Bonds Behaving Badly ft. Katy Kaminski

[00:00:00] Intro

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

[00:00:23] Niels

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

What’s going on where you are?

[00:00:38] Katy

Good. Things are good. It’s still summer.

You know, it’s warm still. So, trying to soak it in, I guess.

[00:00:45] Niels

Yeah, make the most of it for sure. Now we have, as usual, a really thorough lineup of topics, of course, somewhat inspired by what’s happened in the recent weeks. But before we get into all of that good stuff, as I always like to do, I’d love to hear sort of what’s been on your radar, market-oriented or not market-oriented, in the last few weeks since we spoke.

[00:01:12] Katy

Well, I guess, you know, the market’s been so wild. So, let’s talk about something else. I mean, I think this summer has been so fun with all the different sports and, you know, obviously the Olympics, but I think we were also really excited watching the Euro Cup and I happen to be in Spain when Spain won, and not at the actual game.

But it was so cool because all the Spanish at the restaurant we went to to watch it got up and started singing the national anthem. And I was like, I just love the Euro Cup. It’s so fun.

Yeah. So, I guess sports has been kind of a good distraction this summer.

[00:01:47] Niels

It’s been a great, great summer for sports. Funny you mentioned it. My daughter, actually, was also in Spain on the night they won. And she also said it was amazing.

And being old enough, of course, I do remember in 1992 when Denmark won the European Championship, and being in Copenhagen that night was just magical, frankly. You were pretty much allowed to do anything. The police didn’t worry about it at all.

So anyways, now back to maybe more market-oriented things. Something that has been on my radar and it is influenced by what’s happened in the last few weeks.

And it’s something I read this morning in one of our previous guests, David Dredge, his update. This particular part is not new to our listeners, but it’s something that’s worth, I think, thinking about. I’d love to hear your thoughts about it.

Now, we’ve just been through a period of time where we see a hike in rates from Bank of Japan. We’ve seen a hold by the Fed. But of course, expecting a cutting later this year. We’ve seen the Bank of England cut for the first time since 2021. And we’ve also seen, actually, Bank of Japan continuing to cut on their side.

Now, BOJ only increased by 15 basis points, but then they mentioned this tiny reduction of quarterly purchases of bonds. And that obviously got the whole thing rolling, which we’ll come to. But I think for me, what’s interesting about it is two things.

One, it shows you how difficult it is for central banks to unwind a lot of the monetary policies that they have been now doing for so long that we take them for granted, so to speak. And the other thing is that I wonder if investors fully appreciate what a divergent world is? and what I mean by divergent meaning is now central banks are kind of doing their own thing. They’re looking after their own economy. It’s not synchronized as it used to be. What it really means for the palette of investment opportunities they look at, which strategies will be heard in a divergent world, and which strategies will thrive in a divergent world.

And it’s something I think that is not discussed that much. But I think, of course, it’s something that you’ve been thinking about for quite a while and written about. So, I’d love to hear your thoughts about whether you think investors have internalized this change and if they’re prepared for it.

[00:04:19] Katy

No, I mean, that’s actually a good question, because if you look at where we are now versus where we used to be, there just seems to be a lot more, you know, difference in terms of how things are working. And whenever you have more divergence across global economies, you have more opportunities in some sense, because there’s just not one narrative. There are multiple narratives, and they’re all interlinked.

And I think that’s where, from an investment perspective, there are much more interesting ideas to be tactical, to be dynamic. Because in a world where the US is the first, I mean, you also didn’t mention that the US waited to cut first. They were first.

They’ve always been first and everyone else follows. Right now, the ECB, the Bank of Canada, a lot of other central banks said, we’re not following the Fed. We’re doing what we want to do. We’re looking at our data. And I think that provides this divergence across different themes where there’s definitely opportunities there and people are going to make different mistakes and correct decisions over time.

And that’s going to cause a lot of tactical opportunities. And hence why active management, I think, has become much more interesting post-2020 because of this divergence.

[00:05:36] Niels

You mentioned, Katy, that in a divergent world, there are more things for investors to invest in. And I kind of thought, hmm, I wonder whether that’s actually true in the sense that I remember (I don’t know if it was you who wrote about it or someone else) when they talk about this convergent/divergent universe and they list a typical portfolio that an endowment or pension fund would have. They look at all these different strategies, but actually 85 percent or 90 percent of them are actually convergent strategies. And there’s a very small sliver of divergent strategies they invest in.

So, I kind of wonder whether it might actually be really difficult for some people to find divergent strategies to invest in because they’re so used to being implied short vol because they’re the stable convergent strategies.

[00:06:25] Katy

I definitely agree. And I mean, maybe this week was a good peek into the vulnerability of convergent strategies because your classic convergent strategy is the carry trade. And so, if you look at past crises, and I think what was so interesting in the recent period is I tend to think about, oh, we had a shock. Could this mean more?

Because a divergent thinker is thinking, you know, where asset class is moving, could we be moving away from this convergent view that we’re going to have a soft landing? And that’s kind of what you’re seeing in trend signals as a result of this recent event.

And so, I think that, you know, in general, people like to view that things are going to be stable. That over the long term, they’re going to capture this risk premia. But there can be huge changes. I mean, look at COVID.

There can be things we don’t expect that, you know, convergent strategies are much more vulnerable in that scenario. So, I do think, you know, there are going to be potential opportunities for divergent strategies going forward, because honestly, it doesn’t look that clear to me. And the market is definitely holding on.

I mean, you can look at the last two couple of days after we had a big drop. We have, “Everything’s fine. Just calm down.”

And I don’t know if that’s really the case. A convergent strategy just goes back to thinking, OK, we’re going to be fine. We’re just going back to where we thought we were going.

A divergent strategy says, ooh, what could be happening now? We might be moving to a recession trade at some point, or we might see, you know, some policy mistakes. And I think that’s a very different focus.

Like a divergent asset manager is thinking about where we might be going as opposed to saying what we should do. Are we going to get what we wanted? And so, I think it is an interesting time right now to think from that perspective.

[00:08:22] Niels

Yeah. And you and I are talking right now about kind of a shifting, divergent, less stable world as a result of policies that, to some extent, we control. But there’s another joker in all of this, and it’s obviously a very serious one.

And that is with all the global conflict we have right now, when people start shooting and firing rockets at each other, it doesn’t take much for something to go wrong. And that having a massive unintended consequence, so to speak. So, there are lots of factors to take into this.

Obviously, this is a nice segue into what we normally do, namely the trend following updates. Let me run through a couple of things and hear your thoughts about this. But, of course, you know, clearly August has been an interesting month so far for a lot of strategies, for good and for bad, clearly.

And somewhere in the middle, I think you’ll find trend following, where clearly the beginning of the month was a bit of a challenge, for sure, due to the rapid nature and the amount of markets that changed course all of a sudden. But, by the way, also, people may think about what happened in August as, oh, this is the initial shock. But let’s not forget what happened in July.

July was kind of maybe the precursor. So, these are these things that often happens in waves.

[00:09:38] Katy

In April and June, too.

[00:09:40] Niels

Yeah, exactly right. Let’s not forget about that. But to me, at least, when I think about August so far, it’s almost like the first half of the year in reverse, where we had a strong Q1 and a weak Q2.

And this was kind of a weak start, but actually the last week or so has been pretty good. But if we stick to the last four to six weeks, so we bring in July into all of this, there are things I think we could say we’ve taken away from this period, things we’ve learned, maybe a little bit about signal adaptability, maybe something about risk management, clearly.

I don’t know, in the day to day, how much you look at different models and different model speeds. From my vantage point, I think people might be interested, but also surprised in knowing that some of the trend models would have picked up a while back, a few weeks back, maybe a couple of months back, that something was starting to look different in some of these main themes of the portfolio. Long equity, short yen, was starting to look tired and starting to change. So, way before the BOJ came on board.

And of course, maybe we could also talk a little bit about the role of commodities in the last eight weeks or so in the portfolio. So, what are your kind of thoughts? What are your observations about this period?

[00:11:07] Katy

So, this is interesting because, you know, two points. One is if you look at signals and trends, some of the shorter-term signals were much more aggressive in terms of their pre-adjusting to what happened recently. And if you look at longer term signals, of course, they are still looking at these miraculous moves that we’ve seen in the first part of the year. And there was definitely a dichotomy between speed.

So, faster models would have been less affected because there was some information leak in the price movements in the last few months. But longer-term models, which is pretty much the predominant theme in our space, it’s because it has a higher sharpe and that classic 12-month momentum is well known.

But one interesting fact, and this is interesting to me, is that we did a couple of years ago, this deconstruction of the SG trend index going back since 2000. And earlier on, a lot of CTAs actually had much faster models than they do today. So it would be interesting to me to see, given the regime, in a regime that we’ve been in with a lot of consolidating monetary policy, a lot of really, sort of, a world that was converging a little bit more, pre-COVID, to a world now where the things are moving much quicker and you have more divergence, it may be the case that shorter signals might be more effective.

I mean, look at COVID. It was such a big move. So perhaps some of the shorter-term trend signals, if you took a CTA back in 2000, they might have been much more unscathed and they might have been better at picking up the energy moves.

Because let me just guess, you mentioned commodities. Commodities have been really tricky. Look at their horizon. In the spring, we saw this reflation move that people were nervous about. Copper was rallying. People were nervous that we’re going to get inflation numbers going up again. Then boom, this summer, they started to go down.

The BCOM got decimated in the last three months or so. So, you’re seeing that, you know, three-month horizon actually being sort of dominant in some places.

And so, I think that that kind of gives you a little bit of thought. And this long-term, long window for trend, although it works more smoothly, perhaps not every environment is a long-term trend.

[00:13:35] Niels

Yeah, I know we’re going to talk about a little bit later when we talk about what have we actually gone through right now, a crisis, corrections here. So, let’s keep some of the powder dry for that, because I do think it is interesting in terms of speed and the impact and so on and so forth.

Clearly, in terms of some of the themes that I see, and I think is pretty general across the space, is that it’s been the equities that have been struggling performance-wise.

It’s been some of the commodities like grains, maybe even some of the soft that has been trying to dampen and offset some of that. And then, of course, you have the bonds somewhere in between. Depending on how long you managed to get before this turned around, which, of course, also relates back to speed and so on and so forth. And then, of course, there’s always the yen itself and how people have been handling this.

My own trend barometer finished at 39 yesterday, which kind of suggests a neutral to weak performance right now for trend followers. And I think that’s pretty much confirmed. As of Wednesday, at least, BTOP50 was down 2.25% for the month, so nothing dramatic, frankly. Up 2.99% for the year. SocGen CTA index down 3.12%, up 1.5% for the year. Trend index down 4.36% for the month and up 1.44% for the year. And the Short-Term Traders index, as to your point, Katy, they’re up 62 basis points for the month, but they’re trailing for the year, only up 63 basis points. So, everything they’ve made so far, in a sense, has been made in August anyways.

Again, maybe a little bit surprising when we look at the numbers. MSCI World, pretty flat for the month right now, still up 12.5% for the year. And the S&P Global Developed Sovereign Bond Index, up 85 basis points, obviously, enjoying a little bit of tailwind, up 1.44% only for the year. And the S&P 500, up about 38 basis points, up 16.21%.

I think if people had explained to me what had happened, but not shown me any data, and they then revealed that the equities were up for the month, I would have been surprised.

[00:15:49] Katy

Nothing surprises me anymore. I mean, if you listen to the numbers that you’re stating, too, it sounds like nothing really spectacular has happened. But really, in between, there’s been a lot of movements.

And I think that, in general, I mean, philosophically, I’d say right now, what’s happening is we’re kind of at an inflection point. I mean, and it makes sense. We’re looking at the Fed starting to cut rates, and the markets are trying to digest, are we going to see a correction or not?

And so, it does feel very much that sentiment is shifting at a much quicker pace. And there’s not a lot of consensus about what’s going to happen with the US election, what’s going to happen with geopolitics?

So, it does feel, even though the VIX is low, it does feel like there’s a lot of undulations in markets this year, until we figure out what’s the new regime in a world where we no longer have coordinated central bank policy.

[00:16:51] Niels

Yeah, true, very true. And actually, I think also another thing that kind of supports how little maybe things that are happening in the beforehand was the fact that within the same week, I think it was last week, actually, we had the worst day for the S&P on Tuesday, and the best day for the S&P in the last two years on Thursday. So yeah, anyways.

All right, we’re going to dive into to your first topic, which is super interesting, incredibly relevant, of course, as always. And it is, of course, somewhat tied to, I wouldn’t say it’s tied to what’s happening in the last few weeks, but it certainly has an impact in terms of what’s happened in the last few weeks.

And of course, I love the title of your paper, which people can go and download. And because it’s a clever play on a TV series, I think it was, which was called Men Behaving Badly. I’m glad now it’s not just the men, it’s Bonds Behaving Badly, the BBB here. So, let’s talk about connection between bonds, volatility, inflation, correlation.

Let’s set the scene here a bit, Katy, and we’ll dive into it.

[00:18:07] Katy

I mean, I’ve been kind of obsessed with bonds for the last two years, just like everybody else. And there have been a few things that have really stuck out. And, you know, there are a couple of things that stuck out in such a way that, you know, we wanted to write a short paper about it to give investors some insight into the connection between fixed income and inflation, because I think most investors out there have not seen inflation.

Or if they did, you know, it’s what their parents told them about it because they didn’t perhaps invest during the 70s. And so, what happens to bonds is they behave badly, right? So, they just don’t behave well in an environment where inflation is a little bit higher.

And so given what we just experienced, although inflation is going down, it also tells us something about what to think in that environment. But we saw two key things. Number one, stock bond correlation goes positive when bonds experience inflation.

And that’s exactly what we saw earlier this year. And that’s a confusing thing to think about from an investor long term perspective that thinks about bonds as their safety trade. Suddenly bonds are no longer the safety trade. They’re now going down when equities go down. So that frustrated a lot of investors. That’s number one.

Number two, and this is something everyone saw as well, bonds are just much more volatile. So, when you look at bonds during a typical regime, and the paper that we wrote talks a little bit about this, is that the average bond volatility is usually around 4%. But during regimes and periods with higher inflation, bond volatility goes up to maybe 6% on average.

And we estimate this over decades of data. And the pattern is very clear. So, in essence, when inflation is around, bonds behave badly. They do not work as a flight to safety trade. They also move around a lot more. So those two things, from a portfolio construction perspective, are concerning.

If you’re living in a 60/40 world where bonds are your sort of the stool that you stand on, that stool now doesn’t always stay there, and it also moves around. So, I mean, I guess that’s kind of the key takeaway of this paper, just kind of understanding that link between inflation and fixed income performance.

[00:20:33] Niels

Yeah, so a couple of thoughts on that. Firstly, I don’t know if you did the analysis, but it’s just something that popped into my head when you talked about it, because I think on one side, it’s easy to visualize, OK, if inflation is higher, then, you know, as you say, bonds start behaving badly. But there are actually two types of inflation, in my view.

There’s kind of the level of inflation, but there’s also the volatility of inflation, so to speak; how predictable or unpredictable it really is. And I don’t know, I’ve not done the analysis myself because I don’t know how easy it is to systematically determine what’s a volatile environment for inflation and what’s not. I don’t know.

But I was kind of wondering whether bonds might even behave worse in an unpredictable high inflationary period, which, and the reason I mentioned it. is something that I might think we may be in or heading into, so to speak.

[00:21:32] Katy

Exactly. I mean, I think the challenge is going to be, it could also be, you know, deflation could also be bad. I mean, so what you’re talking about is volatility in inflation.

And the reason that’s important today is, you know, you come away from this paper and read it and you see like, oh, you don’t have as much diversification, but you also have to ask yourself, where are we today? And even though things look very smooth, and that’s a very convergent view, by the way, that bonds are going to behave better because inflation is going down. The CPI came in very nicely. Things are looking very smooth. But anybody who studies inflation knows that it doesn’t tend to just disappear. It tends to go in waves.

And right now, we’re on a downward wave. The question is how strong and what type of acceleratory force are we going to have in that downward wave? Are we going to go from high inflation to moderate inflation to deflation? Or is it going to peter away and sort of go back to normal?

And in the backdrop of geopolitical issues, supply chains and other things that could go wrong, we could easily have another shock that brought us back up again. So, in general, volatility in inflation should also have naturally complexity and create more volatility for fixed income and make things more complicated for fixed income in general.

And I think, given the backdrop of investors that live through this great period of constantly decreasing rates, with low volatility and inflation, it was basically close to super low, and not moving for decades, there’s a real concern there that even if inflation is going down, it’s not over yet.

[00:23:18] Niels

And some people might actually say that because we had such a long time of stable low inflation, on the backside of that, you’re also going to have a much more, “violent reaction”, so to speak, which, of course, we have no idea whether that’s going to happen or not, but I wouldn’t be surprised.

Now, let me throw a couple of things at you when it comes to these things that I, for example, some of the comments that I meet when I speak to investors, they’re quite excited, you know, 5% on bonds. So, let me sell some trend following and buy bonds instead, because what’s not to like?

Maybe you can shed some light on what’s not to like.

[00:23:55] Katy

Well, I think a lot of people also don’t know that 85% of trend portfolios are invested in fixed income. So now there’s actually carry in derivatives portfolios right now, which is non-negligible, something that we’ve wished we had for quite some time. And there’s the fact that trend has the ability to go both long and short fixed income.

So, if you just buy and get your yield, you know, that’s one thing. But, you can lock in those yields. But if you have a portfolio of bonds, you’re still susceptible to valuations over time.

And so, I think the challenge is, is that there may be more yield out there, which may be disappearing some, but there’s going to be volatility around those decisions. When did you get in? Did you get in at the top? Did you buy before the yields went down?

And as we’ve seen recently, when yields fall, they don’t fall a little, they fall a lot. So, people are always saying… It’s more like it’s a buying that dip, it’s buying the top of the yield.

And so, I think I do agree that it’s great to have that yield, but there’s still a lot of volatility around those investments and the timing of them and the rolling over of those, especially as the curve is shifting. So, it may sound like a great proposition, but there’s still a lot of risk associated with it.

[00:25:16] Niels

You know, what’s interesting about it is there’s actually a key difference between whether bonds are bought as part of a CTA portfolio, because we have to spend the cash on this, or if it’s bought as an outright investment for an investor. Because from a trend following perspective, if a fund that we manage has, you know, 80 percent free cash and we put it into up to a year’s worth of paper, we know it’s going to have a very beneficial effect on that. But if you are an investor buying it outright, and I think you kind of touched on it in a sense that they make it a yield that they think is attractive.

Of course, if they buy further out, they may also get a yield that’s attractive. But it’s this reaction pattern that has changed, which makes a much more important difference for them as an outright buyer of bonds than it does for us as buying short duration bonds inside a trend following portfolio. I think that actually is somewhat underrated in terms of that, because people expect, OK, I get 5 percent, and I get all the other benefits I used to get with bonds. But you’re saying, no, actually be aware, you’re not going to get all the benefits you used to get.

[00:26:32] Katy

Well, it’s that flight to safety trade, right? I mean, they’re not only trying to get that yield, but they’re also thinking about this as a hedge in some sense. And if it no longer is a hedge then you might have to sell it at a lower valuation.

And so, I think that’s what kind of spooked investors in 2022 is that, you know, my equity is going down, but this portfolio of bonds that I have to collateralize it is also down. Even though rates are locked in, there’s still temporary valuation that is actually not that good. And so, the asset valuation still matters, especially from a flight to safety perspective.

[00:27:12] Niels

Yeah. And something you didn’t touch on in your paper, but that we’ve mentioned briefly a few times on the podcast here is, of course, the fact that, you know, there are some people out there called the bond vigilantes and they don’t necessarily agree with all the policies that are being made. And we saw that specifically in the UK a couple of years ago.

So that’s the other part of when people buy bonds, they kind of expect, well, government bonds are government bonds. They’re safe in themselves. But maybe at some point, with the level of deficits we see and how they continue to expand, at some point, I’m not predicting that, but at some point we may have to consider that maybe even the quality of the bonds are not the same as they used to be.

But let’s leave that aside. I want to ask you a little bit, I think you mentioned that in your paper as well, about conditional return distribution and how that changes when inflation comes into the picture. I know it’s hard to describe a chart on a podcast, but maybe if anyone can, you can, Katy.

[00:28:17] Katy

So, we have this really cute plot in here and it basically has a distribution of bond returns during equity down periods with both high and low inflation. And what we show is, when inflation is low, you have a very nice right shifted, positive centered, low left tail events, bad events distribution for bond behavior during equity down periods.

So that’s your classic flight to safety. Equity marks go down. Bonds tend to do well. You know, everything is rosy, negative correlation.

But if you look at the distribution of bond returns when equities are down, when inflation is higher, you see a very different picture. You see a negative average distribution. You also see a much wider range of values and you see a few very large fat-tailed left-skew events where bonds basically went bust at the same time as stocks.

And that kind of shows this very different world where the distribution of what your bonds may do with low inflation is, you know, generally a good distribution. But when inflation is higher, you see that, again, bonds don’t look as good – behave badly. Bonds are behaving badly.

And so, I think your question about the volatility of inflation is also important here because we didn’t study that. This is a pretty straightforward paper. But in a world where you have big shifts and changes, that naturally causes more disruption. So, I think that’s something that we didn’t study, but it definitely is something to think about in terms of volatility of bonds.

[00:30:02] Niels

Yeah, yeah, yeah. We talked a little bit about the fact that this will have an impact on the 60/40 portfolio. We saw that already in 2022. Of course, people will remember that as an awful year for a 60/40 portfolio for sure. Talk to me about some of the alternatives you looked at in the paper and what you found.

[00:30:23] Katy

So, we looked at mostly long/short signals across different asset classes. So, if you imagine a typical classical investment approach, right? You have stocks, you have bonds. What can you add? So, we added also gold. We also looked at commodity indices and we looked at the dollar.

And what’s interesting about that is that, you know, most of them don’t have very good correlations during equity down periods. But we, instead, examined a long/short trend following approach as a simple signal of imagine a world where you could be dynamic in how you allocate to these asset classes instead of just long only. What kind of correlation benefits can you get during equity down periods?

And what we found was that long/short positions in fixed income, so being able to be long or short had a negative correlation with equities during down periods. So being able to have that flexibility.

And secondly, you also see that in the dollar index, you also have some negative correlation, and even gold. So being able to be long/short and strategies, or tactical in those environments, in either direction, when equities are down, has that negative correlation which is diversifying. And commodities, actually, went from having a very positive correlation to a flat correlation (basically close to zero), which is much more diversifying.

At the end of the day, for an investor, there are two things that kind of matter for portfolio construction. Number one, correlation across the assets that you own. And number two, the level of volatility that you add to your portfolio.

So, if you just add long only bonds, you have something that goes from negative to positive correlation that also increases in vol, which means your diversification of your 60/40 goes down. Whereas if you add things that have that negative correlation during down periods, and also could be, for example, managed, so you don’t have extra vol from that, then you actually can provide a lot more diversification when a 60/40 portfolio will struggle.

[00:32:31] Niels

It’s interesting you mentioned that, and it’s not surprising to me, I guess. But what’s interesting about it is that so many people continue to talk about, oh, you should just be long gold. Like, okay, it’ll solve all your problems, just be long gold.

Now, I know some of them, and actually some of them I respect a lot, they do it, they also talk about it for different reasons. It’s a slightly different role. But I still think there is this perception out there that people think that long gold will always be beneficial kind of in an equity downturn, or if inflation, you know, spikes. But I just don’t see any consistency in that argument.

You clearly have also found that taking a long/short approach would be better. And it brings me to this point about, I just wonder if we are doing ourselves a disservice not labeling what we do, using the words long/short kind of global futures, instead of managed futures, instead of trend following.

But people can tend to understand the word long and the word short. And, you know, so I know you and I are not going to change the way people talk about what we do. But I think it’s very descriptive to just break it down simply and say, this is what we do, and this is why it works.

[00:33:48] Katy

I agree. I mean, and I think in the space where people are generally long only, the simple explanation that you don’t have anything that goes short in your portfolio, and we’re also adding some asset classes that you probably don’t have. So, things like gold, other things, it’s just expanding the number of opportunities set that you might have across different macro regimes and different environments.

And I have to agree with you on the gold point is that assumption that gold is going to do well during any recession or inflation, it may be true on average, but the timing of those is never perfectly synced with those markets. So, there is some essence of being able to capture the trend when it’s actually happening. I mean, if you look at gold, it’s been more resilient, but there’s been volatility in gold too.

So, any particular recessionary period or challenging period where people turn to gold based on the safety trade, there’s always some residual of like at what time and when does that gold trend actually have the most juice? So, if you just buy it long, on average, it does work to some degree with a lot of noise, but being a little more tactical might make sense.

And then will it overextend? And then you should be going short. I mean, when it ends, right? So, I think the long/short point is really the ad of having a dynamic strategy is that with the 60/40, you have no ability to do that. You can’t capture these type of environments because the market moves aren’t all long.

[00:35:19] Niels

A lot of things work, Katy, when you hold it for 20 years. People just forget to talk about the 10 years where it didn’t work in between, but there we are. All right, well, let’s move on to another topic, which is, of course, highly related to what we’ve spoken about and where we’ve kind of talked around the term crisis alpha that you coined many years ago.

Because our friends over at Hedge Nordic wrote an article this month, I think, very well headed, Crisis Alpha in Short Supply, because they were talking about what has been going on for a few days in early August. And of course, when you look at the CTA returns, they were not positive early on in August. And they, I think, went to your old shop, so to speak, RPM in Stockholm, and got some sense in terms of what’s been going on.

And they even also mentioned the fact that this has been going on in kind of a two-stage attack, so to speak, on trend. Namely, a big part of July was challenging for trend followers, and then, of course, the first week of August, very challenging. Talk to me a little bit about when you read an article like this, to me, it reopens the discussion about first responders, second responders.

What are the roles in the portfolio? How do we define them? I’d love to hear your thoughts, your kind of recap of that. And then, of course, as you and I already touched on, a little bit about speed when we talk about this.

[00:36:57] Katy

Yeah, I mean, this is a great… I get a lot of questions about this, because this concept of crisis alpha, it’s really opportunity gained during periods of losses in markets. And there are different types of crisis alpha, right?

There are the short-term losses, which is a very different crisis, versus sustained losses. So, for me, a crisis is a sustained period of losses in markets, meaning months to a couple of weeks, at least, whereas a correction is when the markets go down and then come back to where they were. So, there isn’t really a crisis, per se, of classic sense when you have something that happened last week.

It’s very difficult for trend followers, because if you look at the frequency that we trade the markets, there’s very little ability to be that quick to react. And we’re following sort of medium to long term general themes of the markets. So, crisis alpha will be in short supply for strategies like ours in a very, very quick environment.

On the other hand, what does make me interested right now is that if you look at where trend signals have pivoted, we went from a situation where we were short bonds, long equity, and generally long commodities, and long the dollar too (but that’s a little more complex), to, now, trend signals (although they’re weak), they are still slightly long equities, but they have long fixed income views and short commodity views and neutral in the dollar. That looks a lot more like a recessionary type signal.

And so, the question will be, does this correction eventually turn into an actual crisis? Or was this just noise? And so, I think the challenge for investors is (going back to that first responders, second responders, third responders), the first responders are things that actually benefit when the VIX spikes. They’re sort of short-term trading, they’re options, it’s very hard to capture those big moves at the beginning. But the second responders are things that kind of see that something is changing, change positions with it, and then eventually follow that train if the train goes running off the tracks.

And I think that is where there’s a huge difference in terms of understanding these strategies that really, it’s not just about one day, it’s about much more prolonged periods of crisis that are more interesting for the strategy.

[00:39:28] Niels

Yeah, I want to remind people that Alan, Dunne, and I did a long form conversation with Katy last year, where we actually dive a lot deeper into crisis alpha. And Katy shares the original definition of crisis alpha, which is a lot more nuanced to what people have used it for. And I think it’s really important people go back and listen to that conversation.

It’s in the Top Traders Unplugged series, and you’ll find it very easily. The other thing that I think is interesting about this discussion, crisis versus correction, is that a crisis can be so quick that you and I would classify it as a correction. And that actually might not hurt too bad for a trend follower, because we’re simply too slow.

It’s a blink of an eye, and we’re back to where we were, so to speak. But then people might not appreciate necessarily that it can still affect our positions, because volatility would have spiked. And we will pick that up regardless of whether prices go back to where they came from.

So, there are a lot of moving parts in all of this. Whereas maybe, going back to the point about speed, where a short-term strategy, and I loathe to use the word short-term trend following, because I don’t really think there are short-term trend followers. But let’s say a short-term strategy might do really well in the first or second day of a “correction or crisis”.
But if it turns back (as it almost has been this time around, that markets just jump back straight away), they’re going to be on the wrong side of that trade in the rebound. So again, very difficult for them, very difficult for us to be on the right side, depending on literally the speed of the market change.

[00:41:16] Katy

Well, I mean, you bring up a good point. I love that expression, ‘Catch a falling knife’, right? I mean, that’s kind of those one-day moves. It’s extremely difficult to play those. And there are people that try, but in general, if that’s what you’re doing every day, then you got to do that the other days. And I think that’s hard because really those extreme moves like that are very hard to capitalize on as an investor in terms of timing.

And so, I think the challenge with Crisis Alpha that people always have is that if you think of the original title, the title is In Search of Crisis Alpha. The point is we are searching for it, but it doesn’t always come, right? It’s not a guarantee.

It’s a strategy that’s searching for a divergent world, for things to go in a drastically different direction. And we’re searching now, and it doesn’t seem to be there yet. So that’s kind of a point is that this is not a guarantee. It’s not a put option. And it’s really more about a strategy that’s adapting to different macro environments and ask yourself the question, does anyone know what the actual macro environment is going to turn into at this point? I think there’s a lot of diversion views right now.

[00:42:34] Niels

Except for the people on mainstream financial media who seem to know everything about the future. But certainly, in the trend world, we know nothing about the future.

Our friends over at Hedge Nordic, they wrote another article they published, I think maybe yesterday or today, that caught my attention, but maybe not for the reason that people might think.

So, they talk about the fact that they follow the Nordic CTAs quite closely, and there are some big ones still around. And they mentioned that one of them, I’m not going to mention it by name, but one of them got caught, it seems, in the first part of August and seemed to have built up a decent loss for its volatility, let’s put it like that. However, what it got me thinking was that it all started with kind of the carry trade being unwound, if we should just point the finger at one thing, so to speak.

But it reminded me the fact that a lot of trend followers, I think (again, we’re speculating here), kind of started adding, and some of them are very open about it. They say, yeah, we do 70% trend or 80% trend, and then we have 20% or 30% non-trend, diversifying strategies. One of those strategies that they had put in was carry, for sure.

And I’m not suggesting that this particular CTA is doing carry. What I’m saying is that what we’ve just gone through is certainly one of those rare occurrences where the “carry strategy within CTAs” has been tested, because it doesn’t happen very often. At least it hasn’t happened often in the last 20 years, but maybe in the future, who knows.

So, I don’t know if this is something you follow, even if you follow carry signals, so to speak. But what are your thoughts on this? And do you think this might change people’s mind about that side of things?

[00:44:22] Katy

Well, this is a good point, because what we have seen when we’ve done analysis of CTAs over time, we have seen that statistically that the carry factor comes up more prominently in CTA returns over time. We saw this in general, we studied a couple years ago in a paper where we studied CTA evolution. And the point of that was we were finding a lot more non-trend signals and factors coming up in CTA returns.

And this makes a lot of sense because trend did struggle quite a bit prior. And so, I think a lot of managers, to smooth the ride, added some more convergent strategies like carry to smooth the ride for their investors. And I think the challenge with that, and we also talked about this in a paper where we studied the COVID crisis. So going back to that as well, what we found during very extreme environments, again, carry being convergent, being pure trend and being faster was better equipped to deal with COVID, which was very violent and very short.

And so, I think what happens is when you have these types of events, it really can expose how much carry you have in your portfolio, especially if you’re doing it relative value with leverage. If you have some directional carry, it probably wasn’t as bad. But if you’re kind of managing how much leverage you have in that, you’re not doing pure out relative value bets on it. But that all comes out.

What’s funny with carry is it’s great until it isn’t. It’s kind of like that movie. There’s that famous movie, Carrie. And it’s kind of Carrie and carry. It sort of reminds you, you should go watch the movie when carry blows up.

But anyways, so I do think it will give investors pause that see that because if we do have another event where we actually do have that crisis alpha environment, maintaining a big exposure to carry generally doesn’t work as well during those environments. So, we saw that in COVID. We could see that again if we’re using trend following as a diversifier, as a divergent strategy, it will water down some of that ability to capture that.

[00:46:41] Niels

Yeah, I mean, I think it’s hard as a manager in a sense to… We know that investors love consistency, right? So, if they could get a much more smooth return stream, they would take that for sure. It’s just that pure trend doesn’t allow you really to give them that.

So, it’s always a tradeoff. And yeah, people love trend in 2022 when everything is roaring. But then they really don’t like it in 2023 when it’s giving back some of those profits.

And likewise, here, they love the fact that carry probably has added some lifted through the lean times and smooth out the returns. But then it introduces losses and volatility on the downside during something like that. But that’s just how it is.

I want to maybe end on a slightly different note to where, and then we can sort of freestyle at the end, bring up anything you want, Katy. But another article that hit my radar, it’s from a firm, I don’t know them, Academy Securities. And they wrote an article, it was actually sent to me by a really good friend of the show, Brian.

And the headline is, did the VIX really hit 65 on Monday, which was the 5th of August? And so, they go into kind of a somewhat deep analysis as to what actually took place. And they mentioned specific time stamps and so on and so forth.

And a level of 65.73 on Monday, which I think was the highest VIX level reported, is a very high level. It’s very rare we go to those levels. And it does have an impact.

It’s not a number that we can just ignore because so many people follow the VIX. Is it the gauge of fear or whatever they call it. So, it is an interesting topic, even though I’m not an expert by any stretch of the imagination.

They go into some of the reasons why it may have been calculated at 65, things that I didn’t even know. That it’s a very short window of time they use for the options that prices the VIX. And they talk also about where the futures contract for the VIX was trading around the same time, which was much, much lower than 65.

And the reason I bring it up is that I think the VIX and the level of 65 certainly would have instilled some panic to some extent in the markets, in an investor’s mind. But what if it wasn’t really 65? What if it was a much lower level? Perhaps there wasn’t really any reason to panic and so on and so forth.

So, I would love to hear your thoughts on this, whether you even follow the VIX, whether it’s something that features in some of the stuff you do. And maybe you know much more about how it’s calculated than I do. I’d love to hear your thoughts.

[00:49:39] Katy

Yeah, I mean, I think that’s a very important point because that was one of the biggest headlines on Monday. There was one thing I did notice, and this was interesting to me. On Friday, before this Monday occurred, there were a couple of bad things that kind of accelerated the pot, I’d say.

So, Friday was a classic risk-off day. Economic concern, equities are down, bonds were way up, right? So that’s a classic risk-off move.

It turns out then we had into the weekend and we saw these big moves in the yen before the opening on Monday. So, we’re kind of going into this straight up cold turkey into the Monday morning. And if you look at asset classes in the US, the bonds actually didn’t rally on Monday that much.

So, it was less of a risk-off move. It felt just like a recalibration, an equity shock on Monday as a result of the carry trade unravel and sort of the big moves in the yen. So, what was interesting to me is that what started as risk-off turned into Japan and sort of a systemic effect of Japan and how many people were in positions related to Japan on Monday.

And the fact that the VIX, if it wasn’t really 65, that wouldn’t surprise me. But what concerns me is that the VIX is really the thing that people talk about, and it was all over the news. And so, everybody going, the VIX is 65, that is like, it’s 2008, freak out.

And I’ll tell you one other funny fact, this is a cool point, is that they’ve done some studies back at MIT. The MIT lab for financial engineering have done some cool studies where they measured a trader’s reaction physiologically. And they found that stress levels of individuals were directly correlated to the VIX. I’m not saying that they were looking at the VIX and it made them stressed, but that when the VIX is high, that people are stressed out.

And we know cortisol is going to make you go to McDonald’s and have some French fries because you’re stressed out. And so, if in fact that is an artificial number, there could be some feedback effects of that, that people look at that VIX and they report about it. And then people think that it’s a bigger sign that we actually hit a real recession move and that it is time to panic.

I don’t know which one is right. Is it the chicken or the egg? But the VIX is a very, very important barometer, especially for financial media and for just investors as a whole. So that is a very, very interesting paper.

[00:52:19] Niels

Yeah. And also, I didn’t really know that in the calculation of the VIX, apparently you also look at just a bid of a spread and it’s not just traded prices. And it really was eye opening.

And maybe it’s time to revisit some of these things as, you know, in terms of how we calculate that, because if there’s one thing we kind of pride ourselves with in trend following is that, I mean, the only truth really is price. And that’s what we use in our models. And of course, we don’t use the VIX as a volatility in sizing our positions, unless you were trading specifically the VIX, you probably would.

But for all the other markets, we look at the individual volatility. But volatility is an important ingredient in what we do. Volatility is an important ingredient in risk management.

I mean, VAR models, value at risk models, are used by many people around the world. Which, by the way, there was another paper, I think, I can’t remember if I discussed it with Nick last week about a lot of people have adopted the VAR methodology in their risk management. But what happens is if everybody follows VAR, and we all have to delever at the same time and so on and so forth?

But of course, not all trend followers use VAR. We know that for sure. But still, a lot of interesting things come from periods like this that we can all learn from. And I think also, more importantly, investors can use for assessing some of the strategies they’ve been looking at or invested in to see how they deal with these situations.

Overall, my impression is that, on an industry level, we’ve done pretty well so far. I mean, as I mentioned earlier on in our conversation, the indices are down a little bit, but no panic. Nothing, untoward compared to other periods with stress.

And maybe it’s a good reminder for people that equities can actually drop 12% in a day. They did it during COVID. And now they did it in Japan out of nowhere. So, risk is different.

[00:54:24] Katy

You just need a catalyst, right? I mean, I think that’s what COVID taught us that, you know, you just need some sort of catalyst to shift sentiment. And I think that’s why I mentioned what happened on Friday and Monday.

Because to me, the story makes sense after the fact. You had nervous investors that were worried already because there was some risk-off behavior. Then you have this massive Japan-focused event, which kind of served as a catalyst for deleveraging.

And how much risk management and other constraints magnified those rules, I don’t know. That’s hard to measure. But there’s always a good probability.

And there’s also a lot of people out there that are using sort of buffer funds and other things that also use options. And if those go way out of range, then there’s rebalancing that occurs based on systematic or sort of rules-based processes that are hard to kind of calibrate. I mean, we talked about 1987, right?

That was a portfolio insurance event, right? Everyone selling off at the same time. So, it looks like we’re kind of still up to our old tricks in markets, no matter what.

[00:55:33] Niels

Although I wanted to end on a note of new tricks, because I think you told me once that recently that you were on some kind of AI panel. And I was just wondering, a lot of people think that AI, oh, that’s going to be the solution to all our challenges in the investment management world. And I’m just thinking, even with AI, what on earth would that have helped in the last two weeks with this situation? And I can’t come up with one single idea that it would have improved.

[00:56:05] Katy

I mean, it’s really hard. A big move like that is really hard to predict. It’s really hard to trade.

And oftentimes what we’ve learned is not overreacting is probably the best thing to do. And I think as systematic managers, it’s particularly interesting, these environments, because you get a lot of questions like, what are you doing? And we say we’re following our process.

And that has worked for us. And it does work, on average, to remain calm. I mean, because look at today, somebody could have panicked and sold out of everything at the bottom on Monday. And then everything’s back. And so, it would have been better if they just didn’t watch the news and see the VIX at 65 and then go sell, right? And that’s kind of the challenge is sort of sticking to the process and not overreacting in the heat of the moment is important.

[00:57:01] Niels

Couldn’t agree more. They don’t need to watch the news. They do need to listen to our conversations though, Katy. And I really thank you for yet another super insightful, engaging, fun conversation. I’m sure people listening to us have learned a lot from you today like I have and can’t wait to do it again in a few weeks.

If you enjoy these conversations, why not head over to your favorite podcast player and leave a rating and review to show how much you appreciate Katy and all the time she puts into this. And also, if you want to send a question in, next week I’m going to be joined by Rich. So that’s going to be another hardcore trend conversation, I think. So, if you want him to answer some questions, send them to me, info@toptradersunplugged.com is the usual email and I’ll do my best to bring it up.

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

[00:57:59] Ending

Thanks for listening to the Systematic Investor podcast series. If you enjoy 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. And 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.