265 Systematic Investor Series ft. Nick Baltas – October 14th, 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] Alan

Welcome back to Top Traders Unplugged, where each week, we take the pulse of the markets from the perspective of a rules-based investor. It’s Alan Dunne here again this week sitting in for Niels while he’s away traveling for this week and next week. Today, I’m joined by Nick Baltas. Nick, how are you?

[00:00:40] Nick

Alan, it’s a pleasure to have you as a host. I’m doing very well. Very, very busy as Q4 is here. But I’m doing well. How are you?

[00:00:48] Alan

I’m good. Great to speak to you and looking forward to speaking to you in this capacity this week. So I’m sure it’s going to be a lot of fun. I think it’s about, what, it must be about a month or so since you were last on with Niels. There’s been plenty going on in markets and you say you’ve been busy. Anything particularly grabbing your attention in markets?

[00:01:09] Nick

Pretty much. Obviously, Q4 is here. It’s a good question where we’re going to head. Towards the year end, I think there’s a bit of a reluctance at the moment. Is it going to be higher for longer? Obviously, we just had the inflation coming out, small upside, but not quite substantial as we were discussing earlier on. So I think it’s more about this reluctance in how we see investors getting towards year end.

We have had some discussions with some that have performed well, and therefore, there’s a bit of reluctance as to whether they should diversify their portfolio or possibly just getting into a bit more of a risk-off mode. We’re kept busy. I would say we’re kept busy with a lot of good requests for obviously trend following, which is our favorite topic, but a range of other strategies and a range of other ideas as to how we can diversify portfolios. But yeah, we’re very busy, very busy, I should say.

[00:02:08] Alan

Good stuff. Well, we’re recording on Thursday, a little bit earlier in the week. So as of the 10th of October, the latest performance stats we have, the SocGen CTA index is down 2.25%, SocGen Trend Index is down 1.73%, and the SocGen Short-Term Traders Index down 41 basis points. So a bit of a reversal from a week ago when all of the indices were up.

Obviously, I think what we’ve seen as we’ve come into October is reversals in fixed income and currencies, and obviously, we’ve had volatility in oil markets and energy markets driven by the geopolitical tensions in the Middle East. But yeah, I would say probably fixed income and currency are the main drivers. Any thoughts on October to date, Nick?

[00:03:01] Nick

It’s been a challenging month for the majority, I would say, of the cross-asset strategies in the more linear front, if you like. So whether we look into trend following, obviously, you gave the stats and we pretty much see the same type of impact here. Whether we’re looking to carry-oriented strategies, there’s also like a reversion here coming from some of the complex as well, as you rightly pointed out. So it’s been relatively volatile. I would say performance-wise, yes, it is quite true. We’ve seen some reversion.

[00:03:33] Alan

Yeah, it’s been a choppy period. Obviously, if you look at the year-to-date numbers, SocGen CTA down 50 basis points, SocGen Trend down 80 basis points, and Short-Traders Index down 2.3%. So it’s been very much a year of performance fluctuating up and down a few percent around zero, I would say. Even with the SocGen CTA Index down 50 basis points, you probably have some managers up 5, down 5. That kind of range will probably capture the majority of manager returns.

But anyway, we have a couple of great topics to jump into today and thanks very much for bringing those with you today. We’re going to kick off by moving a little bit away from trend following as the primary focus to talk about some of the non-trend complementary strategies that you work with in terms of constructing portfolios and I guess how you go about that, how you think about that, and the process for that.

So maybe I’ll hand it over to you in the sense of when you think about constructing a managed futures type portfolio, it’s synonymous with trend, but what’s your thinking in terms of adding non-trend premia or non-trend strategies to an overall portfolio?

[00:04:57] Nick

It’s a good topic and I think we’ve discussed in the past. Also, other speakers in the podcast series, I think they have discussed the topic of trend-plus. I think I’ve made the point whereby the definition of where this plus takes us away from trend or it is acknowledged as a better risk management tool for trend, it’s very vague in my view.

I think we’ve had discussions along the lines of I do trend following and I follow price moves, but hey, if the market goes up so much, should I basically cut my exposure or should I vol scale my signal? All of those features in the design are primarily risk management features in a way that we can debate as to whether they are the trend-plus bit or simply something completely different and therefore we should just look at it as an additional alpha.

Now, whether alpha is purely a risk management engine or a statistically positive return that we add to trend, it’s also to be debated. But in my view, we should be building portfolios, and I’ve been quite vocal about that, in the most prudent risk management way, being very careful about how we distribute risk and how we react to price moves, balancing out cost reactivity, focusing on what is the utility function. Some clients want it to be very defensive, some want it to be much more unconstrained.

So I think balancing out and creating a portfolio that in its totality behaves in line with expectation is key. Now, whether we would move outside to other sources of return, I think it is very important not to cannibalize what we’ve built already, and that’s a very solid trend following system. I’ll give this basic example.

Let’s say we’re talking about carry and we want to allocate into markets that have positive carry, which in our mind, it’s nothing more than the return we could accrue if nothing moves as we roll down or roll up the curves; we roll down the contango curves, we roll up the backward dated curves, and then being positioned in that favor, it is very likely we’re going to go hand in hand with trend in some times and possibly we’re going to go against the trend in some others.

What is important to flag, I think Niels earlier this year was kind of making this comment that I very much agree with. when we design trend following strategies and we look into the historical return, part of what we’re assessing is the ability of the assets to roll up or roll down the curves. So it’s almost as if we’re informing our positioning by the fact that there is a carry component accruing as the time goes by. So would we use that as an additional signal to create directional exposures?

I would debate that possibly we shouldn’t, or I would argue that possibly we shouldn’t. If I look into trend following, I look at it purely as a way to dynamically not time the market necessarily, but dynamically adjust the exposure. Sometimes we’re net long, sometimes we’re net short. We make the supposition that those market moves will continue. But if you somehow capture the first principal component of each and every asset class, again with a cross-sectionality it comes along with it.

Andrew basically talks about a few markets are enough to capture the clusters, and I very much agree with that. Setting aside that, I also believe that broader diversification has value to bring. But going back to my earlier point, if trend does capture those directional moves, then we should add something on top that at best tries to minimize exposure to the beta moves, whether positive or negative.

So I think looking into other sources of return, I can make a pause here in case you have any comment, I think we should be looking into designs of strategies that can provide some differentiated return by capturing higher order moves and not just beta moves. That’s my last sentence and then we can expand further on it.

This year, with trend following doing relatively okay, March was obviously quite a reversion month, now we’re experiencing another one. As you said, the numbers are relatively flat year-to-date for the various indices, actually, even for the short-term, right? Short-term trend.

[00:09:26] Alan

Short-term. Yeah.

[00:09:26] Nick

Yeah, exactly. But in the grand scheme of things, relatively flat-ish. Exactly. Flat-ish, muted performance. We have received some requests from a number of investors saying I love trend following, I now see the value that it brings, I saw it last year performing, what more? When you’re in this kind of environment of not necessarily choppy markets but some sort of a sideways market, what do we do? Can we enhance it further? I think that’s where I want to open up the conversation.

[00:10:00] Alan

Yeah, I think that makes sense. I think that is the typical journey for most CTAs is you have some managers who are absolute purists in terms of trend following and then you have those who say, well, can it be improved a little bit, and not only can it be improved, but can we enhance the investor experience a little bit. So a few questions there just picking up.

Maybe just going back to the first principles, obviously, with trend following, we have a very clear narrative at least, if not understanding, of why trends exist and persist in markets around speeds of adjustments and behavioral biases and economic cycles, etc. So when we move into non-trend strategies, and maybe to talk about carry first and foremost, what’s the rationale for the existence of that premia?

Obviously, the economic or the investment data would support the idea that it is there over time, but how do you think about getting comfortable that it is something that will be persistent and then I guess in terms of the size of that or the magnitude of that premia over time?

[00:11:15] Nick

It’s a good question. So what is driving let’s say carry to your point? One thought before diving a bit deeper into carry, if we think stylistically about asset returns, so asset returns, and that’s a model-free characterization. So asset returns can be decomposed into two components. It’s what we call carry, which is the return we’re getting if nothing changes, and then some spot move. I typically use this basic example. You buy a house, you finance it by getting a mortgage, the price is 100, you get the mortgage, these days you might be paying 5%, you rent it out for 6%.

Over the course of the year, you’re going to make the differential yield between whatever you’re getting out of the rent and whatever you’re going to be paying back, which is the 6% minus 5% equals 1%. That is a risk-free return, but there is some risk to it and the risk that the mark to market of this $100 that the house costs is going to fall to $99 or $98, and so on and so forth. So the question then becomes, if I can get carry if nothing moves, then we can make the argument that in periods that there is no significant price movement, surely, there is some convenience to get out of carry.

Now the question is, what does that represent? Then obviously, if prices do not stay as they are, you end up experiencing some sort of directional moves and that’s when trend comes into play. There’s going to be I think a third episode, not of the podcast but of our discussion, whereby when trends break, what happens, because I guess there’s a transition phase before you end up experiencing carry dynamics again.

So let’s go to carry. I think carry is one of the most well-studied premia. It started from the currency world. Now you’re looking to two different countries, you go for the higher-yielding, New Zealand dollar at 10% and you finance that by the Japanese yen at 1%. You borrow in Japanese yen, you convert into Australian dollars. You make 10%, you have to pay back 1%, happy day is 9%. Well, not necessarily because there has to be a reason why this 10% is there versus the 1% and that is obviously the expected depreciation in the currency.

Now, the question is, is that depreciation big enough, in other words, 9%, to eat up your gains, because that would be I guess the no arbitrage, if you like, situation here. What we find empirically over the years is that this is not the case. Even if there is some depreciation, relative depreciation of the of the higher-yielding currencies, this is not enough to eat up the return. There’s all sorts of ideas and academic studies as to whether this premium is justified from a rational risk-taking perspective.

I would say the quick summary of where this premium comes from is from some conditional exposure of those higher-yielding currencies to global growth shocks, extreme downside equity events, and therefore, broader welfare risk materializing is the one that can drive those returns negative. So this is the first point and this is how at least in the literature FX carry is understood.

There are also some interesting other studies. By the way, it’s a long time since I looked into those, but there is a nice study I believe in the Journal of Finance talking about how FX carry can be thought as the difference between commodity-producing versus commodity-consuming countries. Ultimately, this becomes really a dynamic between two types of countries. I think the paper is called something like the tale of two countries or something like that. So they use commodities to try to give reasoning to FX carry.

Now, if you take this idea in other markets, and by the way, all I’ve discussed here is not a univariate strategy. I’m not saying that this is a positive yield, I’m going to buy and that’s a negative, I’m going to sell. It’s a relative ranking. So implicit in the construction, there is some ranking. Implicit in the construction, if we take all currencies say against the dollar, we can build a cross-sectional portfolio to minimize the dollar moves or the exposure. So really get out of the dollar that, frankly speaking, when we do trend following, it’s possibly the dominant driver of the currency universe.

So thinking outside of currencies in rates, I think carry is a well-understood concept. Obviously, we have futures curves. We can look into carry as effectively the roll down of the curve, higher-yielding bonds versus lower-yielding bonds, and whether that is reflecting some macro risk or not and whether the difference in the yields if nothing moves will of course accrue a return. Again, we can look at it I think in rates. People have looked at it both as a univariate as well as a cross-sectional premium.

So I think the challenge that trend followers have faced for years and years up until last year came was that, yeah, most of the performance has come from the fact that you go long bonds and guess what, by going long bonds, you benefit both from the positive carry as well as the defensiveness when yields are falling when a flight to safety occurs. That’s kind of the narrative. But obviously, last year was very different because everything was going down or the yields were going up and you could still perform from a trend following perspective.

Our view is that, setting that aside, is the differential yield that we can harvest often trying to minimize spot moves. Spot moves here, we’re talking about more like global yields, if that term exists. I think we can spend a bit more time thinking how we also measure carry in the presence of inflation, for example, because inflation, in my view, can create spot movements above and beyond investor activity, and we see it these days.

The only thing we’re spending our days over the last two years is whether the central banks are going to hike or not, which is a forced spot move, right? So we possibly would have to take that into account, and I think we have ideas as to how we should be doing it.

[00:17:29] Alan

Obviously, I guess one of the interesting features of carry is, in terms of its correlation profile vis-à-vis trend following, obviously, they tend to be uncorrelated I would say generally. I suppose intuitively, you would say trend following is more of a dislocation type of strategy, whereas carry is more of a convergence strategy, so a kind of natural complements from that perspective.

I guess where the purists and the non-purists might diverge is in terms of what’s your perspective on adding that to trend and does that then blunt some of those nice risk management statistical properties of trend following in terms of the skew and convexity and is it a matter of not going overboard on the carry. How do you think about that?

[00:18:23] Nick

That’s a very good point. Happy to also discuss later how we also think about commodities, for example, in the context of carry. But to answer your question, I think it’s an important question. Once we look into adding carry together with trend, and by the way, I view carry not necessarily as a convergent premium, even though mechanically it works this way. I kind of think of it as nothing really happens, and therefore, my futures kind of roll into my spot.

Whereas if I think about a reversion, I bring more of a value concept here that I’ve been trying to identify markets that can be possibly oversold or that have fallen in price or are possibly cheap in the cross-section and then I can form a reversion portfolio, which by the way, we can even go to because I think that’s another interesting source of return. But you’re very right in saying, listen, if I add carry in my trend, clearly, I’m diluting its ability to be defensive.

So one of the nice studies we’ve actually looked at is how the various strategies perform across vol regimes or across volatility changes. By the way, that’s a subtle difference, but I think it’s very important. Transitioning into a high vol regime is a different market dynamic versus being in a high vol regime. It’s not necessarily the case that something that is performing the transition phase performs while you’re in the high volatility regime, or possibly the need to transition down to a lower vol regime.

So we’ve done some interesting analysis and obviously no news to anyone in this podcast series, trend has this convex profile and the more defensive the implementation is, the more performance you get when the vol is spiking but also when it stays high, because by staying high, volatility creates those clusters and those clusters make the price movements more persistent on the downside. So that’s kind of the convexity we know of. When you think about carry, whether cross-sectional or more like time series implementation, it does embed some procyclicality.

So yes, it does not necessarily perform when you observe a high vol spike or you remain in a high vol regime, but it delivers some sort of good return in all other periods. So if we take trend in the years between 2010 and 2020, that’s exactly when carry was going to perform really, really well. This year as well, specifically coming from the FX complex, it’s been a very strong year from a carry standpoint. Commodities too delivered some good performance over the year on the carry front. So it can be seen as a complement and this complement comes at different regimes.

So if you go back to my original point, when we see low volatility and whipsaw markets, well, that’s when you see the curves kind of rolling down to the spot. Even if trend doesn’t perform, then you get the carry engine supporting with some return. When the markets turn, trend takes turn into it. Obviously, you have to make sure you don’t lose too much on carry. So importantly, what I’m trying to say is that you should not obviously add in a highly negatively correlated strategy to trend because then you kind of net everything out.

I think by forcing our constructions to be more cross-sectional versus more directional between the two, we minimize, to the extent possible, the correlation between the two. One is purely spot-driven, the other one is spot-immune in a way. The way we then define the combination between the two or more strategies is that we look at it from a defensive angle.

When we look into defensive angle, we would typically define some stress environments either theoretically or empirically, and we say, well, I really want to get some defensiveness when the market is going down by X percent or I want to have some hit ratio and I want to be reliable when I’m supposed to be delivering some defensiveness. Now, obviously, this comes at a cost, and that cost can be mitigated by adding carry.

So I guess if you think about it mentally, you start building some sort of efficient frontier now that somehow balances out defensiveness for carry or delivers less of a carry bleed for a defensive solution. So where now we draw the line and we say we want this portfolio versus the other portfolio, I think the beauty is that we’re in an efficient frontier now. So it’s just a matter of a utility function.

[00:22:53] Alan

That’s something I wanted to ask you. You used the term utility function, which I guess if you asked somebody on the street what’s a utility function, they wouldn’t know what you’re talking about. We kind of have a sense what it means. But practically, how do you go from the label utility function to saying exactly what it is? I guess it is, as you say, by mapping different combinations of allocations and showing the impact on different performance stats. Is that it?

[00:23:22] Nick

So a utility function, and I use the term utility function, all I’m trying to say is that a combination of characteristics that align with an objective. So when we look into investments and we speak to asset owners and asset managers, we typically discuss a problem, an investment problem, and we try to find a solution for it. So they say, well, I want to protect my portfolio and I’m worried about equity downturns or I’m worried about inflation spiking and so on and so forth.

I think you asked the right question here because one of the toughest, and I’m not saying that in bad faith, but the toughest in terms of the process discussions that we have with clients is to walk through and work through the determination of a utility function into tangible numbers. Because if you say I want something defensive, then I can ask you, defensive versus what? Then you might say, equities. What do you mean then defensive? You want something perform when? Well, when equities fall. By how much? Then you say like 10%? I’ll tell you, okay, over what period? Yeah, good point, like in over two months.

So then somehow, we tried to contextualize those stress environments together with our investors or clients and then try to work around those stress scenarios by quantifying statistically the abilities of trend following or carry or volatility carry or commodity carry, or whatever that might be the instrument that we try to solve that utility function with, and create portfolios that balance out trade-offs. It’s all about trade-offs. Everything we do is about trade-offs. So recognition of the trade-offs, acknowledgement, and then working through is the recipe that we typically try to operate under.

[00:25:09] Alan

I suppose the elements that you’re trying to trade off between, is that fair to say? Intuitively, it’s kind of consistency of return versus uncorrelation to equities and crisis alpha presumably. Are you measuring Sharpe or are you measuring compound growth versus max drawdown or length of drawdown? How would you define the variables?

[00:25:37] Nick

I’m quite skeptical about generally long-term measures. So when you talk about Sharpe ratio, ultimately, it’s a starting point, an endpoint, a trajectory through that. If I take a put option between 2020 and 2021, it would look like an amazingly positively Sharpe ratio. But I’m just blindfolded by the fact that it just did this massive jump and then that was about it.

By the way, it ended up kind of giving a lot back after the March 2020 crash. But point-to-point and Sharpe ratios and long-term average returns, specifically when the objective is not just maximum Sharpe, but it is more about defensive profiles or more uncorrelated profiles. I would shy away from Sharpe ratios, drawdowns because there’s so much path dependency. What I’m trying to look into is specific scenarios which are shorter-term in nature because that allows us to improve our econometric understanding or statistical understanding.

So for example, we’ll say let’s find the worst 10% or 20% or 30% of the market you’re supposed to be hedging against on a weekly basis or on a three-day basis or on a bi-weekly basis, but not longer. Because the more you add, the more smoothing you add in your assessment. then I say, okay, if I want to build something, how does it perform in those regimes? So that’s more like a conditional analysis. the flip side is, well, if I maintain that portfolio in good times, how much do I have to “pay” for it?

Obviously, if it’s a positive Sharpe ratio strategy over the longer term, which again, I’m not necessarily a fan of just looking at that number, well, you don’t even have to pay for it. I think the problem is this I tend to say the search for the unicorn. I want the hedge, I just got to do well every time. No, I’m sorry, it doesn’t really work this way because there’s always a price associated with some hedging activity. So the question is, how do you balance that out? Then it becomes like that’s the frontier now.

By combining different sources, you don’t want to negate what you already hold. You want to diversify from it without destroying it in the first place. So you might say let’s do anti-trend. Well, I put them together, zero. So we don’t want to do that. So there’s a fine limitation as to how diversifying your portfolio can get, and not just on the opposite front.

[00:28:11] Alan

Maybe talking about implementation for a little bit, obviously, there are indices out there I believe on say currency, carry indices. I think from memory at a JP Morgan or some of the other banks publish the current security indices on Bloomberg. So it kind of intuitively seems very easy. You take 10 currencies, you short the same three lower ceiling, invest in the three higher ceiling, and then presumably, you look across the commodity space and you’re long where you’re getting the positive carry versus the negative carry, etc.

In terms of implementation, I’m sure you can do better than that simple approach. What would you say are the obvious things to look at in terms of going beyond the very naive kind of carry into more nuanced, sophisticated approaches to implementing a carry strategy?

[00:29:09] Nick

I’m a fan of as possibly now a lot of people should know by listening to what I say every month or so, I’m a fan of good risk management. So if there’s one thing, I would not necessarily vouch for like top three, bottom three. I would vouch for top half, bottom half as a starting point. I think there is some value bringing everything in place, but bringing everything in place with some reasoning around dollar and risk allocation among them. So when we start with this top three, bottom three, based on some measure, even that measure, I would challenge the premise. Is it comparable across?

So like carry is the expected return, but that comes at some vol, which is the vol of the spot. So in principle, we should just take the ratio between the two and have it more like an expected Sharpe ratio in a way, which is not different to what we’re doing in trend following for example saying hey, this is some sort of historical return but I want to put it in the context of its own volatility that becomes like a risk budget, for example.

So I’m a fan of, or if you like, I vouch for finding a way to create measures in a unified setting, effectively unitless that we can compare across. I am a fan of allocating risks versus allocating dollars. So as opposed to saying I’m going to go long those markets, I’m going to go short those markets on $100, $100, I’d rather have 100 units of risk long, 100 units of risk short, and then allocate across.

The other point which I think is also both philosophical but equally important when we look into this complementarity with trend following, and that was the point we made in the very beginning, there is some spot movement that sometimes goes in favor, sometimes goes against you when you hold the cross-sectional carry portfolio. Reality is I don’t want to be exposed to it because I have that from trend. I don’t want to be net positive dollar, short dollar or whatever that might be the case.

These are details that we would have to spend some time in the portfolio construction. So just to give a few hints on that one, one possibility is that we try to control some overall beta or some overall net exposure to a market we want to avoid being exposed to. So that’s one possibility.

[00:31:34] Alan

So if the Aussie dollar had a high equity beta…

[00:31:38] Nick

Precisely. So let’s reduce the overall beta of the portfolio. Is that to equities, like global equities, could there be some sort of growth shock, could that be GDP numbers? Again, different implementations would make sense, but I think it’s the philosophy that I’m more in favor of. The other thing is the estimation of carry itself in my view should be quite immune to spot moves. To make a measure less exposed to spot moves, we have to recognize what could be spot moving the market that is in a way quasi predictable. I think I made the point on inflation for example in interest rate markets.

So if inflation is very much elevated and real yields are where they’ve been completely in opposite terms of what we have seen the last 30 years, possibly we should account for inflation in one way or the other and penalize some of our signals before even looking into portfolios. I’ll give another example. Let’s talk about commodities. That’s a space I’ve been spending my last one year. It’s a fascinating world. The more I get engaged with it, the more I get to know about commodities. Some of the markets, by the nature of the fact that at the end of the day, there’s a physical good that is bought and sold and producers are hedging and so on and so forth, you have seasonality patterns.

So for example, natural gas, as an example, is one of the most seasonal commodities because guess what, winter comes, there is demand, we don’t want to feel cold at home, so there is some need which is anticipated, and therefore, you can see the seasonality in the futures curves pretty obviously. Or you look into agriculture and how the supply and demand play out around the harvest season.

So there are points across, as we say, the curve or I guess in the future that the various players, specifically producers, are trying to hedge out. That creates, if you like, those seasonal patterns, but it’s not something extremely important. The seasonal patterns are effectively predictions for spot moves. So the fact that you see a hump in the curve is not necessarily an indication that you can roll down that curve and you would short that market because it’s kind of upward sloping, and therefore, it’s like in local contango. What happens is the exact opposite.

As soon as you get closer to that period, the price is going to go up. So the spot is going to move. But let’s remember, futures prices are effectively the risk-neutral expectation of the spot move effectively. So if there are points of the curve that we feel that are pricing in a spot move, I’d rather not have that measure in my carry estimation because I’m going to do the exact opposite. I’m going to be shorting a market that is expected to go up in a way.

So once we look into some of those markets, there’s a lot of work that we need to do to reduce the impact of seasonality in the way that we estimate carry.

So back to my point, it’s not just the construction and how we cross-sectionally put stuff together, it’s also how we think about the measures themselves. Do they make sense to start off? Can we immunize them to spot moves to the best of our capacity?

[00:34:53] Alan

Yeah. From that perspective, you touched on inflation. If you were a discretionary trader and just thinking about where’s the value from a carry perspective, you might look at say US rates, which are I would say 5.5%. UK rates are maybe a little bit below, but not that far away and then Kiwi rates are in the same broad area. They might be a little bit higher. I can’t remember offhand. But three currencies there, similarly 4.5%, 5%, 6% rates.

If you were to just go with mechanically the best one, you could go all in on the Kiwi dollar. Is there a more sophisticated way? Obviously, you are touching on some of the things in terms of controlling for beta, looking at the future spot moves, etc. But is really yields part of the solution there of looking at inflation?

[00:35:53] Nick

I think at the end, it becomes a balance between how much of the nominal yield if you want and how much of the real yield, obviously accounting for the roll down during the curve. So it’s almost like a pendulum between the two and how much attention one should pay on the real yield versus the nominal yield. You just hit the nail on the head. That’s precisely how we look at it.

[00:36:23] Alan

We’ve talked a lot about carry already. I know we want to talk a little bit more about commodities but also other non-trend strategies that you typically hear in the space. I mean, there’s a whole suite of quant macro, but reversion is another one. You don’t hear of a lot of dedicated reversion managers out there, so it’s obviously something that’s quite difficult to do. How do you think about reversion strategies in the context of a diversified futures strategies portfolio?

[00:36:54] Nick

This is one of the more interesting ones because when we talk about trend, we say, is the market getting into a concentrated position? It has accrued some positive returns, we crystallize the gains and so on and so forth. Is it going to revert back? Even the terminology we use implicitly or explicitly states that, hey, let’s be worried about reversions.

Now, the problem is if we start looking into reversions in the same way as we’re looking through trend, I guess we get in a loophole because we say I’m going to follow negative one-month trend and positive six-month trend, but the six-month is incorporating the one-month, so do I forget about the one month? So the whole thing becomes so complex, but in itself, I don’t think there is true value in trying to capture trend reversions on a directional basis.

So when the markets go up let’s say in equities, we go net long equities in trend following. When commodities are falling, we go net short commodities. But if there is one, I think if there is one, I guess, turning point that it’s extremely, extremely hard to predict both statistically and empirically, it’s a reversion of beta markets. If I knew when equities are going to go down, guess what? I wouldn’t even care about building a strategy that’s doing reversion in trend following. I would just go short the market at the right time.

So there is a significant challenge. I guess the build-out of trends is easier to capture but the reversion, which is typically more systemic, so like principal components tend to revert, it’s harder. Therefore, the way we think about reversion, and that goes back to this discussion about value and how this whole thing started from back in the ’70s and the ’80s with single stocks and buying value and combining it with momentum, obviously, momentum in equities is more like sectional, blah, blah, blah, blah, blah. But the context of cross-sectional reversion is basically where we try to get to.

So even if trends tend to break, what I’m trying to spend a bit more of my time on is on the cross-sectional reversions. In other words, markets that sold off recover and markets that spiked up moderate. And then look again into this construction from the same lens as we do for carry. So let’s minimize the spot moves. Let’s not be exposed to the spot moves because guess what? You do get the spot moves purely from your trend followers.

So in that context, then the problem becomes that you know if we think of it as value, well, go define value in commodities to start off. Possibly we can make an argument about real yields in FX, possibly we can make an argument about, sorry, real yields in rates. We can make an argument about purchasing power for currencies. We just wanted to make it a bit more unified across markets. By trying to obstruct yourself from fundamental value, all you’re left with is price.

[00:40:14] Alan

So what you’re saying is that they get more looking at deviations on a relative basis that look incorrect. Is that it?

[00:40:22] Nick

Precisely. If you think about AQR, that was like I think Tby Moskovitz and Lasse Heje Pedersen and Cliff Asness, I think it’s those three, that’s like one of the more classical cross-asset papers back in 2013, 2012, 10 years ago, this value momentum everywhere. So they take the value concept and they say, you know what? I am going to do value across the classes, but guess what? I have this problem. How do I define it?

So then they go about, they make an interesting transition between how single stocks operate and how we can learn from that and move away from single stocks, and they basically show that five-year moves go hand in hand with the value premium in stocks. In other words, if something is cheap today, it is very likely that it has fallen in price over the last five years. So the classical single stock long-term reversion, it’s very much related to value.

By the way, I think there was another report, another paper, a few years later that looks into single stocks. They basically ask the questio (I’m just simplifying here a bit for the benefit of our conversation), they say, when does a stock become cheap? Is it when the price falls or the book value goes up? By the way, I’m not claiming that today, we should be looking into book-to-price ratios, but for the sake of our discussion. So is the price falling or the book value going up? Which of the two is driving the ratio? What they find is about 85 of the cross-sectional variation, 85%. So the largest reason, the biggest reason why single stocks get reshuffled between expensive and cheap is because the price is moving. It’s not that the accounting value is moving.

So there’s a nice fundamental link here or empirical link that cheap and expensive in a way reflects some long-term price movement. Cliff Asness and Toby and Lasse, well, then they say, take that as an example, the connection of value to long-term moves, let’s go outside of single stocks, and use long-term moves to capture valuation. So let’s buy all the commodities at their spot price fell over the last five years.

So to your point, trying to find a reversion dynamic. Now, this, we can debate as to whether it has played out quite well from a design standpoint and from a design of reversion strategy. We tend to think outside of that but in a similar mindset. There is some work that we did and have discussed, I believe, the first time that I was here last November. I think Rob was together with Niels, and Rob told me, can you just speak to us about this paper you did on skewness? So this is now very much related because realize skewnes (so this is for the people in the audience not very much into such statistical measures), skewness is a statistical measure that tells you how aggressive bad events have been if negative, or how aggressive positive events have been historically.

So let’s say a lottery ticket is typically a positively skewed strategy because you end up paying a penny a penny, a penny, a penny a penny, and there comes a time that you make a million. Whereas let’s say volatility carry, when you sell vol, you’re getting the premium from insuring whoever is holding the put option for the downside, but then when the market gets into a crash mode, you have to pay. So then you have negative skewness because you do get on average a small positive return, but you crash.

Now, if you think about that, I guess, overactivity on selling off or spiking up, then we have another price-based measure using historical returns that can allow us to rank assets by that and say, well, let’s look into commodities. Which of my commodities over the last one year experienced the most negative skewness shocks? I’m going to bet on the recovery. What has been in that context of relative ranking the most positively skewed or least negatively skewed, and then I’m going to go short those markets to finance this relative value trade.

So again, some sort of a balance between the longs and the shorts to minimize the spot contribution but now playing a reversion premium. This is very much complementary to carry, for example, because this is purely a spot-driven premium. It’s not a trend premium because whatever had this massive shock is going to revert back in whichever direction. There are some nuances there but that’s the principal idea how we can go from the premise of fundamental value down to price movements, down to extreme movements above and beyond let’s say normal distribution and standard deviation movements.

[00:45:36] Alan

But reversion strategies in general will be heavily negatively skewed. Isn’t that fair to say? Would you see it that way? No? I mean, the point would be, obviously, you’re standing in the way of the trend, so most of the time, you might get it right on a short-term basis, but periodically, you’ll get run over. What would be the perception? Is that now fair to say?

[00:45:37] Nick

No, that’s a good question, and it is not the case because what we end up doing is that we are building a strategy that is looking to go long and short half and half of the cross section. So for that to realize negative skewness, it would mean, and that’s the risk to it, that the markets we bought that are those that realize the most negative skew will keep on selling off. It’s almost like an excessive value trap in a way, if you think about it this way. But it’s not, and I think it’s important. That was actually a question we had when we sent the paper for publication. Does the strategy realize negative skew?

So we had I think a table that shows that the skewness of the strategy itself is zero, but the selection is done on that basis. I think that’s the important dynamic. But then I think that complementarity then becomes quite nice because if you do trend following, you look back a year and you say, well, the average return was positive. Okay, let’s buy. So you ignore what happens pretty much in the distribution of returns because you kind of care about the middle of it.

All I’m saying now is forget about the mean, look into the deviations from the mean because that’s how an outlier is identified, I’m so far away to what I typically do, and then use that to quantify your trading signal. So we’re using the same information in a way but we’re looking to very different points. Instead of looking at the average behavior, we look at the excessive behavior in excess of the mean. I think that’s a nice complement if we try to think how we use the same information in different ways to be positioned for a strategy.

[00:47:48] Alan

I know you wanted to talk a little bit about commodities and some specific strategies. We’ve already touched on some of them.

[00:47:58] Nick

I think we can continue I guess in the same mindset, because for example, what I’ve been discussing, the reversion is primarily decided from commodities, the skewness dynamic and then we did this work of extending it across the classes. In commodities, it’s also one of the stronger premia out there. Of course, you might ask me why skewness is there. Why should it be compensated from being exposed to those skew dynamics?

I think there’s a number of ways we can justify it, and that is also covered well in the literature. You can think about the excessive demand for assets that behave like lottery tickets. I want to buy the next asset that is going to skyrocket, but surely you do, all of us do.

[00:48:46] Alan

Overpriced relative to their fair value.

[00:48:48] Nick

Exactly right. Equally, you know what? I just want to be out of this thing that historically, by the way, two or three or four months back crashed more than anything else. I’m just going to get out. This is just pure risk aversion. So that’s one idea, this idea of excess demand or excess supply above and beyond the justified one for markets that exhibit excess tail dynamics, number one. Number two, and that’s by the way in the context of behavioral finance, it’s a bit more of an irrational behavior.

In principle, we should look into the stats and all behave like rational human beings and we have this agent or the invisible hand that is distributing wealth, da, da, da, da. But this is going against that premise if we’re following mean variance principles. There is also another way justifying skewness or reversion and that goes more hand in hand with the cumulative prospect theory, the classic Kahneman and Tversky Nobel Prize winning theory about utility functions being concave on gains and convex on losses.

In other words, if you give me a dollar, you will make me less happy versus how sad I’m going to be if you take a dollar out of me. It’s the same amount that we exchange, but the pleasure I feel from receiving it is much less than the pain I feel if I give it, and that creates incentives. If all of us behave this way, it creates incentives that we tend to exaggerate skewness dynamics. Whatever sells off, we don’t want to hold it, and then whatever spikes up, we want.

The last thing I would say which I think is primarily documented in commodities is the so-called selective hedging. What does that mean? If you’re a risk manager, what’s your prime focus? I want to minimize risk. Okay, fine. So let’s say I’m a producer and I don’t want the price to fall. So what am I doing to hedge it out? Well, I’m selling futures. So if the price does fall, at least I’m hedged.

Now, imagine this, if you calculate how much of a short position you want to have, one principle says I’m going to have as much as I need to minimize the overall vol of my portfolio. But this ignores completely higher order dynamics, what we said or ability for markets to spike up or spike down. Imagine what you want to hedge typically exhibits spikes up.

What’s your incentive now? You say, well, I want to short the futures, but guess what? I’m going to moderate my hedging demand, I’m going to reduce the amount of the futures I’m going to short because I’m really worried it’s going to spike up and then the short is going to kill me. So selective hedging is all about, and by the way, a consumer would act in the exact opposite way. A consumer would consume, I don’t know. Oil, airline company, they will want to hedge out, they want to buy the futures, but if this thing is tanking, they will not allocate too much into it as volatility minimization would suggest. In other words, when we try to hedge out, those low-frequency but extreme events become part of our decision-making.

Therefore, you create those excess demand and supply for negatively and positively skewed assets, and that’s why in commodities, you typically observe those dynamics as being quite substantial. The commodity variation of this skewness, for example, premium, it has had a very good year. I’m just looking at some numbers, something like 7% for a 10 vol year to date.

[00:52:49] Alan

Okay. Just listening to you there, it strikes me, is the skewness premium quite similar to the carry premium in that sense?

[00:52:59] Nick

That’s a very good question. Yeah, that’s a very good question. I guess the point is, if something is selling off, does it also at the same time rank itself as a good carry opportunity?

[00:53:10] Alan

Yeah, I was thinking more from the perspective of if an asset has that propensity for periodic sell-offs and people may not want to hold it so the return from holding it has to be higher to induce people to hold the asset. Equally, for something like nat gas, the futures reflect the fact that it will have periodic shortages. So therein lies the contango and the benefit from being short on an ongoing basis.

[00:53:38] Nick

You’re very right in pointing that out. We look at it statistically. I think the only place that you see some connection between carry and reversion, in this regard, is in the currency markets and less so in commodities. So they’re not completely different, but the overall correlation over the years has been fluctuating around zero partly because both are trying to minimize the spot contributions in this cross-sectionality.

So the occasional correlation that can go up to 20% or 30% is primarily driven by some excessive moves that are equally captured by both. But for example, in equities, defining carry is to be debated. But this skewness dynamic, it’s much more straightforward because it’s purely driven by the short-term distribution. So there are similarities but also differences. But it’s a very good point. You actually got it right. Absolutely.

[00:54:31] Alan

Good stuff. I’m just conscious of time and I’m just conscious that I wanted to touch on paper by Howard Marks. His latest newsletter is out called, I think it’s called more thoughts on sea change, Further Thoughts on Sea Change. He wrote a paper or an investment letter a while ago you’re talking about sea change. The idea of sea change is basically that we’ve moved into a very different investing environment now versus the 2009 to 2019 period, and obviously very evident in the rates market.

The upshot of all of this is potentially strategies that that didn’t work in that period may not work and strategies that worked in that period may now work. I’m getting my words mixed up here, but you get the general idea. How does that apply to all of these do you think in the sense that obviously, we’ve made this comment in relation to trend following because in the 2010s, given that macro environment, we had less directional movement in markets and now we’re starting to see more directional movement in market?.

But from the perspective of carry and skewness reversion strategies, how would you see this very changed environment? Is that positive or negative for them?

[00:55:49] Nick

Good question. I think the straight answer is that I haven’t carefully thought that through in the sense that, in my view, looking into those sea change dynamics and the significant regime shift, I think the primer, I guess the dominant impact will be on beta markets, in a way. So I think part of the reason why we all believe that trend following starts becoming an essential component for any asset allocator is primarily driven by its ability to be opportunistic as Katie says. Whether the markets will go up or down, trend will pick it up.

I think that’s also what Andrew is very vocal about and we’ve discussed at length. So it is an interesting transition from the perspective of how we see alternative instruments bringing value to asset allocation. I think it is raising the question of whether asset allocation should be more dynamic per se. I’ve discussed with Niels quite at length I think possibly last time or the one before, I cannot recall now, as to whether we should be looking into inflation and growth dynamics and be a bit more responsive to those shifts we’ve seen.

I think over the last year and a half, we’ve seen the growth inflation mix changing three times or four times depending on your measures, which is possibly however many times we saw this mix changing over the last 30 years up until that point. So the very dramatic shift in how the economic regime changes, I think it has implications for asset allocation, and those implications I think go beyond just being dynamic. I think last year was a prime example. However dynamic you were, everything was falling in a way. So guess how you can make returns. By shorting stuff. So by shorting stuff, we have to go to alternatives.

In my view, the primary impact is for directional moves, and therefore, trend has a place in it. Now, the question is, and I think it’s a good debate or good food for thought, if cross-sectionally designed carry strategies or cross-sectionally designed reversion strategies maintain their alpha principle to complement trend when trend does not work. I’ll give you an example, reversion for example pretty much mechanically, when you see some volatility movement, it is typically systemic and there is no cross-sectional reversion dynamics. The strategy doesn’t do much, possibly, statistically, it falls. But high significant spike move in vol, it’s also similar simultaneously occurring with dispersion.

So there’s more cross-sectionality that you can come out of a universe following a vol move. Because that cross-sectionality is not creating opportunities, you end up having reversion. So one of the things that we’ve seen is that the reversion helps not in a vol transitioning phase but in a vol stable phase, but not stable being low, but not changing.

Even if your vol is high, it’s the recycling phase that you go through, the trend reversion, trend started performing, and then you end up having this kind of cross-sectionally. So there’s a mechanical element here, which is net of beta because I think the sea change is about the betas or about the directions of moves and possibly about the relationships of the moves. So equities and bonds will become more positively correlated. That’s the story we keep on discussing over the last six, seven months or whatever. So I think it’s the behavior of the beta moves and the correlation among them.

So in my view, yes, trend, we are here, definitely biased. It’s here to address those concerns. But at the same time, I think those cross-sectional alpha components are here to bring complementarity. If there is one thing that we think quite carefully about and that’s in the commodity space, in the commodity carry space, I think that’s one worth commenting upon. One of the interesting ways of harvesting carry in commodities is by, as we tend to say, we roll our exposure on a bunch of commodities outside of the curve and then we short the front. Because what we’re basically capturing is the historical contango dynamics and the steepness in the curve on the front.

Now, this construction, specifically if it is done on, as we said, a dollar neutral basis, I’m going 100 long on the back, 100 short on the front, because the front is more volatile, you end up being net short the market. Historically, that was a very interesting defensive complement for asset allocators. Why? Because if commodities are procyclical and equities go down and commodities go down at the same time we have a growth shock, then this construction that is harvesting yield at good times, it is also defensive by shorting the front.

So you have something like a small unicorn here, like a good defensive for equities, and at the same time, a good carry opportunity, except when you see significant backwardation and when you see equity movements that go down, that go hand in hand with an inflation shock and prices spiking. Last year was a challenging period initially, in the early days of the year. It was a challenging period for some of those curve strategies precisely because of the commodity rally.

Over the recent days, obviously, we’ve seen the geopolitics as you said in the beginning creating some sort of tension and significant energy moves that has been impacting those structures. So to conclude here and touch upon the point you made, if we see those inflation dynamics being more prevalent, we would have to think through how some of those implementations, that historically have delivered defensiveness, add good carry from the commodity landscape to some that becomes a bit more dynamic and possibly tries to address this implicit slash explicit defensive exposure being mitigated as a function of inflation dynamics.

So these are some of the ideas that I believe might make some of those strategies better or worse or I guess irrelevant on a going forward basis, but we put some thought into it. So that’s a strategy for example that we put some thought into it, how we can make the strategy from being short time spreads to being more dynamic about it.

[01:02:27] Alan

Well, looks like we’re out of time, but that’s been very interesting and great to get that kind of deep dive into your thinking around all things non-trend and all these strategies that then can potentially be complementary to trend following. So thanks very much for coming on today, Nick.

From all of us here at Top Traders Unplugged, I’m back again next week for my final week in the chair. I’ll be talking to Rob next week, so stay tuned and talk to you again soon.

[01:03:00] Ending

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