107 The Bright Future of Trend Following with Jean Jacques Duhot of Arctic Blue Capital - 2of2

Niels

…block trades that I think gives you an interesting new dimension versus the very traditional volume and open interest type of analysis.

Niels

Yeah, yeah, absolutely.

Mort

So, once you’ve opened a position and you’ve entered a position with a certain size, can that size change, or will it only change when you close the position, and you get a new signal?

JJ

No, no, that size can change. First, we should get stopped out, naturally, but also if you are reaching some partial profit taking based on the different scenarios of the expansion of the market, if you are speaking from the long side; or you have those several standard deviation types of movement in your favor where you think that’s the best way to maximize your profit and you exit everything, and you go to the sideline.

But also, you can have different intermediate steps based on the shape of the evolution where, basically, you can have a model that transforms itself from a short-term breakout model to a smaller short-term trend; i.e. after a breakout happens, and you reach a specific level where you think that the probability of mean reverting or observing further expansion, those probabilities are equal.

Then, that’s where you take your partial profit taking, and it’s in the second part where you are re-engineering your money management in order to consider that now you had enough P&L to be reinvested as a buffer to turn your model from a breakout to a trend model. So, that is also an avenue where you can have the models that stay as they are and the ones where the position is evolving to the next stage. That’s where the position sizing happens after that intermediate or partial profit taking.

Mort

Got it, got it, could it also change as a function of volatility that your system experiences?

JJ

There will be a recalibration of the token based on the evolution of the volatility during the life of the position, but if volatility declines, the position will not be increased.

Mort

OK, so you’re not adding to an existing position and increasing the risk?

JJ

We do not, we do not. We do not because we are mid to long-term traders and we have filters as we are very picky in our participation in the market. It means that if we are adding to an existing position and there is a sort of change in the momentum, we will have degraded our entry price by adding to that position that will force us to adjust the money management to get a tighter protection to that increased position by increment. That would make us more vulnerable about being stopped out in case volatility starts to increase at that stage.

Mort

Sure, sure, very good. One interesting thing I came across, and you’ve worked inside of larger firms, Millennium, Stable Asset Management, and I was just wondering, what do you think is advantageous of that approach? What are the good things about that?

JJ

So, I think that they are very different from each other when you are in a sovereign pension fund in Canada, you really have access to a very large pool of capital, computer, and brain power. That enabled us to really build the strategy.

Then, you are moving to a firm like Millennium where your recipe has to be ready, in place, and you’ve been hired and allocated capital to manage the money in a certain way. So, I think where you have a lot of room for innovation, like at CDQP, we had to be extremely disciplined, from a risk management standpoint, at Millennium.

Then, Stable Asset Management, as you mentioned them, they have been our partners that allow us to launch in an independent format when we decide to spin off from Millennium and become Arctic Blue Capital.  Stable has being a great partner and told us everything about marketing, launching your own firm, until Stable Asset Management sold their share to H2O Asset Management. Stable is now continuing with specializing in seeding and helping young firms to perfect or to blossom.

Mort

Yeah, good, great. How many people are you at Arctic Blue?

JJ

At Arctic Blue, we have three pure investment professionals plus we have a pool of quant developers, and we are, therefore, purely focusing on investment and research. So, all the noninvestment functions which are legal, compliance, middle office, back office, risk supervision, distribution, we benefit from the H2O platform.

H2O, today, is managing twenty-six billion Euros in different types of vehicles and the main shareholder, the majority shareholder, is Natix’s Group. So, for all off-shore products, we are benefiting from H2O distribution. And, on all UCITS products, we are benefiting on Natix’s distribution. So, that allows us to purely focus on investment and research.

Niels

Right.

JJ

My main partner, Philip, we’ve been working with him for eleven years now, since Canada used to be at Norton Networks before. The third gentleman joined us from the trading implementation group of a very large systematic asset manager and then we have the quantitative development group.

Mort

Great, thanks. So, we have touched on your commodities program, and we’ve noted that in, I think, August of this year, you’ve launched an equities program. We’d like to learn more.

JJ

Well, thank you for the opportunity. So, back to the journey, the equity program was launched in Canada. We were reporting to the CIU office, and the pension fund, at the long-only aspect and exposure to the beta. We are in the second part of 2007, valuation of the market is clearly a bit high, but it’s quite difficult to be fully contrarian at that level. But, the need for protection was thought to become quite obvious for many, many market participants.

So, when we developed our model (and we have a very equal allocation between the different starts for commodities), we looked at mid to long-term and longer types of horizons for equities. We found that shortened breakout tends to be correlated with the trend. We found that, on very long expansions of the equity market, really the main value, the alpha generation, was the ability to identify reversal patterns that were, most of the time, more powerful than expected at the beginning.

So, we looked at the same recipe for commodities. We looked at longer types of horizons and, this time, we’ve been overweighting the contrarian family of models up to eighty percent. So, we can arrange from sixty to eighty percent, so it’s a very, very, high way.

We have a presence in the trend which is capped and ranges between twenty and forty percent maximum. Therefore, in a way, we’re in the trend to finance our ability to be contrarian because being contrarian in an expansion, like the one we are going through, is the best recipe to die by a thousand cuts.

Therefore, you also have the ability to capture different types of dynamics through the reversal model and, mainly, the mid-term reversal model that tends to capture V shape type movement, up or down, and we have no bias into the model. All the models have pure symmetric long or short.

We end up capturing a lot of rotation of sectors, in the U.S., just because of the model being able to benefit from those abrupt changes of direction between sectors. Not building position as long/short, but when you look at a portfolio snapshot you can observe a lot of long/short positions between the different sectors. Sectors, historically, have represented forty-five percent of the allocation of the strategy.

On the other side, when you are looking at the trend and the contrarian positioning at global indices or country specifics, we can capture some of the geographical divergences. We look at, if it is like in 2010 like with the beginning of the Greek crisis in Europe, and where the U.S. market was doing better; and more recently in February, or even more recently, in August, where we’ve seen opposite types of trends with the U.S. market at an all-time high, but when you look at Europe, we’re very, very far away from an all-time high; and where the Chinese market is down nearly twenty percent down on the Euro, at a certain stage. You have a very long-term bottoming out process in Japanese equities.

So, we’re in an environment where, also, we observe a very nice type of dispersion we can capture through that multi-directional approach via the model, and therefore we are trading sixty different indices and sectors. We do not trade single names.

Mort

And the sectors that you trade through ETFs, and the indices through futures?

JJ

Absolutely, most of ETFs, and that’s for the off-shore version, and we have a UCITs version where we have the ability to replicate the position also through other instruments.

Mort

On those contrarian models, they’re all driven by price action? You’re not taking in news flow or any other sources; it’s all just prices?

JJ

So, we take prices, implied vol., realized vol., and we are looking at convergence of divergence between those different data in order to identify emerging change. We have different types of reversal models. Some tend to capture over-positioning and therefore steep consolidation such as the one of February of 2018.

You know, I mean, a bull trend tends to die from its own excess, like a bear trend, if you look at 2008, 2009 kind of pivotal with a little help from the Federal Reserve. Then you have the more long-term reversal model that is capturing some structural change as we mentioned previously in Japanese equities. But, yes, there is no news concerned as an input for the strategy.

Niels

I think in just a little bit you mentioned that equities, they’re a bit stretched, perhaps, at this time in the cycle, and Europe has already started to, maybe, create some kind of downside momentum, Asia as well, and certainly some parts of Asia. Those risks, in general, I think we all feel that they’re there in the markets.

I was interested in finding out about how you think about risk, in general. How would you define risk when you look at your strategy? Also, maybe what keeps you up at night? What are the things that you worry about when you look at these kinds of strategies but your own, perhaps, in particular?

JJ

Well, that’s a very deep question.

Niels

Well, we go deep here on Top Traders Unplugged.

 JJ

Yes, the concept of risk for the strategy, to start with is, really for us, the ability to distribute a maximum risk amount in a fixed way, through the different models, through the different investment horizons, underlying the different markets. Therefore, even if some of that risk is not used by some models, it’s not reduced dynamically.

So, we work at the fixed risk approach between the different markets which is also, maybe, more about looking at [it form a] different angle than some other market participants. We look at volatility as being a very good measure of the risk, and therefore it is difficult to forecast or to get confirmation of sustainable volatility regime versus the noise. That also makes us more binary in terms of our approach than incremental, mainly due to the computerization of the market and the distribution of the volume which is not as steady as it used to be before. Therefore, for us, our risk approach tends to generate up to sixty percent of the performance itself.

Now, in terms of what keeps us awake at night? Where we start to get, I mean even if we’re all, here, seasoned systematic traders, and therefore emotions are not part of the game, I do think that we start to observe (and staying very humble here) potential conjunction of factors from geopolitical tension, trade wars, Brexit, emerging crisis. We start to see a lot of potential events at the time where central banks are withdrawing the liquidity that has been acting as a safety net under the markets.

So, instead of extending that catalog of potential events, as systematic traders, I do think that we are good in an environment where we can capture, and we are long convexity. So, where we can capture terror risk, where we can protect our investors and play a mission in the portfolio of our investors.

Therefore, I would think that most investors have been driving on a motorway. A motorway where an entire generation of traders has only been with investors driving in a motorway, forgetting that at the end of the motorway there could be some more narrow roads, curvy roads. The risk we have is that U.S. equities can push even further up, and we are maybe [as we were] in December of 1999 where Nasdaq was absolutely very overvalued, but you were going short in December of 1999, and by March 2000 you were maybe down thirty, forty percent.

We have some emerging events that make us think about 1998 or 1995. So, overall, we do not forecast anything. We’re reactive, we are not predictive.

But, back to the inflection point of November of 2017 and the change in the VIX market, for a different reason we do think that we’re on the way to a significant change of environment over the next few months or few years. I really do think that mid-term systematic traders, trend followers, multi-directional approach, and so on, will mean-revert in terms of historical return generation versus those where the jobs of the CTA or trend followers have been, in a way, taken by the Fed.

We’ve been observing that socialization of the risk and there was no more terror risk being able to develop due to the fact that there was a wall of money being able to engineer that very long-term rally and that recovery in the economy that has been doing very well for most of the world. But, the protection role and the ability to generate uncorrelated returns, by CTA and trend following, seems promising with higher probability than a few years ago.

Niels

Yeah, I agree, certainly on those points, and the risk that I see, in a sense, is really the risk that clients end up giving up on the strategies that will give them the protection because they haven’t needed them. But, when you read some of the newsletters coming out, even from some very, very large shops, the “underperformance” or lower performance than normal from some systematic strategies is causing investors to become a bit impatient.

I’m sure it’s the same just before the tech bubble when once everyone got invested in equities and there were no more people to continue, that’s when these things happen, and it does seem to have some parallels today. But, if we turn it around on the other side, there are some interesting opportunities you see. You touched upon this for our industry. Do you feel that there are also some positives from what is happening?

JJ

Yeah, I think China is clearly on the way to open its financial markets to non-China based institutions. We saw the launch of the oil futures contract denominated in Yuan and it makes sense. I think we’ll see community markets, really, when you look at the depth and the volume of the Chinese community markets, they’re really becoming extremely attractive even if there are some significant barriers at entry.

When you are looking at the consumption of commodities from China, in 1990 it was representing about five percent, and now it’s a bit more than forty percent. So, I really do think that, at the same time, you see Japan over the same period went down from twelve to five. Also, Europe declined, and the U.S. declined, so I think there’s redistribution of economic growth which is now validated by financial markets. We do hope that those markets will open because, in terms of opportunities, those could be absolutely phenomenal for most of us.

Neils

Yeah, we’d all like that.

JJ

Yeah, we’ll like that.

Niels

Do you have anything more on the strategy, Moritz, do you want to?

Mort

No, I think we’re good, I really enjoyed that. Thanks for all the background and the detailed information about the two programs that you run. It’s been great.

Niels

I want to go and talk a little bit about that you’ve been around for a long time. I think it’s always interesting to try and summarize some of these experiences that we all collect as being practitioners in our industry.

So, if you think back over the many years that you’ve been doing it, are there certain things that you would say have stood out to you as some key principles that you… For your kids for example that you would pass on to say that, in your life ahead of you these are some of the things that you should consider or bear in mind? Is there something that stands out to you from your career?

JJ

Well, absolutely, now we turn a bit more philosophical.

Niels

Well, that’s fine.

JJ

We’re deep at Traders.

Niels

Yeah, we go deep again.

JJ

I really think that the quality of the individuals that you have the chance to meet, to work with, and therefore the importance of nurturing those relationships of your team, your investors, your partners, I think it’s a long and beautiful story. On a daily basis, I think it’s all about habits that create processes that help you to stick with a very disciplined approach.

So, from a very idiosyncratic aspect of our job, such as signal implementation and risk monitoring (but speaking about life and our children), it’s really being able to wake up every morning and thinking positively about what you could achieve. That seems very obvious, but it’s all about your mindset, and your mindset will start by some routine and those daily routines I think help you to stay cool-minded in moments where you’re getting challenged. I think that the markets have an amazing ability to humble you all the way.

Niels

Yeah, that’s very true. So, you meet a lot of investors looking at you, and from this industry, and I certainly felt through my career that a lot of investors were asking the same questions. I remember once, in the old days, when you had these templates of due diligence questionnaires, and you could basically see all the questions coming from that source.

So, I’ve always been curious to find out what my guests feel are the questions that investors should really be asking. What are they missing out in terms of trying to understand, perhaps, better what we do as an industry which, hopefully, will also allow them to hold onto these strategies during the times where, maybe less informed investors would pull the plug, so to speak? What are the questions that you think investors are missing as a part of their general due diligence? I’m not saying all of them, but perhaps most of them?

JJ

I think, in our industry, in our part of the industry – systematic trading – most of us are trading listed instruments. The room for error, the room for fraud, the room for misunderstanding has been really quite well mitigated. It’s very minimal compared with all non-listed illiquid type of structure.

I think also the regulators have played a big role and a very positive role in protecting consumers and investors since 2008. I’m thinking really all the regulators in the United States but also in Europe that have been quite key about making the due diligence job easier, in a way.

I think that the frequency of audits, the audits based more on snapshots during the year, the regular inquiry by regulatory bodies, I think also are adding safety nets for investors. So, in terms of due diligence (from the investor), I would think that all the formal points and all the formal very transactional questions regarding the processes, the logistic. But, I think that the conversation with the portfolio manager or the teams, giving the ability to the investor to understand the nature of the product and having the best possible expected behavior of that investment in the portfolio, I think it takes a deep understanding of the strategy, and not being purely blurred by a specific set of numbers on a specific period.

I think it’s extremely important to have that level of confidence from the investor where he can expect, in different types of market environments, how this investment will behave in the overall portfolio. So it’s more an IDD sort of psychological damage that purely, and the due diligence process that I think is becoming extremely thorough now. And, thanks also to the regulatory framework in place since 2008.

Niels

Yeah, just wrapping up, so to speak. You mentioned the advantages you’ve had being part of bigger organizations in launching your own firm, I was just curious, have you had any mentors that you would say, if I could call it that, through your career that have helped? Are there any books, any literature where you say, “That really helped me evolve as a manager,” that you could maybe recommend to our listeners as well?

JJ

Sure.

Niels

Besides listening to Top Traders Unplugged, of course.

JJ

Absolutely, thank you, that was my first point actually.

Niels

I’m sure it was.

JJ

I think podcasts are really amazing. There are a few good ones around. I also think, in terms of books, some of the Peter Bernstein books on risk reminiscent of a stock operator; the story of Jesse Livermore, a classic, absolutely; [also] the book of Andrew Lo about adapting markets.

I read a lot. I think it’s all about the conversation with Moritz just before our discussion. It’s all about learning and staying on the learning curve. I think that’s maybe also the best lesson you can give you your, best advice you can give to your children because I think there are so many good books around, so many good sources of information, so many… In terms of mentors, I didn’t have the chance to be taught by a Paul Tutor Jones or…

Niels

Richard Denise, yeah, sure.

JJ

You know, legendary traders like this, but through the years I had the chance to meet Ed Thorpe or Jerry Parker, that I think you know well, these gentlemen that are so humble with very deep experience in markets and at a human level, that any conversation with them is an amazing opportunity.

Niels

Is there anything that we missed that you want to bring up as we come to a conclusion?

JJ

No, I really enjoyed this conversation. I’m very honored to have been your guest. Thank you, both of you for your very interesting points that you gave me the opportunity to extrapolate on. I really enjoyed that, thank you very much.

Niels

Absolutely, you’re welcome. On that note let’s wrap up this fascinating conversation, recorded live, here in the famous Abbey Road Studios, here in London.

JJ, thank you so much for being on the podcast and sharing your thoughts and experiences with Moritz and me. It is so important to have practitioners like you share these ideas, because when ideas become conversations that lead to action that’s when real change happens.

To all of our listeners around the world, let me finish by saying that I hope you got a lot of value from today’s conversation and that you enjoyed it as much as Moritz and I did for making it. If you did, please share these episodes with your friends and colleagues so that the conversation can continue.

From me, Niels Kaastrup-Larsen and Moritz Seibert, thanks so much for listening and we look forward to being back with you on the next episode of Top Traders Unplugged. In the meantime go check out all of the amazing resources that you can find on the website.

Ending

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