50 up 3.59%, up 3.25% for the year. SocGen CTA Index up more than 4% as of Thursday in September, up 2.5% for the year. SocGen Trend Index up 3.9% for the month and up 1.44% for the year. The Short-Term Traders Index had a good month, up 1.9% but still down 1.55% for the year. MSCI World did finish the month of September down 4.45%, still up 9.6% for the year, and the World Government Bonds, a tough month, down more than 2% in September, and the S&P 500 index down almost 5% in September but still up 11.68% in 2023.

All right, Mark. We’re kind of halfway through our conversation and it’s time for you to take us through some of your wonderful topics that you have listed and sent to me. I’ll try and keep up and do my best. But the first things, you kind of already alluded to. We’re going to talk about things, the more that they change, the more they stay the same.

[00:30:27] Mark

That’s a good place to start only because as you come to month end, I’m looking at that as soon as you get to the end of the third quarter, then people say, what’s going to happen in fourth quarter? What do you see going on? We’ve talked about that we have the auto workers strike, we’ve got the oil price shock. Clearly, oil prices are in the $90s. We’ve got the shutdown in the federal government. We’ve still got a debt crisis and we’re sort of seeing this. Delinquencies are up for auto loans. We’re seeing real estate is having problems.

Then we’ve got the ongoing issue of just rates. Rates are going to be higher for longer. We had a discussion earlier because we run quant models that, well, what should we do about this? There are all of these events that are occurring. Should we be prepared to lower leverage for the fund or should we turn some things off? That’s why that initial phrase of changes are not permanent changes came to a height. So what do you do or when should you turn off models or how should you make that decision was something that is been bantering around with myself and the partners.

Generally, you come to the conclusion that no matter what we see in the marketplace, the null hypothesis should always be that don’t turn anything off. You should be aware of what’s going on. You should hold the course because overrides are costly. They’re costly in the sense that first you’re making a prediction. You’re saying the prediction is that market will do X or do something else. If you’re wrong, then that could have an impact on overall performance.

Then you have to make a second decision of when do you get back in? So if you cut leverage or if you turn off a model or if you turn something off in a strategy, well, then you have to also look at when do you get back in? So we’ll always say that not unless there’s a liquidity event that impairs your ability to actually trade, you always hold steady or make sure you hold the models. That should be the fundamental view for all the quants. The reason why I could have confidence doing that is how you do backtests, so you want to try to do backtests as long as possible.

Now, I think some managers have very, very long histories so they can look at actual live performance. But you want to say, if you’ve done backtests, you want to say, I have environments where I don’t know if a specific event like this type of strike has occurred, but I know that there have been disruptions and my model has included that. I could either sort of look at what those disruptions, what happened during those periods of time, or I could just say, here’s what the worst periods have been, and I could still live with that or then I just try to move forward.

But I think that this is a constant battle that most people in the quant world have to deal with. Are there situations to turn things off? We’ll say that they should be very limited. So if you say that a doctor said, first do no harm. So for a quant, first do not turn off the model.

What you find out is that when you have a lot of uncertainty, it actually generates slower behavior. One of the things I was looking at is there’s something called a Rogers diffusion curve. The Rogers diffusion curve, if you look at a bell curve, there’s a speed of adoption for different technology.

But you could say the same thing happens with themes in the marketplace, or information, that there’s a speed of adjustment, and sometimes, adjustments can be very quick, sometimes they can be slow. If there’s more uncertainty or fluctuations in the market, that throws up bargains and it causes people to miss seeing value. So when we think about the diffusion curve in innovation, well, you get an unemployment number comes out, well, there might be a reaction right away. So the diffusion of that information and reaction is very fast.

But if you say like oil price shocks, well, what’s the diffusion rate for an oil price shock? It might take a while before it works out, and so consequently, that’s going to lead to slower adjustment in prices and that’s going to lead to sometimes better opportunities. A rate increase, we’ve gone from zero to 5.5% on rates. Think of there’s a diffusion index or a diffusion curve for the idea of higher rates.

In some sense, we’ll say it’s taking a little bit longer, but that still means that there’s going to be more opportunities going forward as the market starts to react to the fact that rates are going to be higher for longer and now this is impacting my ability to lever. It impacts my ability to borrow, and it impacts my ability to, in some sense, if I have a variable rate loan, to pay back the loan.

So in some sense, let’s go back to first principles for trend following or other models.
We’ve talked on the podcast before, I like to say that myself, Andrew Brunner and Pete Wild is our Theme team, is that we focus on change point detection. We’re looking for change points in markets and change points can come in two forms. They can either be an opportunity for reversal. But if there’s no change, then you’re probably going to be trend. We’ll say that because a lot of the storm clouds we’ve seen actually sort of have had a longer-term effect.

We may be in the fourth quarter, going forward, more in a divergent world. We’re going to be in a period where there could be more opportunities for more dispersion in returns and more dispersions in behavior. So I think that that’s going to be the positive sign for the fourth quarter if you’re a trend follower or if you’re someone who’s looking for divergence in marketplaces. We can already see that in let’s say sector returns. The overall market is looking a little flat, but at the same time, communication services, as an equity sector, is up like 40%.

You’ve got real estate and utilities down. Real estate is down 5% plus, utilities over 14%. So there’s actually a big divergence between different sectors in the marketplace. The issue is that that always can’t happen forever. So what you’re going to see is that there’s going to be opportunities as markets move from high divergence to smaller divergence, and in some cases, for other markets that are going to go from low divergence to higher divergence or higher dispersion.

So, when we talk about the return pattern that we’ve seen, energy has some great opportunities. That’s a great opportunity for trend following, but we also know that that’s going to have an impact on other sectors and that could be in an opposite direction. If the cost of energy goes up, well, the cost of mining goes up, the cost of agriculture farming goes up. It may not have an impact in the near term, but eventually, that’s going to have a stronger impact on the overall pricing across markets. So we’re seeing that this is a good opportunity.

But at the same time, while we look at these short-term storm clouds, and that would be for example a strike or a government shutdown, we still haven’t really internalized all of the worst cloud, which is the rate increase. In some sense, there’s still speculative excesses in the marketplace from a trend perspective and from a bigger macro perspective of where the opportunities are. We still have a bubble economy.

As credit becomes more expensive, then we’re going to see that that’s going to have an impact on any market’s ability to maintain a bubble. So look at this, housing is starting to finally turn over around the world. So, with housing prices, now the issue is that we would have a worse housing crisis, especially in the United States, if it wasn’t for the fact that many people have such low mortgage rates because they locked them in at the lows that they can’t afford to move or can’t afford to sell their home and go somewhere else.

But if you look at new homes, the prices are coming down. So there’s adjustment of the housing bubble. We’ll say the goods bubble, from the pandemic, has led to inflation. We’re seeing that come down. We’re looking at the rates bubble that occurred. Now we’re saying that we’re getting to a new permanent high in interest rates. In particular, you more in Europe relative to the United States, Niels, can you remember that there used to be negative interest rates in Europe and other parts of the world?

[00:41:05] Niels

You know what’s funny about that particular part is of course that I think the last let’s call it 15 years or so, in many ways, have been very illustrative in the “strength” of trend following, the strength of not predicting anything, because as I’m sure others will remember, there was certainly a long period of time where, and I use this as a general term, but I think investors started to believe that clearly rates couldn’t go below a certain level, whether that was 2% or 1%, whatever. But as you rightly said, it turned out that actually they could go negative.

I think that kind of rules-based disciplined approach where you just don’t make any prediction actually was a very good example of the benefit of that, even though CTAs were most likely criticized for they’re just making all their money in fixed income, and we did, but we did it because we had to. That was the rule. Now you can say, well, actually, we’ve seen the complete reversal here where lots of people, and experts in particular, refuse to think that interest rates could go as high as they did at the speed they did.

But once again, trend followers probably for the most part have been short fixed income markets for the better part of two years now, even if we’ve had a few wobbles along the way and a big one in March. So to me, I think there are so many good examples of the benefit of having a diversification of investment process, not just diversification across markets.

Maybe that’s what we will see more investors realize as time goes by, and as they seem to realize now, the fixed income markets that bond yields might actually continue to go higher. I haven’t said this for a while but I still believe that we’ve lost our imagination of what can happen. So we need to start imagining the unimaginable. I think we’ve seen quite a few things already in that like negative interest rates, negative oil prices, short-term interest rates going up by 5% in 15 months, and so on and so forth. That, I think to many people, is the unimaginable. But I worry that this is just the beginning.

I didn’t read the article, but I saw some headlines where Jamie Dimon was out saying, well, is the world ready for 7% Fed funds? I don’t think it is. I don’t think he believes it is. But what if it’s not 7%? What if it’s 10%? The thing is it’s almost like we know how this will play out. But the truth is, we don’t know how this will play out. So many surprises in the coming period, whether it’s the next 5 or 10 years, but I don’t think it’s going to be more calm, unfortunately.

[00:44:13] Mark

When we talk about negative interest rates, I’ll admit to all of your audience, it was one of my days of infamy. I was with John Henry and we were talking about what we should do. Interest rates were going low at the time when I was working with him and I said, well, rates, they can never go negative. I said, yeah, there was some structural issues that it went negative for a few days. But I said, it’s not going to happen. He was just like, well, yeah, it could happen. It’s possible.

It was one of those things that’s always stuck in my head. We’re having this argument about whether rates could go negative and then darn it, it goes negative big time in many markets, and I sort of said like, yeah, he was right. I probably didn’t have the right emotion. That gets back to what do you do about markets and overriding> What do you do? There are worlds we can’t imagine for different assets that could occur that as trend followers you have to be prepared for.

The same is also on reversals if you’re looking for any kind of change. There are changes that will occur that we’re not prepared for that you have to allow the imagination to take hold of. So I think that the rate environment is a perfect one. The term premium, the New York Fed has a nice website that shows what the term premium across the yield curve is, which should be like what’s the excess return that you should have for holding duration. It was negative for a very long time.

So you’d never say I’m going to have a negative term premium for taking on duration risk. It happened. Now it’s going to go positive. So you can never say never. You always have to be prepared for those. If you can’t have the imagination, then you have to at least allow your models to be able to have the possibility for some things that you have not explored in your own mind.

[00:46:42] Niels

All right, Mark. Where do you want to go next? I’m not sure we’re going to get to all of the topics that you listed, but maybe a few more. Where do you want to focus?

[00:46:53] Mark

Let me talk about two things that catch my eye, always in terms of research, that are a little bit of things that I found interesting. Then let me just talk about some of the research that I’m working on currently because I think that I can always come back with that later on after I get more results, but then, to at least give listeners a chance to sort of say… Sometimes the view is that we have our models and we keep them in place and we don’t change.

I think that a lot of quants are very dynamic. They’re always looking at a feedback loop. They’re always trying to say, can you improve? Others don’t. But I would say that at least my approach is to say that I always have got to be learning; I have got to be thinking about how can I improve model or what can I do next for the next model? So let’s start with first, the two things that I found sort of interesting, and these are just little psychological studies, because I think psychology has such an impact on markets and part of a model is to take out the emotions or actually quantify the emotions.

There’s a study that looked at counter-cyclical risk aversion and they said that if you prime professionals, so they did a survey of professionals, financial professionals, that you’re in a boom period with positive stories, and then you show them let’s say a graph of what could be the potential return for an asset, that they’ll actually take out more risk. So if they think that they’re in a boom period, they’ll take on more risk. Lo and behold, if you prime them with pessimistic news or the idea that we might have a recession, they actually cut their risk.

So the risk aversion is very counter-cyclical. Based on what the priming of what the news they read or how they look at it, that will have an impact on the sizing of positions that you take, which I find is really interesting. Now, modelers, in your model, we don’t necessarily say prime on the news. So we don’t have this counter-cyclical risk aversion because we just say here’s the kind of size you’ll take if this is the opportunity or the count or the signal size. So you get more extremes.

So if let’s say we’re in a period when now we’re going to get more news that is negative, then we’re going to see that risk sizes are going to be taken down in positions. So that’s going to have a certain overall impact on behavior. The second study that I found really interesting is (some of these haven’t been done recently, it’s just that I uncovered them), there’s a big difference between whether a trader believes or sees that it’s their realized returns or unrealized returns.

If let’s say that you have an unrealized loss, you don’t react as strongly as if the loss is realized. If the loss is realized, you’re going to actually cut back your risk. You’re going to become more conservative if it’s realized. If it’s mark to market, it’s unrealized, you don’t react as strong. Now, from an economist’s point of view, you’d say it doesn’t matter whether it’s realized or unrealized, especially in a futures market, you mark to market every day.

Whether you happen to realize the loss or not, there’s a loss if let’s say it gets marked every day, so my reaction should be the same. The research tells us that people react differently versus realized and unrealized loss. So again, the emotions that people have in their trading wouldn’t be displayed in a model. I always say that’s the reason why you want to try to go with models.

[00:50:58] Niels

It almost touches on, I don’t know if you were just about to say, but obviously, we do have some very close friends that have this very different way of managing risk where they look at open and close profits separately. But of course, open profit could also be an open loss. It doesn’t have to be a profit. But yeah, I wasn’t sure whether you’d dare go down that rabbit hole.

[00:51:22] Mark

Well, this is actually a good topic for further exploration for other people. I wasn’t going down that path but that actually matters. Do you play with the house money or not in terms of like okay, if I’ve got open trade profits, should I use that to lever up more or do I say, no, I’m not going to play with the house money? But that’s an ongoing issue of how you build models. So there’s the psychology, then there’s the model building issue, which I think adds another complexity, and also, sometimes I use the word it adds complexity to models. It also adds personality to models.

So I think that the audience may not always realize that every model is not dispassionate. Every model has a personality. There is a personality associated with the model builder that’s embedded in what they do. Now, you can say, it’s very rules-based. You can say that it’s unemotional, but a model has personality. So what am I working on? I guess this might be a good place to end some of the topics.

My partners and I, we spend a lot of time looking at dispersion and correlation. We trade a lot of markets. We’ll trade the individual stocks in the S&P, the Russell 2000, and so we spend a lot of time on what is the opportunity set, and if there’s more dispersion in markets, then that should lead to more opportunities. This applies even if you look in the commodities markets.

Periods of more dispersion should give you greater return opportunities, and then when there’s less dispersion or dispersion is very low, then it doesn’t matter whether you have a trend following model or whatever type of model. If there’s low dispersion, then the opportunity set is going to be smaller. You’re not going to get as much return potential.

[00:53:45] Niels

But can I challenge that a little bit? I could be completely wrong here, Mark. But we are right in saying this thing about, well, in one way, we want markets not just to move. Ideally, we want them to be divergent, and that’s a good environment for trend followers, for example. But you could equally say that when… I think maybe you could say that that’s a good environment for trend followers where there are opportunities but where the portfolio doesn’t get too risky, so to speak. Because I actually think we make a lot of our money, frankly, when there is concentration.

So there are a couple of themes that drive, and you could say the correlation risk might be high, because suddenly, things can change, but as long as that train is running, that’s where we can make a lot of money, like last year where there were just a couple of themes, and so on and so forth. So I think it’s always a balance of how do we manage more dispersed periods of time and how do we manage periods where the portfolio has more conviction? I don’t know that it’s the dispersed periods that are the most profitable, but they may be more low-risk and profitable.

[00:55:05] Mark

Well, you hit on the problem itself. I can make these, especially on a podcast, you can make a broad generalization like, well, we want more dispersion. But then you say, the devil is always in the details. The detail, for example, in terms of why this is important research issue is that obviously the dirty secret for trend following is that, yes, we like to have diversified markets, but we make our most money when correlations are high, when a lot of markets start moving all of the same direction or they’re reacting to the same common theme.

So when you have high correlation across markets, then that usually means that there’s a common factor that’s driving them. So that’s one environment. There you have less diversification, higher correlation, but then you have a common factor, and so you’re trying to exploit that. Other times, you’re saying, I want diversification because I want to have one market going in one direction, another going in a different direction, and they’re not correlated. That’s great.

But sometimes, that doesn’t work because you could have like, “I’m making money in one market, I’m losing money in another,” and it sort of cancels things out. Then there’s also the transition. If I’ve had high correlation or I have high dispersion, that usually doesn’t last. When the dispersion across markets starts to collapse or starts to decline, well, then that’s a period for you know we’ll call it mean reversion or reversals. So that’s a different type of market.

So when I have low dispersion below normal, I expect it to explode out. Well, then that’s a more divergent environment. When I have high dispersion, I expect that that should collapse to the mean, that’s going to be more mean reverting. So correlations could be high across markets. Well, that could be a great environment because if I get it right, I’m going to make a lot of money. But if correlations are low, it could be a different environment.

[00:57:19] Niels

So how do you deal with that, Mark?

[00:57:22] Mark

You’re just going to have to invite me back again so I can give you some answers. That’s why, when we’ve talked about, I spend time on this change point detection, because we say how can we look at different environments and look at what’s the likelihood of different types of changes? So, I think we solved some of it.

[00:57:49] Niels

Okay. So just maybe for my understanding here, are you suggesting that one of the things you guys are trying to do is to kind of determine which periods you want to be a trend follower and which periods you want to be a mean reversion sort of contrarian type?

[00:58:07] Mark

Right. We like to say that there are change points. Those change points could be like a trend environment, or let’s say if there’s no change, then we could say that markets trend because there’s no change so a market in motion will stay in motion. Then there are other periods where markets might get over-extended, so they’re at an extreme, and those will be periods of reversal. So the core problem always we’re trying to work at, I think we’re doing a good job, you always want to do a better job. Can you identify those periods when maybe markets are more at an extreme and so there’s more of a likelihood that there’s a reversal? That doesn’t mean that it’s going to happen with certainty.

I always say, don’t tell me the narrative, tell me the count. So if certain conditions happen, what’s the probability or likelihood that there could be a reversal? What’s the likelihood that it’s going to continue to trend? That’s the overall issue that we’re trying to face and get to.

So for a trend follower, every time you’re looking forward, you’re trying to say for a man with a hammer, he’s always looking for nails. If you’re a trend follower, you’re always looking for trends. If you’re a mean reverting guy, you’re always looking for mean reversion. So in some sense, those are special cases of the more general case of what is a change point. So either a change point exists or it doesn’t exist. So how do we actually measure those periods of whether there’s change or no change?

[00:59:49] Niels

Yeah, we’ll definitely have to continue that another time. That’s a big topic because I think that’s one of the things that, as an industry, we’ve always struggled with. We keep saying to people, well, you need to have a core allocation to trend following because you never know when the trends occur. So trying to predict when to be a trend follower and not to be a trend follower is an interesting topic. I’d love to explore that. I’ve not seen many people be successful at it, but it doesn’t mean that you can’t be. So we need to dig a little bit deeper here, Mark, to find out how we can do these things. So we’ll do that next time you’re on.

[01:00:28] Mark

We’ll tie that into we’ll call it the regime environment. Earlier, we said, well, there are a lot of clouds. So then you might be saying something about in a narrative sense, I’m suggesting that there’s going to be a change in regime. When you think about it, even for all types of hedge fund strategies, most people will look at this as an unconditional forecast.

So I just look at an entire backtest, I sort of see what works, what doesn’t work and then I say then I’ll just apply it to all cases, oversimplifying. But in some sense, the holy grail is to say, what happens if I condition on the environment? Is there things that I could say about what kind of regime I’m in? If I’m in a different regime, do I skew more of my risk to certain types of markets? Do I skew some of my risk to the long side versus the short side?

So now, in some sense, we talked about a lack of imagination. From a quant perspective, it’s not made out of lack of imagination, maybe a lack of data to say I have to have enough regime environments that count. So I can be able to say that yours actually has a meaningful probability of it occurring.

[01:01:53] Niels

That’s actually quite an interesting point you make because I think a lot of strategies that have come, we mentioned multi-strat, right? Multi-strat is incredibly popular with many institutional investors. But let’s be frank, that strategy has never traded in a high interest rate environment before. All the data is from the last 20 years where interest rates were low. There’s probably a few other strategies like that. So this is interesting.

I think trend following has certainly an advantage in the fact that there are managers out there, of course, I work for one of them, that have traded through many different environments because their track records are so long. That’s very unique and I think it’s underappreciated by folks because they just look at the fact that, oh, yeah, when you have a long track, your Sharpe might not be as good as if you only had a five-year track and so on and so forth. Yeah, true. But the fact that you’re in business after 50 years, that should mean something, so to speak. Anyways, lots of good stuff to talk about Mark.

[01:02:57] Mark

I was going to say that a lot of the newer strategies and the new techniques, CS Lewis often talked about chronological snobbery, that the new should always throw out the old. So in some sense, if you’re a seasoned veteran, well, then we’re going to put you on the bench because our chronological snobbery says that the new strategy, the new technique, is the way to go relative to all others.

[01:03:29] Niels

I think we’ve been conditioned of that every quarter or every year when all these new gadgets come out. I mean, iPhone 15 should be better than iPhone 14 you would think, right? But it doesn’t necessarily mean that a one-year-old strategy is better than a 50-year-old strategy, as you rightly point out.

[01:03:50] Mark

As I get older, I’m more acutely aware of chronological snobbery. So with that, probably, that might be a good place to stop.

[01:04:03] Niels

Yes, yes, absolutely. Actually, I want to make just one important announcement because I did mention it last week when Alan was on, because I will be getting a little bit of a break from the weekly conversations on the systematic series because I’m going traveling. So Alan has very kindly said that he will be happy to host the next three weeks while I’m on the road. So I’m sure Alan and our usual amazing co-hosts will be tackling some really interesting topics. Maybe they have completely different opinions about these topics that we’ve been discussing, Mark. We’ll find out in the next few weeks.

Obviously, I hope everyone will tune in as usual and give us your feedback, your comments, rating and reviews as you are so kind to do every single week. So from Mark and me, thanks ever so much for listening. We look forward to being back with you next week, although it will be Alan at the helm. Until next time, take care of yourself and take care of each other.

[01:05:12] 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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