270 Systematic Investor Series ft. Alan Dunne – November 18th, 2023

[00:00:00] Intro

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

[00:00:23] Niels

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

[00:00:38] Alan

I’m good, Niels. Good to be back. All good here. Nice, sunny winter this morning. But yeah, looking forward to speaking today.

[00:00:45] Niels

I’m envious when you say sunny. I don’t think I’ve seen the sun for weeks now. It has been the wettest autumn I can remember in the countries that I’ve been in for the last couple of months. But anyway, maybe Dublin’s taking over as the sunny place in Europe, which would be unusual.

[00:01:03] Alan

It’s been pretty wet here as well but now the sun is shining this morning.

[00:01:08] Niels

Good to hear. Anyway, it’s an interesting lineup I think of topics, very broad-based. We’re going to tackle a few different things from macro to trend, CTA, and so on and so forth. Before we do that, not necessarily from what we’re going to talk about today, but is there anything in particular that’s been on your radar recently? It’s been a while since you and I spoke.

[00:01:31] Alan

Yeah, obviously, it’s been another interesting week in terms of bond moves this week. We had the CPI number on earlier this week which obviously shows the declining inflation trend. I was surprised at the magnitude of the reaction when I checked the number and I saw the movement. I had to check it a few times to see had I missed something.

But certainly, there is no doubt that the inflation numbers are showing more evidence of the declining inflation trend, possibly because the most recent speech from Powell was maybe a touch on the hawkish side, so maybe people at positioned that way a little bit. I don’t know what the whisper number was for CPI, but certainly, even particularly from the FX perspective, I think the euro was up to big figures, which is a big move. Yields, obviously, big moves. Equities.

Certainly, I would say the number was consistent with the view of no move from the Fed in December, but certainly, the size of the market moves were exaggerated. I don’t know if that was positioning coming into the event or the release, or big stops or something like that, but certainly, that was a surprise.

We have had some other reasons for optimism I guess outside of that with the Biden-Xi meeting which I guess is a step in the right direction. But you might question how much substance there is or how much things will really change. But certainly an interesting week, and yeah, as I said, that was the most noteworthy aspect from my perspective.

[00:03:15] Niels

Yeah. Now, I want to do something a little bit unusual, because obviously, generally, we’re not that concerned about numbers and fundamental information. But I have to say, when that number came out, I looked at my Twitter feed and there were suddenly a lot of people talking about, well, this number looks dodgy. So let me just dive into some of the things that I came across that I just found was interesting.

Well, first of all, I would say timing. Timing of this number in itself was also a little bit interesting because as you probably know, the week before, we pretty much had a failed 30-year auction. So that had also put a lot of pressure and I think you’re right in terms of positioning played a role.

I think people got scared the week before with how the auction went. But then when I start paying attention to what people are writing about these numbers, one guy, well, not just one, but lots of people were focusing on this, the fact that the (and I’m just quoting from one of these tweets), according to the magic government CPI math, your health insurance went down 34% in the last year. Oh, and by the way, they gave it only a 0.5 to 5% weight in the CPI basket.

But what I can say is that here in Switzerland, it did not go down 34%. In fact, it probably didn’t go down at all. It probably rose I would say. So that’s kind of interesting. Also, there were people picking out the weights of how they do the CPI number saying well, actually, they weight fresh vegetables higher than health insurance, meaning we, officially, are spending more money on fresh vegetables than we are on health insurance. I’m not so sure.

Also, we spend, apparently according to this CPI basket, we’re spending almost twice the amount on alcohol than we do on health insurance. Interesting stuff, I think, just in terms of how it all was put together. When you look at a chart, someone was posting a chart of the US inflation health insurance year over year (this goes back like 10, 20, 15 years), and you see it bouncing plus/minus, I would say, 10%. But then suddenly, it goes from up 30% a year ago or so and now it’s down 35%. So interesting to say the least.

Personally, I do think the timing of it is a little bit suspicious, frankly, after that. You mentioned that sentiment has changed. I saw one guy tweeting out that now futures show a 0% chance of additional rate hikes with cuts beginning in May of 2024. Prior to the CPI report, there was a 30% chance of at least one more hike ahead of us. So that’s an interesting little thing as well.

Of course, last week, Fed chairman said that he was not confident that they had done enough work. Then you had people like the Fed whisper guy, Nick Timiraos, coming out saying the big question will be how they’re going to talk about their next policy move at the upcoming meeting. I also noticed one person that you may follow as well, Lisa Abramowicz. She was highlighting of course the fact that there is a massive amount of debt coming that needs to be rolled.

From the S&P 500 companies, we have more than 100 billion in debt coming due next year. That I think used to be last time was when the rate was around 2.8%. But of course, now refinancing is probably twice that. So that would be interesting. Just talking about the market moves that you highlighted, I saw an article on Bloomberg talking about how this was kind of almost like a black swan. But I guess if the markets go up, it’s like a white swan because it was a very rare move when you look at the percentage move that we had on Wednesday.

It says something like, in fact, in the nearly 8000 instances of 10-day periods going back to 2002, only five other times has there been such a move as big or greater than the post-Halloween coincidence surge in stocks and bonds. Investors who dressed up as bears are very much regretting their costume choice.

[00:07:58] Alan

That’s the thing that surprised me, because, for sure, the headline CPI had posted or was a flat or down month, whatever it was, but obviously, that’s very energy-related. But the core CPI, it’s moderating, but still, if you looked at three, six-month annualized versions, they’re still 3% on most or above on most of the time horizons. So certainly, it’s consistent with the falling inflation, the disinflation story and it would give more comfort to the Fed. But yeah, to justify the too big-figure move in the dollar and treasuries and equities, yeah, I was surprised at that.

One other thing I would say, in the falling inflation camp, it was interesting a number of the retailers were out this week talking about deflationary pressures, which was interesting. I think it was Walmart or possibly Macy’s. A couple of them had results and they were talking about the consumer stepping back a bit and starting to see a bit more price pressure there. So I think there’s a lot of cross currents.

There’s obviously the shelter component which people focus on as well and saying that still hasn’t fully caught up in terms of fully reflecting (and it won’t, obviously, it always starts with a lag), what’s happening on the ground in terms of new rent. So yeah, I do think it’s hard to argue against the falling inflation trend and what the numbers are showing, but at the same time, it seemed to be an extreme reaction.

But as I said, possibly, the fact that Powell had tilted the market towards a slightly hawkish stance last week, which again, I was a little bit surprised at that one as well. But yeah, it would seem there’s a fairly a high chance of no move now in December you have to say.

[00:09:44] Niels

Yeah. I want to stay with the global macro a little bit longer. I want to dive into something that both you and I glimpsed over that Ray Dalio wrote. But before we do that, I just want to tie this week into the trend world, the performance of this, because clearly, November is turning out to be perhaps the most, well, March was pretty difficult as well, but a difficult month for trend followers, I think. I think it’s mostly really to do with what took place on Wednesday for the most part, especially those with longer-term horizons, maybe a little bit heavy in fixed income.

Obviously, Katy and I spoke recently about the whole big short fixed income position and where we are on that. This is of course very relevant. But I would say from what I can tell, energies obviously didn’t do great for trend followers, and currencies (you touched on that as well). Now, we are about six weeks away from the year coming to an end, Alan, and clearly, our industry will have welcomed some new investors on the back of a really strong 2022.

I’m wondering, from your perspective, obviously, you sit on or have sat on the other side of the table to me for so many years. How should investors think about their initial experience if they’re relatively new to the space? They’re coming up probably for some year-end investment committee meetings. How would you help them frame this year’s performance where we are also in relation to what happened last year?

[00:11:28] Alan

Yeah, I think it’s a tough, okay, maybe tough is too harsh. The SocGen Trend Index is down 3% on the year, so it’s a negative year. We have been highlighting that we’re getting more interesting in trend and managed futures funds. So it’s actually worse than that if you think about that. If this was back in the year of zero rates, we’d be at a minus six-year or something. So it’s actually tough.

I was looking at the SocGen have a report that they send out of all of the vast majority of the CTAs, and they have data of about 200 CTAs in the CTA and quant macro space. About 100 of them are up, about 100 of them are down, so it’s that kind of year. In aggregate, the industry, based on the indices is down, but there are managers up, there are managers down.

For strategies that managed futures managers run with the kind of Sharpe that they are, you should expect some flat years, some negative years. Nothing statistically significant about it. It’s part of the normal ups and downs. It’s just a reminder that it can be a tough strategy to hold when other things are doing well. When we did the series talking to all the top CTAs, this was something that came out that trend following and managed futures can be tough to hold.

After a period of two or three years where it’s doing very well, you say, well, what’s that? What’s difficult about holding CTAs? The Trend Index just delivered 27% in a year when the equities market was down, so what’s tough about that? Then you get March and then you get what we’ve had in November, and it is a reminder, particularly in a year when equities are doing well and your 60/40 could have done okay driven more by the equity side and a diversified liquid alts portfolio is probably around flat. So people will immediately be saying no, do we really need this?

So I think it’s all about, one, keeping the long-term perspective; two, reminding yourself, why is it in the portfolio; and three, an investor made a good point that zero correlation doesn’t necessarily mean negative correlation. It just means zero correlation. So it’s just a year where managed futures and trend following hasn’t done particularly well, but I don’t think there’s anything to read into that.

[00:13:58] Niels

Exactly. I certainly want to stress the fact that you say, yeah, the Trend Index is down about 3% for the year, but yeah, let’s not forget, it was up 27% last year and it was up 9% the year before, 6.25% the year before, and 9% the year before. So actually, of course, in our completely biased point of view, this is very normal.

Before we head back to the global macro space, let me just say that my trend barometer that you can find on the website finished yesterday at 41. So completely neutral. It’s been staying in neutral for most the part of this year, and I think this is also reflected in the performance that we’ve just discussed.

Performance-wise, BTOP 50 down to 2% for the month, but still up 42 basis points for the year, which is a little bit unusual compared to the other indices. SocGen CTA Index down 3% for the month, down 3% for the year. Trend, we talked about, down 4.25% for the month, down 3.25% for the year. Short-Term Traders Index down 1.3% for the month, down 2.6% for the year.

Compare that to obviously incredibly strong equity performance this month. MSCI World up 7.38% so far, up 14%, so half the return so far this year coming in November. World Government Bond Index for a change, a really strong month, 2.29% up and the S&P Total Return up 7.6%, up 19% for the year.

I just wanted to head back before we dive into some of the other topics. You and I came across one of Ray Dalio’s latest articles. Of course, he’s been very vocal in the last few years about the change, the dramatic change he sees. I think he’s been saying by the way that five years from now, we’re not going to be able to recognize the world we live in, and so on and so forth.

You had a little bit of an article that came out obviously focusing on the relationship with China. It’s very important. Now for the first time in six years, I think Xi came and met in person President Biden at the APEC meeting. Actually, Ray Dalio came out with an article saying, well, maybe the actual hot war between the countries, the chance of that has come down. But there’s another war that’s going to be intensifying, in his view, over the next few years. Can you talk a little bit about what he has in mind and any thoughts of your own?

[00:16:33] Alan

Sure. You sent it on to me. I had to read through it. What he’s saying is basically, the US and China went maybe not to the brink in terms of an actual physical war, but things were heading in that direction of heightened risk of an actual conflict in relation to Taiwan and the Chinese military buildup around Taiwan. But in the last couple of months, things have warmed up in terms of their relationship as opposed to cooling further.

Obviously, Janet Yellen had been there. There had been a couple of officials there and things have culminated in this meeting between Biden and Xi which seems to have been signaling a thawing of relations and lots of positive talk from Xi about the globe being big enough for two big superpowers to grow and no need for a conflict. So I think that all of that makes sense.

Ray Dalio’s point has just been yes, okay, physical conflict, maybe not on the horizon immediately, but that doesn’t mean things are all rosy between the US and China and that obviously, you still have these two superpowers vying for global influence, global dominance, and that’s going to continue, and that the war will be more in the background and technological, and that the strategy will be more like, as he says, hide your strengths, bide your time. It’s an old Chinese proverb.

Deng Xiaoping, that was his philosophy of build up your strength, but don’t necessarily promote it. So I think all of that makes sense. Just because we’ve had a meeting between Xi and Biden, all of those structural concerns about national security don’t go away. Obviously, they’re both still trying to build their own chips capability and trying to limit each other’s access to (well, certainly in the US’ case), certain key technologies in relation to chips.

Obviously, China has rare earths that the US would like to have. So this ongoing battle is going to continue, but it’s just not going to be an overt battle. I think that makes sense. I don’t know if it’s anything too dramatic. I think there’s a little bit of optimism this week on the back of it. But equally, Xi spoke at a business leaders dinner, after his summit with Biden, and the feedback coming out of that was interesting that it was described as a lot of propaganda, but no real positive talk about opening up barriers around trade or investment or anything like that.

Obviously, US business leaders would love if US-Chinese relations thawed and grew because the likes of Apple, BlackRock, all of these huge firms have massive exposures to China and their whole processes are massively embedded in the Chinese economy, at least in relation to Apple. So obviously, you would expect the business leaders to be sympathetic to China and upbeat, but there doesn’t seem to be a whole lot of substance.

So, yeah, it wouldn’t be surprising if we see the shifting sands move back towards greater conflict at some point in the future, but for now, things are looking a bit rosier.

[00:20:03] Niels

Yeah. I think that’s a great summary. What he also says which I think is also kind of interesting is of course that even at times when two, say, superpowers in this case realize that they are better off working together than fighting each other, they still might end up fighting each other because they are worried that one will beat the other if they wait too long.

What I find interesting about this, well, there are two things, obviously, I’m a little bit skeptical about what people say because actions speak louder than words. I think there hasn’t been a lot of action that confirms this new love affair between Biden and Xi. But it’s also the economic side of things where what Dalio actually is saying is that you should spend your time to really build on your strengths and get your house in order.

But if I look economically (I don’t know much about Chinese economics), but from what I can read, it’s not in great shape. I know a little bit more about US economics and that for sure doesn’t look like it’s in great shape. So it is an interesting time. Who knows? But you’re right. For this week, probably a little bit of cooling off the tension between the countries. Other things cooled off because I think you’re going to talk about a few other macro things that you found such as the savings rate, for example.

[00:21:27] Alan

Yeah, I just wanted to touch on- we normally spend a few minutes talking about the big picture macro view. But rather than going into all of that and what we’ve seen in the data recently, there was just two or three data poin/observations that I thought were interesting recently that are kind of important not so much in the day-to-day, week-to-week, but are important in the big picture.

First one is the recent release of the US consumption and income data which includes the savings rate. It showed that US savings rate is down to 3.4%, which is low. It was down as low as 2.7% in 2022, so last year. But to put that in context, on average, since 1990, the savings rate is about 6% in the US. The US savings rate is generally low. In Europe, the savings rates are all above 10%. So the US historically has low levels, but it is unusually low at the moment.

We have seen this in the past. If you go back to 2005, ’06, ’07, it was averaging around a similarly low 2% to 3% level. But at the time, people were worried about is this sustainable. So again, it does raise the question, are US consumers spending too much? Why is that the case? It could be linked to the excess savings. So they had a stock of excess savings that they built up during the pandemic and that allows them to spend more out of their current income (so that’s what the savings rate captures) than they have done historically.

It could be related to demographics and retirees or it could be just a temporary thing that people got used to spending a lot of cash in the pandemic and as we came out of the pandemic, and have continued it, and are running up credit card debt, etc. So it’s a warning sign, I think, but it’s not something that you’ll say is going to impact this week or next week. As I say, if you look at the experience back between 2005 and ’07, the savings rate did stay low for a prolonged time but then eventually snapped back.

So I think it is something to monitor like, is this sustainable? Because if you think about it, if the savings rate went back from 3% to 6%, that’s 3% of GDP, that would be quite a big hit to the economy. You almost certainly would see that it obviously wouldn’t happen immediately, but if it happened over time, you’d probably see a recession as part of that process. So that’s something on the negative side to be a little bit concerned about.

On the plus side, we had productivity numbers recently. Productivity numbers are really important for the long-term outlook for the economy but tend not to get that much attention in the short term because the numbers are very volatile. The third quarter nonfarm productivity was up about 4.7% annual rate in the US, very strong numbers surpasses pay since the pandemic and those numbers were inflated because of what went on in the pandemic.

If you look at the long-term trend in productivity, it’s been very poor in the last decade. Actually, if you look at the 10 years to 2020, productivity in the US just grew at 1.1% which was very low by historic standards. Whereas if you look at the 10 years between 1995 and 2005, that was the era of the productivity boom, Greenspan, the new paradigm, all of that, productivity grew by 3.1%. So a two-percentage point differential is enormous because long-term economic growth is basically driven by growth in the labor force and productivity.

So if your productivity is growing at 3%, your labor force might be growing at 1%. So that’s why people thought long-term growth could be up maybe at 4% back around 2000. Whereas now, people think and economists think long-term growth is like 1.5% to 2%. Why do I mention this? Well, there is some optimism that things are turning. As I said, the most recent number was stronger.

There is a sense that maybe what happened during the pandemic with hiring and firing, companies were hoarding labor for a while. So they had more people on the books maybe than they needed because they were worried about being able to get more labor. That meant that the output for the amount of labor that they had is falling, so productivity declined for that reason. Maybe working from home and all of those disruptions impacted productivity. So there are reasons to think that might unwind.

Obviously, the big hope for productivity is around AI and automation and robotics and all of that. If we did see a boost from productivity, so basically if these recent trends that we’re seeing are better numbers, if that continued, that would actually be very positive. Why? Because higher productivity would mean higher economic growth, it means wage growth can be higher without fueling inflation, and it would mean the debt would be more sustainable because everybody’s looking at the debt situation and they look at the interest rate.

But it’s all about the interest rate in the context of the economic growth rate. It’s basically the difference between rates, r minus g. It’s what economists talk about. So I think some good news there. I don’t know if the market is partially responding to that. One, productivity numbers, they are so volatile that it wouldn’t make sense to do so. But certainly, it is something I would say is worth monitoring going forward over the next number of quarters for sure because if productivity was to pick up, that could be part of the story around maybe a more optimistic outlook.

That takes me to the final observation. The Economist magazine had an article out not this week, last week I think it was. I can’t remember the title, but it was basically saying that the expansion can’t last, which is kind of talking about what I’m seeing around savings rates and saying, okay, productivity has been low but slightly picked up, but too early to draw any conclusions. We’ve had monetary tightening, fiscal policy can continue at the same rate, all of the things that I would have said myself, to be honest.

But when I read it in The Economist, it makes me worried. Why? Because magazines like The Economist are great for general information and insight on the economy but tend to be terrible forecasters of markets and the economy. There are a number of people in the Twitter world who highlighted the poor record of these publications. Some of the classics are “The Death of Equities” from BusinessWeek in 1979 just before a massive bull run.

The Economist had a piece “Drowning in Oil” in 1999 when oil prices were at the lows. Even last year, they had a piece “The Trouble with Sticky Inflation” and obviously, inflation has come down. So when I read that from The Economist, you do start to worry that maybe we’re too pessimistic. I would have been in the camp of saying you have to be concerned that fiscal policy won’t be as stimulative next year and we haven’t seen the full impact of monetary tightening. But yeah, maybe that’s too much of a consensus view.

On the plus side, one final piece within all of this, Goldman Sachs had their macro outlook out and they are more upbeat looking into 2024. Their view is basically the hard part is done. The outlook is rosy. So that’s an interesting as well. I actually went back and I had to save last year’s version of Goldman’s because I was thinking, well, how good have they been, and they were actually pretty good last year to give them credit. They were more upbeat on the outlook than everybody else. So maybe something to keep in mind.

Personally, still cautious, but it does make me pause for thought when I see it in the mainstream media like The Economist magazine.

[00:29:09] Niels

Another chart that I came across in the FinTwit space that gives a little bit of a pause for thought also is to do with, I would say, optimism I guess you could say, because I found this chart from Bank of America. They did a survey of fund managers and found that they are the most overweight in bonds since March of 2009. Then they go in to say, well, we probably shouldn’t read too much into it.

To cut a long story short, March 2009 wasn’t a great time to be bullish bonds because they actually sold off quite sharply after that. So not saying that this will happen again, but yeah, investors are maybe turning bullish on bonds and perhaps there’s still a little bit more room to the downside before it all turns, which of course it will at some point.

All right. Enough of all this global macro mumbo jumbo. People are here to talk about hardcore systematic CTA trend stuff and you found some great articles and papers that we need to dive into. The first one is from our friends over in Paris, CFM. They had a paper so I will pass it over to you. Actually, I think it’s a point that I seem to remember Philip brought up in our conversation when we did it.

[00:30:46] Alan

That’s right. It’s actually not a recent paper. It’s back in 2017. But the context came up in a discussion I’ve been having with a client recently around trend and non-trend and the benefit of non-trend strategies. When we interviewed Philip Seager from CFM, part of the SocGen series, he made a point that they had done a study saying if you look at the SocGen CTA Index, trend following explains all the returns and non-trend basically had contributed nothing.

So I wanted to go back and say, because I’ve heard that now being repeated by other managers and people maybe using that in certain ways, so I wanted to get a better sense of exactly what they said and is that a reasonable thing to take away from their study? This was done in 2017 around a time when there was a lot of focus on CTAs saying they’re all the same, it’s all commoditized. So it’s kind of in that period, and that was the context.

So they regressed a very simple trend model on the returns of SocGen CTA Index. They looked at 2 months, 6 months and 12 timeframes using exponential moving average model, and they found that the 6-month model was the best fit. They found that this was able to generate a 0.9 Sharpe versus the Sharpe of the SocGen CTA of 0.4. Their replicator obviously didn’t include any trading costs or fees.

They were able to say, well, if you take out that, take out 4%, which I’m not sure if that’s supposed to be reflective of all of that, that they were able to match the performance of the SocGen CTA Index purely based on this trend model. Just to quote a couple of bits, they said, “The aggregate of the CTA industry is well described by trend following,” fair enough, “and the performance of the remaining unexplained return stream is flat.” So that was their takeaway.

Therefore, CTAs only offer exposure to trend following with the contribution from non-trend being zero. Obviously, some firms can outperform and others will underperform, but in aggregate, that’s what they were saying. So that made me think based on my own experience allocating to managers, seeing the performance data, I would say that’s not my experience. I certainly have seen certain instances of non-trend strategies being additive in individual CTAs and in the aggregate.

Even if you look at the performance of the SocGen CTA Index versus the SocGen Trend Index, historically, the SocGen CTA index has a higher Sharpe ratio. It’s a lower vol index. But if you levered it up to the same vol of the SocGen Trend, you do get a higher return. So that is suggesting that non-trend is contributing something to the overall performance.

I think there are methodological issues here that you have to keep in mind that if you look at something like the SocGen CTA Index, it’s 20 managers. They’re all equally weighted. So it’s basically 5% dollar allocation to all 20. So if you have a trend following manager, say a 20 vol manager, and if you had a macro manager say at 5 vol (5 might be low but just to highlight the point), the risk contribution from the trend is going to be four times at the macro manager.

So in general, I would say trend followers run at higher vol than what I see from say quant macro or non-trend managers. So it’s not necessarily representative in that sense. It’s an index that is more heavily weighted to trend following anyway. So to say that you get a lot of trend following from CTAs, that’s hardly news. We all know that. I suppose the debatable point is whether the non-trend part adds something or not. I would say it does. You can see that in the performance of managers.

The curious thing when you think about it is, and Philip talks about this, like CFM worth about 9 billion, 8 billion of it is in non-trend strategies anyway. So they’re not saying that non-trend strategies don’t work. They seem to be saying in the paper CTAs are not particularly good at doing it. That’s my takeaway. The paper can be used as I say in different ways and it’s kind of interesting. Some managers have taken that observation in saying all you get from CTAs is trend and non-trend doesn’t work.

Others have taken this maybe and used it as support for replication. If you can do the CTA and take out the fees, you can do even better. So that’s another way you could take that information and use it slightly differently. The final way was back at the time I suppose a lot of people used it to say, hey, look, a six months exponential moving average can fully replicate the SocGen CTA so why would you pay for more sophisticated trend.

So I think it’s interesting how one piece of research which may have some methodological questions can still be used because it generates a stickier headline and then still used by different managers to support different positions. But as I say, my perspective on it was interesting study, but this didn’t necessarily prove the point that they were making and certainly didn’t seem consistent with their own business if you think about it.

They’re obviously non-trend and they’ve been very successful we have to say. If somebody asks me, are there opportunities in the non-trend space? Of course there are, but you have to be skilled at exploiting them.

[00:36:32] Niels

Yeah, there’s quite a few takeaways from my side when I hear you talk about that. First of all, I think there’s one thing that we also have to mention, and that is, some managers that are referred to as non-trend, some of the managers we actually interviewed in our series actually have a fair allocation of trend inside their program even though they’re classified as, say, a short-term manager. But actually, part of their risk budget goes to medium to long-term trend following. So that makes it even more difficult to actually understand completely what’s going on.

I think if you’re a trend follower, you probably would need to be able to show that you’ve outperformed the trend following index to show that you add value. Otherwise, of course, you could make the argument, well, why not just buy the index? Which brings up one thing actually. I thought I heard a while back that there was talks about the index becoming investable. Have you come across that?

[00:37:37] Alan

No, I haven’t. Not for the SocGen. The one that was being talked about was the HFRI hedge fund index. I think there was talk that, I think Aberdeen Asset Management were developing a product.

[00:37:54] Niels

I think that is live. I think that is a live product.

[00:37:57] Alan

Yeah, that invests across the hedge fund universe, but not for the SocGen Trend.

[00:38:05] Niels

That’s fair enough. It’s only because I noticed that they’ve changed their performance. The way you get the performance numbers for the index, it’s become much better now actually, because now you get the monthly returns instead of just the daily returns and you have to figure out what the month turned out when you download it from the website. It talks about a NAV, so I’m thinking, well, maybe they’re toying with a real live version of this.

Anyway, that’s for a different discussion. I’m sure our friends over at SG will tell us if there’s something we need to concern ourselves about. But anyways, of course, a big obsession from the allocator world is justifying their business by saying, well, you can’t just buy a trend following, you need to add a few extra things. Of course, for some firms out there, that has worked very well. So I’m sure that is true.

But I would also buy into the argument saying if you have the patience, and I don’t know if that was the question also in the paper, but I don’t know if these fully diversified or more diversified products actually do better. They can maybe create a smoother return path, so to speak, smoother return stream, but do they do better than a few really good long-term, well-established trend followers put together? I don’t know. I haven’t done the math.

[00:39:23] Alan

I think one of the challenges with this is once you move out of trend following into non-trend, there’s a huge range of strategies. Obviously, you have futures-based strategies, within equities, you’ve got discretionary, systematic. The benefit that we have with trend following is we have these indices that show actual live performance going back at least a couple of decades with daily data back to the 1980s with the Barclay Hedge, the Barclay CTA Index and back to 1990 with the BTOP 50.

We can show with certainty that with a strategy that, okay, there’s different ways of doing trend, but that broad approach is proven over that period of time. Whereas when you get into the non-trend, it becomes more manager-specific. It’s harder to create these indices. I think it’s harder to prove that it works. Maybe it’s more the case, it probably is the case, that manager selection is more important in that space because you can say everybody is doing things slightly differently.

But of course, to say that trend is the only thing that is valid and can generate returns over the long term in the futures trading or diversified macro area, no, I don’t think that you could stand on that.

[00:40:46] Niels

That would be a bit of a stretch.

[00:40:49] Alan

Yeah, it’s a bit of a stretch. Look at the many successful firms who are doing things. CFM, for example, they do trend, but they do other things as well. So that’s what was my point. I think this study has been somewhat hijacked in how it’s been used in some instances.

[00:41:03] Niels

That actually brings up one other thing just hearing you talking about this, and that is, if I look at the evolution of our industry compared to when I started out some 30 plus years ago, I think the big change is that a lot of the people who really were our peers back then have morphed into these, I wouldn’t call them multi-strat firms because that’s a different strategy, right? But it’s firms that offer multiple strategies, and so there really aren’t that many pure, single-focus trend followers out there left in this industry. That I find interesting, frankly.

[00:41:47] Alan

I’d agree with that. For sure, there are very few. There are a handful I would say of managers who just focus on trend following at the exclusion of everything else for sure.

[00:41:57] Niels

Yeah. All right. We’re going to jump back a little bit later in a few minutes into another paper from some of our CTA friends. But before that, I think we’re going to jump into a paper from a well-known firm called JP Morgan because you came across their long-term capital markets paper and what they’re, I guess, advising their clients to do.

I think the big the big, sort of what I took away from it, I’d love for you to expand, and that is it kind of goes back to some of the things we’ve talked about before, and that is, what are we going to do with this 60/40 portfolio? Is it still valid or have things changed? What did you take away from this paper?

[00:42:42] Alan

That’s exactly it. The reason I bring it up is twofold. It’s interesting to have a sense of what people are thinking in terms of expectations for returns around equities and bonds and all of that. But a big part of this paper is talking about the new world that we live in and diversification and enhancing the 60/40, and obviously, trend is relevant.

Just in terms of their capital market assumptions in the first place, they’re looking at US equities delivering 7% over the long term. European equities, more optimistic, 9.3%. They see dollar cash averaging 2.9% over time, and they see 10-year bonds generating returns of 4.6%. So a 60/40 portfolio in dollars. This is using global equities and US bonds. Therefore, forecasting 7%, a US-focused 60/40. So US equities and US bonds would be about 6%. So it’s okay.

But actually, that number would have been closer to 10% in the 10 years to the end of 2019, so in that decade. 60/40 looks okay, but not fantastic. They do make the very important points that we have been emphasizing that bonds can still be a diversifier to a growth shock, but not necessarily to all shocks, particularly what we saw last year which was more of an inflation shock, and that’s because a recognition that the correlation between bonds and equities is going to be less stable going forward. So I think that all made sense I agreed with all that.

When they followed on from that, they do give some forecasts on the alternative space. They mentioned return expectations for global macro of 3.6% down from 4.1% last year, which surprised me a little bit because obviously, with the higher interest rates, you would expect global macro funds which tend to hold a decent amount of cash like CTAs, you would expect the outlook to be looking better. But anyway, that was just one update.

As you go through the reports, they have a lot of separate articles and then they get to one where they’re talking about how to develop a smarter portfolio to mitigate shocks in a less predictable world. So this is basically how to make your 60/40 portfolio more robust. They talk about a number of different sources of diversification. The first one they call risk premia. They actually include trend following within risk premia, which I know will annoy some of us and some of our listeners.

I guess the idea is that trend picks up on the behavioral sorts of risk premia. So good to see that actually trend following is in there, because very often with these reports, there’s actually no mention of things like trend following so I was encouraged to see that. They do also include things like active management, and they reference global tactical asset allocation, so kind of shifting, which is interesting because if you think about it, trend following is a form of global tactical asset allocation, which we’re going to talk about with the Quantica paper.

They also include FX as a source of return. Obviously, a lot of these types of investors might use currency overlay, but they’re saying don’t forget you could take active FX risk, but again, you can do that with specialist FX managers or get it via a diversified manager like a CTA. Then they say other sources of diversification from thematic exposure. So this is fair enough in terms of maybe having exposure to energy would help you in a year like last year.

Separately, they have alternatives which include hedge funds and alternative credit and real estate. So interesting CTAs not included on that side but included in the risk premia side. So I think all of that I thought was very encouraging in terms of this narrative around the need for more robust portfolios and encouraging from the perspective of CTAs and trend following being referenced within that.

They outlined a new enhanced portfolio, but actually, when you looked at it, it didn’t look that different to what you would typically see, bonds 36% with a heavy weighting to investment grade corporates. Equities were about 41%, real assets 10%, private 10%, hedge funds were only 1%. The numbers didn’t add up to 100%, so I’m not sure if they missed something or not. But still, there was no mention of a reasonable size allocation to CTAs or managed futures.

Now, this enhanced portfolio did outperform the typical 60/40. They did redo it using a fully liquid version, so taking out some of the real assets, but they didn’t give the breakdown for that. That also did better. So overall, I would say philosophically good. I like the way they were thinking in terms of describing the world, the more volatile macro backdrop, the less stable correlations between bonds and equities.

We’re probably going to be in a higher return world in terms of interest rates, etc., and they are identifying some interesting strategies there in terms of FX, trend following, etc. But still, they also mentioned within there that it’s important not just to do mean variance optimization, but more robust optimizations using simulations, Monte Carlo simulations. So I’m amazed, having done those Monte Carlo simulations, that managed futures and trend following didn’t pop up at a higher allocation.

So as I say, yeah, interesting, but still looks very much undiversified to my eye when I looked at it. Particularly if you look at it from the perspective of they had say 10% in treasuries, 20% in investment-grade bonds, 3% in high yield, 3% in emerging market debt. As we’ve seen before, things like investment-grade bonds and credits, they have an element of fixed income and then an element of equity exposure. So you’re getting a hybrid of those two exposures. You’re not really diversifying either bonds or equities that much with things like credit or emerging market bonds.

Similarly, with real assets, they are heavily related to the economic cycle. So if you have an economic downturn, they won’t do that well. So there’s a whole sleeve of tactical trading strategies that gives a very different return profile that they’re not really aggressively allocating to. So positive in one sense, but a bit frustrating in another sense was my takeaway.

[00:49:36] Niels

Well, just like we talked about with Xi and Biden, often, actions speak louder than words. So you can talk about all these things, but if you still end up with a 1% allocation, yeah, it’s probably not going to make a big difference.

One thing that I’m also a little bit surprised about when you see these and people end up with something that looks very similar to the 60/40 is just the fact that they ignore that maybe correlations between stocks and bonds can actually remain positive now that we have inflation, because that’s at least what the historical data shows that once you have 3% or above inflation, most of the time, these two asset classes are positively correlated. So you get no diversification benefit in that sense.

So it’s interesting that they ignore this. But anyways, that’s their view. Let’s jump to another view, which is from Quantica. That actually goes to what you mentioned, trend versus global tactical asset allocation.

[00:50:38] Alan

That’s right. I thought this was a very interesting paper. It’s called “Trend-Following Through the Prism of Tactical Asset Allocation”. It’s very much a niche follow-up to what we’ve been talking about because they take the perspective of a long only investor, a typical, I suppose, it could be a wealth manager, asset allocator, and say if you have these 16 ETFs that they identify across different asset class, for example; treasuries, investment-grade bonds, high yield bonds, emerging market debt, municipals and then alongside equities, real estate, commodities, and gold.

If you were to go with a typical risk asset allocation that you would see. What they’re trying to do here is they say, okay, let’s take a typical asset allocation; a strategic asset allocation where an investor would just pick their strategic asset allocation and rebalance monthly. Then let’s look at that and say, well, say if we were to apply trend following to that, trend following in the sense of not going to short and not using any leverage, just modulating the exposure to those 16 ETFs based on the strength of the trend in those markets, you might call it long-only trend following, and does that create value? Well, they found that it does.

So if you applied their standard trend following model to those 16 markets, and they figure out how to equate the risk to a similar level, and the average notional exposures were similar, although not exactly. Because obviously, there’s going to be periods where if the trend is down, you’re going to go into cash and you’re going to have no exposure or little exposure to these assets.

Interesting what they found was the trend following on the ETFs did better, slightly better, I think it was 5% versus 4.8% but at a much lower volatility, so 7.5% versus 11%. So obviously, why is that? Because obviously, when equities go into a serious downtrend, you go into cash and you might have upgraded your fixed income to an extent but you’re not losing leverage, so you wouldn’t go massively overweight and you would benefit in those types of situations.

So you get better performance, lower vol, and more consistent volatility as well than just a passive strategic asset allocation approach. The second thing they did then was to say, well, okay, that’s fine, but what about if we eliminated the constraint around leverage? So if you think about it, this type of investor has three constraints: no leverage, no short positions, and only trading those markets. So what they do is gradually relax each of those restraints.

By taking away the leverage constraint, you’re moving more into a risk parity type of model. So if you think about what’s risk parity, it’s saying, yeah, there’s a return from bonds and equities and other sources, commodities as well. But in most portfolios that are not sized properly, it’s because the volatility is greater in equities. So if you adjust for the leverage, you can add value from that.

What they found is that did add value as well. The third thing they did is they added short positions. Actually, when they did this within the 16 ETF portfolio, the performance didn’t improve that much or was about the same, but it had better risk. It was a more robust portfolio in terms of bear markets. They had a more consistent return profile.

The final thing they said was, well, okay, let’s just not do trend following under 16 ETFs but let’s broaden it out and allow the leverage, allow the short positions, but doing it on whatever it is, 100 markets or a typical trend following universe. Then you do see the returns jump up again by quite a lot as well. I thought that was interesting. I think it’s an interesting and a valuable paper.

People think about CTAs and trend following and it’s all about the signal, but it’s not just about the signals. The value, the benefit of it in a portfolio is coming from the signal. So yes, there is momentum in markets. If you modulate your position based on that, you can add value. But also, it’s about risk sizing and sizing your exposures appropriately. It’s related to volatility, how you measure vol or how you measure risk, but having some measure of risk of equalizing for that does add value.

Then diversification and getting access to different return drivers had a big contribution. If you think about it, it comes back to my point. In their 16 ETF portfolio, it’s all treasuries, municipal bonds, corporates, emerging market debt, real estate, commodities. As I say, you’ve got two things. You’ve got assets that do well when growth is strong or assets that do well when growth is poor, but you’ve got two dimensions there.

If you start adding in commodities, currencies, short-term interest rates, you’re getting much more idiosyncratic return profiles. That’s where you’re getting a lot of the benefit from trend following. You see the big jump up in the overall return. So I thought it was a very good way of decomposing the benefit of trend following into three constituent parts, that of the signal, the risk sizing, and the diversification from a lot of markets. Maybe it’s a good way, it might be a helpful way of showing to more traditional asset allocators the benefits.

Obviously, they don’t have to run trend following or they don’t have to even try to do that under under a multi-asset portfolio. But if you if you add a trend following fund to a 60/40 portfolio, you’re achieving the same thing if you think about it. If you start with a 60/40 passive portfolio, add a trend following allocation, the trend following manager is going to be trading bonds and equities as well, but also commodities and currencies, and it’s going to be risk sizing, and it’s going to be long or short. So what have you got now?

You’ve now got a dynamic multi-asset fund that, obviously, the overall exposure shifts around a lot more and you’re more diversified. So you don’t actually have to go and run trend following. All you have to do is add that into your exposure, your existing portfolio, and you get that more dynamism. So I think that’s the important point to think about when positioning these to more traditional allocators.

[00:57:47] Niels

I completely agree. Thanks for this a walkthrough. Yeah, I agree. I like all their quarterly insight papers. They do a great job. I think you’re absolutely right. This is a fun, subtle way of actually highlighting the benefits but speaking in a language that maybe a lot of these traditional investors might relate to. Now, the last point we will just talk about before we wrap up today is something where we probably both felt that this is most likely above our pay grade. I said to you, well, that hasn’t stopped us before.

You came across this interesting article from the FT. It could be from this morning or yesterday. We’re at an interesting point in time, not saying that there’s going to be a crisis of some sort. We’ve had plenty of that recently. But there are things happening outside our world but in the alternative investments worlds where you sometimes think, well, it’s a little bit interesting. We’ve had private equity having difficulties offloading some of their inventory, and then they’re being sold to other funds that they create. We all think that’s a little bit weird.

Then you came across this one. The headline was “Blackstone borrows to boost lending power of $52 billion credit fund”. What it’s about, it says, “Blackstone is planning to borrow hundreds of millions of dollars to give its flagship private credit fund added investment power as the asset manager taps a new source of leverage that it and rivals aim to increasingly exploit in the years to come. The private equity behemoth is in the final stages of raising just under 400 million through a so-called collateralized loan obligation secured by the very loans held by its 52 billion Blackstone private credit fund known as BCRED according to documents obtained by the Financial Times.”

Now, this is way above my paygrade, Alan. But I could read the chart that is in the article where it shows that Bank of America expects private credit CLO insurance to jump in 2024 to a higher level than what we’ve seen in the last 10 years, maybe even a record level. What did you take away from this?

[01:00:25] Alan

It’s funny. I came across it in the FT’s Unhedged morning newsletter. Right at the end of the newsletter, they said our head hurt from trying to make sense of this article, so I could feel their pain after I read it. It’s interesting that basically, they’re issuing CLOs to get more funding for their private credit fund.

Now, the interesting thing about these private credit funds that I thought about in the first place is they actually have credit lines to the banks, which seems a bit unusual because the whole point about these funds, private credit growing in the first place was that they were going to displace the bank lending, but actually, they had been borrowing from banks to issue their own loans.

But it seems like banks are stepping back a bit in terms of their lending to some of these funds, and now they’re looking for alternative sources of leverage and return. So now they’re issuing CLOs. So it’s kind of funny. Where would you invest? Would you invest in the CLO or would you invest in BCRED itself, the Blackrock credit? I guess with the CLO, you can pick exactly which tranche you want, whether you want the highest tranche in terms of credit rating or not. So maybe there is some reason there.

The BCRED fund is going to hold the equity of the CLO. I didn’t realize there is equity, but I looked it up and the CLOs all have different tranches, and the lowest tranche is called the equity tranche, so I guess it’s the bit that if everybody else gets paid out, yeah, if there’s anything left that you ordered. So as I said, this is to avoid any conflict. But at a simple level, when we hear about CLOs and credit and big amounts, we all get worried. So we’re probably not equipped to critique it in any sophisticated way. But it does seem like more leverage being thrown on the space.

I suppose the thing that I find interesting is everybody’s saying that now this private credit is good because it means it’s not systemic. It’s not going to bring down the banks if you get a problem with some of these loans. But presumably, these big private credit funds, if they run into problems, particularly if they run into problems under CLOs, would that mean they’d have to start pulling back on their lending so you might still get those systemic impacts that we thought we wouldn’t see.

So that was the only thought I had. Certainly worth monitoring. I’d say we’ll probably hear more about this going forward. Hopefully, we’ll have more informed comments to make about them next time we read about them.

[01:03:10] Niels

Absolutely. It’s probably best to leave it there. I guess my uninformed reaction was that when you hear about I’m going to have extra leverage because there are some great opportunities, it sounds like you’re already underwater in some of your positions and now you just want to find a way to buy more doubling down here, but I could be completely wrong of course and this could be the greatest thing since sliced bread for all I know.

Anyways, this was this was fun. Alan, thank you so much for your thorough groundwork for our conversation today. If you like these conversations and you want to help us grow the show, please go and leave a rating and review. We need them coming in on a continuous basis because that’s what the algos like to see. If you don’t know how to do it, you can actually go to toptradersunplugged.com/review and there’s a little guide as to how you can help us with that.

Of course, if you have any questions for upcoming episodes, you can send it to info@toptradersunplugged.com and we’ll do our best to address those. Next week, I’m joined by Mark. He’s back, and so if you have some questions for him to tackle, by all means, email them over and we’ll do our very best to give an informed answer on that.

From Alan and me, thank you ever so much for listening. We look forward to being back with you next week. In the meantime, as usual, take care of yourself and take care of each other.

[01:04:46] Ending

Thanks for listening to the Systematic Investor podcast series. If you enjoyed this series, go on over to iTunes and leave an honest rating and review and be sure to listen to all the other episodes from Top Traders Unplugged. If you have questions about systematic investing, send us an email with the word “question” in the subject line to info@toptradersunplugged.com, and we’ll try to get it on the show.

Remember, all the discussion that we have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions.

Thanks for spending some of your valuable time with us and we’ll see you on the next episode of the Systematic Investor.