Building A Hedge Fund Allocation ft. Alan Dunne

[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 all, welcome back to this week’s edition of the Systematic Investor Series with Alan Dunn 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, great to be back with you this week. How are you doing?

[00:00:37] Alan

Very well, Niels. Great to be back. And how are you doing?

[00:00:40] Niels

Doing well. Summer has arrived in Switzerland, finally, after months on weeks of rain. That’s how it feels at least.

What about Dublin? Are you getting some warm, nice weather now?

[00:00:52] Alan

Not really, I’d have to say. I have to be honest and say we haven’t hit the full extent of the summer just yet, but we live in hope. Hopefully we’ll see some sunshine any day now.

[00:01:02] Niels

Absolutely, absolutely.

We’ve got a really great line of topics thanks to you. We have a question that came in that we’ll be tackling. But before we do so, as always, Alan, I’m always very interested in hearing what’s been on your radar for the last few weeks since we last spoke.

[00:01:20] Alan

Yeah, it has been a really interesting period of markets and a lot to talk about. But this week in particular, we’ve had kind of an unusual shift, a rotation, I think, in the markets with some of the high-flying tech stocks coming under pressure. But at the same time, investors seem to be rotating out of those sectors and into industrials, financials, materials.

So, trying to figure out what to make of that is certainly an important theme, partially related to the Fed, partially related to Trump trade, possibly. We’ll talk about that as we go through. But one piece that I saw recently, which I thought was interesting, I don’t think this particular piece is driving what we’re seeing this week necessarily, but it is a cautionary piece in relation to AI and everything AI-related.

And I know we’ve talked about this before, to what extent is AI going to change the world and what’s going to be the economic impact, et cetera. But Goldman’s had a piece out in the last month or so called Gen AI, Too Much Spend, Too Little Benefit? And they interview a few people on both sides of the argument: an academic, Darren Acemoglu at MIT; and then their own head of, I think it’s equity research, Jim Covello.

And both of them, both are on the kind of the more skeptical side in relation to AI. They also talked to some of their software and internet research analysts at Goldman’s and they’re more upbeat. But I thought it was interesting to get the more skeptical perspective on AI, which we don’t hear too often. And that basically goes along the line of that maybe that there’s not as many tasks that will be automated by AI.

It’s a very costly technology. Jim Covello is making the point that if you compare it, say, to the internet, the internet was a very cheap technology, which allowed a lot of disruption. So, Amazon was able to sell books more cheaply than Barnes and Noble.

So that was the source of disruption. Whereas with AI, it involves a lot of spend. Basically, there’s a trillion dollars expected in terms of CAPEX spend on data centers and chips and infrastructure.

And their point is that there’s no big, complex task that it can solve yet. Now, the optimists say that will come in time. But again, Jim Covello was saying, even when the internet came in first, people were able to say, these are the types of applications.

You’ll see it. You’ll have Google Maps on your phone in time that will displace kind of your SatNav. But AI optimists aren’t able to point to those particular complex tasks that it will solve. So, I mean, who knows is the bottom line, but it does highlight the huge range of expectations around this.

The MIT academic was saying he thought it would increase US productivity by 0.5% over the next decade. And that’s 0.5% in aggregate, whereas there are other estimates that it’ll increase productivity by at least 0.5% per year. So, a huge debate as to how significant AI is going to be.

Interestingly, Jim Covello, despite being a skeptic, was still of the view that you have to be invested and that the spend chasing the dream will continue at least in the short term, and that the tech companies will continue to spend on investing in AI. So, it still makes sense to be invested in these companies that are part of the infrastructure of AI, and NVIDIA being the obvious candidate, and that this can continue.

But he did point out, for companies who’ve had substantial AI spend but are not seeing any boost to revenue, that they are being marked down after their earnings. Salesforce was an example of that. So, bottom line for him is he said it could last another 12, 18 months. But if you hit a recession, then that’s when the spend on this stuff comes under question. And at that point, you could start to see the technology companies scaling back spending, which would then impact the whole boom in the space.

So, I thought it was a very interesting perspective. I hadn’t heard or seen that kind of counter arguments to the AI craze and certainly something to monitor going forward.

[00:05:40] Niels

Have you, on a personal level, have you tried to play around with it a little bit?

[00:00:29] Alan

A little bit, yeah. But it’s been generally for tasks around drafting stuff and even getting it to do certain types of documents that are fairly standard, it can be a good starting point. So yeah, it can certainly automate and be helpful in some tasks.

But yeah, as they’re pointing out, I suppose they say the place where it’s been very effective apparently is coding and there is a benefit there. But beyond that, I haven’t come across other uses for it yet. But how about yourself?

[00:00:29] Niels

No, I’m curious about it for sure. And of course, with all the content that we produce for the podcast, a lot of content that I have to produce for my day job. Yeah, if you can find ways to improve it and maybe also save time at the same in the same round, I mean, yeah, that would be super useful.

But it is really about the quality at the very end. And I fully understand that you probably have to have a human touch to it. But yeah, sometimes I’ll use it for, for example, preparing for an episode where I’m a little bit short on time.

Like today, where we’re actually discussing three pretty long papers, that can help me summarize some of the key points. Now, I’m always a little bit unsure whether it actually got the key points correct so that I’m not saying something completely stupid on the podcast. So I’m hoping it did. But things like that, I think it’s interesting. And, and so and I’d love to learn a little bit more about it, for sure.

Now, I did try, actually earlier today, to just ask for it to both explain but also visualize a couple of different trend following model types in a chart. And it didn’t get it quite right. Let me put it that way.

So maybe it needs a little bit more coaching on trend following. So, you should listen to our conversation today. If you’re out there, chat, GPT, or whatever it’s called.

[00:07:50] Alan

Well, it can be good to come in with some creative titles for a thing. And when I saw you putting up the last conversation I had with Cem as The Unstoppable Volcopolips, I wondered was that an AI creation?

[00:08:02] Niels

Yeah, it’s funny, that’s actually not from me. So, I rarely change the headline that I get from the producer. Because when he comes up with a headline, he will have listened to the conversation. I may not have listened to it yet if I’m not doing the recording. But yeah, you know, it was a good conversation, by the way. And it got a lot of traction.

[00:08:23] Alan

Yeah, well, I mean, one of the interesting points that we touched on in that in terms of we were talking about when would this AI rally come to an end? The obvious thing to say would be, you know, disappointment around earnings in in for NVIDIA or one of those stocks.

But Cem is making a point, which actually looks like a good point in light of what we see this week, that sometimes it can be good news elsewhere. So, you know, the fact that we’ve seen good news for, you know, financials, materials, industrials seemingly reacting to the Fed news and Trump, and that that in itself causing rotation out of some of the other sectors. So, it can actually be good news somewhere else that can cause a trend to reversal just because of the market dynamics, which is an important point, which I think we have seen played out a little bit this week.

[00:09:15] Niels

Yeah. You know, what caught my attention this week is completely different to your very astute observations about, you know, important stuff like AI. I noticed that the price of fossils have hit a new all time high.

And I don’t mean fossil fuel. I literally mean the price of a skeleton of a, I think it’s called a Stegosaurus or something like that. And it was bought by a hedge fund billionaire, Ken Griffin.

He paid 45 million for this at a Sotheby’s auction. And I don’t know if that’s for his new allegedly $1 billion home in Florida or not, but I thought that was an interesting thing.

The other thing I noticed was I heard one of our previous guests. It’s been a while since he was on the podcast. He’s very interesting to listen to. And that’s Ben Hunt. And people will know him from Epsilon Theory. But I heard him speak very recently about the biggest regrets of investors and financial advisors. And you would kind of think, well, losing a lot of money would be a really big regret, right?

But he points out that, you know, losing a lot of money, as long as all your peers are losing money, that’s actually not the biggest regret. It’s the opposite. It’s not making a lot of money when everyone else is making a lot of money. That’s the biggest regret.

And so I was wondering, do you think that’s right? I mean, do you think that’s actually how investors psychology works?

[00:10:43] Alan

I think there’s a lot of truth to that. I mean, FOMO, you know, fear of missing out is a part of that. And, you know, humans are wired to compare themselves to everybody else.

So, you know, what’s the expression? Yeah, better to fail conventionally, you know, to lose money at the same time as everybody else rather than succeed unconventionally. So, I think definitely that that’s part of the FOMO narrative.

[00:11:11] Niels

Yeah.

And the final thing I was just listening, I was out walking this morning and I was just listening to the latest memo of Howard Marks that came out yesterday, I think, at least in audio form. And it’s all about, you know, how it’s really impossible for anyone to predict anything. But of course, he has a very elegant way of explaining this.

This is something we’ve been talking about for decades, because that’s the whole premise for trend following, of course, that you can’t really predict anything. But still, yet most investors prefer to have a manager that claims that they know where prices are going and so on and so forth. But actually, it’s always good to hear, you know, his viewpoints and so on and so forth.

So those were my kind of observations. But more importantly, we’re going to talk about some other observations. And now we’re going to completely forget about what Howard Marks talks about when he says you can’t predict anything, because we’re always interested in hearing your global macro thoughts at the moment.

So, let’s jump into that. You’ve had a couple of interesting conversations. Obviously, a lot of things have happened in the last week in terms of the assassination attempt on Trump, the Republican convention that’s taking place right now.

Now we know who the VP will be. And he’s even, I think, had some conversations, or at least that’s my impression that he’s made some noise about what he thinks he may do when it comes to Jerome Powell. So, what are your thoughts on all of these things at the moment?

[00:12:41] Alan

Yeah, I mean, there’s a huge amount of talk in the markets around the Trump trade. So just to focus on that for a few minutes to get a sense on, are we actually seeing it yet in the market or not. And as you say, we’ve had a lot of developments in the last kind of one to two weeks.

We had Biden’s poor performance in the debate. We had the assassination attempt, and then obviously, J.D. Vance confirmed as a VP candidate. And I mean, in aggregate, if you look at it, Trump has gone from being about a 50/50 likelihood of winning to, on the prediction markets on Betfair, to a two to one on, about 67% likelihood. So definitely, odds are moving heavily in his favor. And equally Biden is not even certain to be the nominee for the Democrats.

So, after the debate, people were saying, oh, yeah, we’re starting to see the Trump trade kicking in. We had maybe about two days of weakness in bonds, which seemed the obvious expression of it. But that’s somewhat reversed.

Well, yeah, very much reversed. And harder now to say, certainly a lot of talk about Trump trade being priced in, but certainly not, maybe in parts, but not in aggregate. And if you look at what does a Trump win mean, there’s nine, possibly 10 different things to keep in mind here.

So, it’s quite broad based, with many angles. So firstly, in relation to tax cuts, there’s a general expectation that he will extend the existing tax cuts, and maybe even shave the corporation tax a little bit. So that’s kind of a key aspect of his platform.

Spending, there is some suggestion he may roll back on some of the Bidenomics inflation reduction act and infrastructure build type of acts. But equally, some people are pointing out that actually, there’s a lot of jobs have been created from these plans and they’re not unpopular, so it might be just as easy to leave them. So, in terms of spending and tax cuts, certainly the obvious thing to say is deficits won’t be coming down anytime soon. That’s a given.

In relation to trade and tariffs, obviously he’s talked about a 10% tariff on everything and 60% on China. The Democrats have already moved this way, to an extent, under Biden, after Trump. So, we’ve seen a continuation.

There was an interesting speech I saw from the Undersecretary for International Affairs, Jay Shambaugh, I think is how you pronounce his name, all about Chinese overcapacity and how it’s such a big issue. And it’s true.

I mean, China has responded to its problems by giving subsidies for EVs and solar energy and all of that. The net effect has been excess capacity, which it is trying to export to the rest of the world. The US is very sensitive to it. Already, under Biden, and that’s going to continue under Trump. So, trade and tariffs is going to be back, I think, as a big issue as soon as he comes in.

Linked to that, though, is the dollar. And, you know, Robert Lighthizer, who is his kind of trade plan architect, he hasn’t been mentioned so much in the news of late, but going back a couple of months, people were very much pointed out that his whole philosophy is around aiming for trade balance on a bilateral basis with all of the major trading partners. So that would mean eliminating the trade deficit with China, eliminating the trade deficit with Mexico, eliminating the trade deficit with Japan. And a key element of that is currencies.

Trump did do an interview with Bloomberg this week, and he’s talking about the misalignment in the dollar/yen and the dollar/yuan. So, I mean, dollar/yen is down a little bit in the last week. Well, it’s down a fair amount in the last week. That’s probably obviously more so related to intervention over the last 10 days or so. But I do think that’s an area where it’s potentially hugely disruptive.

Now, I saw John Authers, in Bloomberg, writing today saying, well, you might want a weak dollar, but can you achieve it if you’re going to be putting taxes and stimulating the economy? But that’s by the by. I think dollar policy is a very important aspect.

And then you’ve got other issues like antitrust and deregulation. The general view is Trump is going to be pro-business. But at the same time, he’s picked J.D. Vance, and he’s already been kind of vocal, along with Elizabeth Warren, kind of trying to regulate the banks or rein in the banks a little bit more. And he’s also an advocate of this lady, Lina Khan, who’s Trump’s antitrust person. So, it’s not clear if they’re going to be as maybe pro-business as you would expect.

And then there’s immigration. We spoke to Adam Posen on the podcast, and that was one of the areas that he really pointed to, you know, in terms of potentially stagflationary. Obviously, the surprise for the U.S. economy has been the strong growth in the last year, which has been facilitated by immigration. If you reverse that, you’ve got a reduced labor supply.

So that pushes up wages. So that’s a stagflationary impulse. And then you get into Fed independence.

Now, he said he would allow, he said something like he would allow Powell to stay, you know, particularly if he was doing a good job. So, it wasn’t clear what he would do if he wasn’t doing a good job. So that remains, you know, kind of a point in left field. Obviously, he doesn’t appoint a new Fed chair until 2026. But, you know, he can certainly have a lot of comments around it and can undermine.

Then the other things, obviously, in relation to green energy, you know, the philosophy is drill, drill, drill.

And then Ukraine, you know, obviously, a risk of less support for Ukraine, which then could obviously feed into European defense spending, et cetera.

So, I mean, this is a multidimensional policy platform, potentially very hard to look at it and just say that’s the obvious impact. But what you would say is, what’s almost certain is high, high deficits. You know, that would be the obvious takeaway to think. What’s likely, you know, tariffs and more fraught trade policy.

And then what are the big uncertainties but are potentially very big issues? I would say immigration, the dollar, and the Fed. And obviously, as I say, we’re seeing a little bit of dollar weakness, but not a huge amount. And they would be the things I’d be watching. Gold is obviously starting to rise, which could be reflecting that weak dollar story, not much in the euro.

The conundrum, obviously, with respect to dollar/yen is, if you want to have some kind of, you know, Plaza Accord or something like that, where you say to the Japanese, we want you to participate in selling dollar/yen and drive it down. You know, they may want to sell treasuries as part of that, which obviously doesn’t suit the US’s agenda. So that’s why I think Yellen has been kind of less keen on intervention.

So it’s not an easy conundrum to solve. But I think they’re the things that would be the really big issues. And I don’t think we’re really seeing that reflected in the markets just yet, but they would be the ones to monitor.

[00:19:53] Niels

It’s a really good list you make and some very important points. These are also points that I discussed with Cem and MacroAlf, Alfonso Peccatiello, which is coming out in a couple of days on Wednesday; a very important episode, I would say, that people should listen to.

One of the questions that I posed to them, in that recording we did a couple of days ago, was in light of all these things. It was in light of the fact that a lot of Western countries are running with very high deficits, I mean, with few countries as the exception, and it doesn’t look like this is going to change for a while. I did raise the question, and I’d love to hear your thoughts as well.

People might be surprised with the response I got from Cem and Alf about should investors start to question the AAA status of some sovereign debt, including the US, and in particular in relationship to what’s going on in the political space. Meaning that everybody knew, before the debate, that something was probably not right with Biden and his health, but the thing is, what changes is when everybody sees it, then everybody knows that everybody knows.

It sounds like a little silly thing when you say it like that. It’s obviously similar to the fairy tale, the Danish Hans Christian Andersen fairy tale with the emperor has no clothes, where everybody pretended that, oh, yeah, he had clothes, but they could see he didn’t have any, until the little girl shouts, the emperor has no clothes, then everybody knows that everybody knows.

So, it’s a small thing. It sounds almost ridiculous when you say that that may have a big change. But nevertheless, it’s one of those things that I’m thinking of, and that is, at what point do we all openly accept, at least, that we’re on an unsustainable path with some of these, the way our economies are run? And that should be reflected differently in the price of bonds and the interest rate levels?

[00:22:08] Alan

Yeah, well, I think it’s a fair point. And I mean, you’re right, because it is a sentiment issue. I mean, because obviously, we’ve had rising deficits.

Okay, you’ve had a higher inflation in the US, which has kept the debt-to-GDP level somewhat in check, but all the forecasts are for high and rising debt-to-GDP levels. And we’ve seen, over the last year, how suddenly it came into the market as a risk factor. Suddenly, we were talking about debt sustainability, whereas months prior to that, we weren’t.

But equally, it went away, and the focus has shifted somewhat away. And I suppose that’s my point as well, even for all the talk of the Trump win, we’re not seeing any change in inflation expectations or term premia, which you would expect for either candidate. So maybe it is, I should say, something that you need an event to focus.

And in the macro conversations I’ve had as well, Adam Posen, definitely of the view, okay, you wouldn’t say there was going to be a fiscal crisis. He said, if there was going to be a fiscal crisis, that would probably be more politically driven, in terms of a disagreement around raising the debt ceiling or something like that. But in terms of the factors conspiring to push up bond yields, so that’s very obvious.

Claudia Sam, very much of the same view. Everybody’s of the same view, hard to see rising deficits and not being part of the narrative moving forward. But as you say, at what point does the market focus on that and it becomes an issue?

It seemed that after the debate, it was starting to come in, but then at the same time, obviously the focus has shifted to Fed easing. So that takes away that negative bond story in the short term. Yeah, maybe it’s the steepener trade that a lot of people have been talking about for a long time, and that will gain traction.

But I do think it is something, I would agree with you, when it enters the psychology, it can be, and obviously it is the kind of thing that is, it’s a classic reflexive process in the sense that higher yields makes the debt less sustainable in itself. So rising yields are reinforcing.

So, to the extent that we’re in a safe place at the moment doesn’t mean it’ll always be like that. But yeah, maybe it’s a catalyst. Maybe it’s a downgrade, who knows, but I do agree with you.

[00:24:30] Niels

Yeah, exactly. Or maybe it’s just a budget announcement like we saw in the UK, where suddenly all hell breaks loose.

All right, let’s move on to a quick trend following update.

We’ve kind of already alluded a little bit to it. I mean, it’s not a bad month so far for trend followers, even though the last day or so has been a little bit more challenging, not least because of what you just mentioned in terms of the yen suddenly appreciating quite a lot and the dollar taking a turn down against the yen. But you know, other than that, there are also a few good areas of the portfolio.

So, you could say maybe the yen is trying to reverse a long-term trend, even though it’s early days. But we’ve also seen markets turning back to their long-term trends. I’m thinking here about the downtrend in grains, which has been quite beneficial for trend following managers.

Of course, we still have equities doing well. You mentioned gold making new all-time highs. That’s definitely worth paying attention to.

And then on the other commodities that people may or may not follow are things like coffee which is doing pretty well at the moment. So, I don’t know if you have any specific observations about the trend following world right now when it comes to that.

At least as of Tuesday, my trend barometer is not you know, it’s not firing on all cylinders. It’s still below neutral, but it is increasing from the lows of at the end of June. And when you look at the numbers, the BTOP 50 is up 1.5%, roughly up 8.68% so far this year. SocGen CTA index up about a percent, up about 8% for the year as a whole. SocGen Trend index up 1.8%, up 10.6% for the year. And the Short-Term Traders Index is up about 60 basis points, up 1.2% so far this year.

Comparing that to some of the traditional markets, MSCI World index is actually down 60 basis points so far in July, up 20% still for the year. And the S&P 500, of course, still doing well, up 2.38% so far in July, up 17.8% so far this year.

But anything that stood out to you that you’ve noticed?

[00:26:46] Alan

No, I mean, as you say, it’s been choppy. You know, some of the markets that were looked to be on the verge of major moves out have reversed. I’m thinking copper, obviously, that’s been reversing for a couple of months now, but had a big move up, a lot of optimism around the space. A lot of the commentators we speak to have been looking for this big copper move, but ultimately turned down and it’s kind of continued that reversal through the first half of July as well.

So, it’s a very mix on the one hand, things like gold pushing on, the yen reversing, some equity markets now breaking out, like if you look at the Dow, look at the Russell. So yeah, very much, you know, manager by manager, I’m sure you’ll see some dispersion link to where risk is allocated, etc. But overall, we’ve kind of entered a kind of a more choppy period over the last two to three months, I’d say.

[00:27:37] Niels

It seems like that maybe some of this choppiness has actually benefited some of the replicators who trade very few markets and have avoided some of this choppiness because they seem to be doing exceptionally well compared to the indices they’re trying to replicate. No names mentioned here, of course. But anyways…

All right, we had a quick question from Kiran, and specifically for you, actually, Alan. And my gut feel here is that Kiran is probably asking out of personal interest here because he may well be trying to or building a new trend-following fund. So, he’s interested in, and of course, a lot of people would be interested in this question, and that is, what are allocators actually looking for in a new trend-following fund?

You and I talked about this a little bit before we pressed record just generally. The environment for raising assets, the environment for raising assets for new products is exceptionally difficult, I think.

Even after 35 years, I would say that it’s… I can’t imagine how difficult it must be if you had to start something brand new. So, tell me a little bit about what it is you think these new managers should be focusing on when it comes to attracting investors early on in their journey.

[00:29:02] Alan

Yeah, I would just draw a distinction at the start, and I think the question is, as you’re alluding to around kind of new managers, new programs, because obviously, we have seen fund launches and new kinds of trend funds, but in some cases, they’re kind of a variant from existing managers of something. So, if you look in the last 10 years, where have you seen new funds being launched in alternative markets, in some, let’s say, dedicated Chinese market, we’ve also seen kind of new mutual funds, we’ve seen ETFs, and we’ve seen you know, managers taking out having a pure trend offering.

So, within the existing manager space, there have been new expressions of trend following and new funds in the last while, but I’m guessing, as you are, that this is more about for managers who are now coming to the market for the first time with a trend following offering. And as you say, it is tough because, you know, the challenge is there are existing players in the space.

So, the question is always, well, okay, what’s different about any new offering, either from a strategy perspective or a cost perspective? And, you know, there’s a large cohort of managers trading, what you might call, you know, major markets trend following, you know, 60, 80, 100 markets, and applying trend following. And people do it slightly differently. Then there are differences in terms of maybe speed or risk allocations, but, you know, you can kind of map a lot of managers to that.

And then you have other managers who may say, well, okay, we’re going to be definitely much more tilted, say towards commodity markets, and they’re different in that regard, and then obviously alternative markets. So, for any trend following manager coming to the market now, the question is always, you know, what’s different or how can you be different?

That’s not to say we don’t see any. You do see a few come into the market. Generally, they are either trading, you know, with a focus on commodities or certain markets like that, or else they could be trading a more concentrated set of contracts. We’ve seen that with some managers launching in the last while, maybe with a different philosophy around that.

Or else, what would be interesting if somebody was trading much faster or going to limit their capacity. So, they would always have, you know, high allocations to smaller markets that could be a source of differentiation for a small manager. So, I think small managers have some advantages in terms of being able to be more nimble, to be able to trade the smaller markets in bigger risk allocations.

The flip side of that is if you’re too small, that can actually limit the number of contracts you can trade. So that can be an impediment. So there probably is a sweet spot in terms of being new.

It can be advantageous. And merging can be advantageous in some ways, but it’s above a certain threshold in terms of AUM. And I mean, I think the other areas where you’ve seen some kind of new launches in the last while, not specifically around trend, but certainly, you know, quant macro and AI type strategy, there’s been more of those.

But there have also been, you know, more adaptive kinds of types of trend following. And so that could be something that might be interesting. So, I think the things that would be interesting for allocators, easily or simply, are things that are different, obviously, to what the market is populated at the moment. And that would be in terms of speed, or sectors, or adaptability and those types of factors.

[00:32:33] Niels

I would add one thing. And that is you’re absolutely right in the sense if you want to start something new, you have to be different. And in the trend following space, there’s certainly a crowded area when it comes to models or programs, strategies that are well managed when it comes to their volatility, delivers fairly consistent long-term returns, drawdowns, well kept under control, and so on and so forth.

So what I’ve seen personally in the last few years is that, to me, it seems like a little bit that some of the new players coming into the industry trying to do something different are actually maybe going a little bit backwards to the classical style of trend following, allowing it to be more volatile, maybe, as you say, deliberately trading some markets that the bigger boys can’t trade. And actually, in some cases, obviously, volatility taking into account, putting on some pretty decent numbers. So, I think that’s one, quote unquote, trend that I’ve seen that maybe people are going a little bit back to the roots of trend following in order to be different, even though that kind of sounds almost.

[00:33:57] Alan

Yeah, I think that makes sense.

Obviously, we’re talking about the challenge for raising assets. I mean, if you’re a trend following manager starting off, you’re typically going to go to more family office or ultra-high network type investors. And they’re, without painting it with too much of a broad brush, but they’re typically looking for more higher octane strategies where, you know, low vol, 8% to 10% vol is more of an institutional product.

So, it makes sense to pitch it at that kind of higher vol level and for newer, smaller managers.

[00:34:26] Niels

You mentioned also, Alan, that one of the things that is a differentiator, but it’s actually also something that has become a differentiator for well-established firms, for some well-established firms. And that’s the whole fee debate and lowering fees. And obviously, we’ve seen our replicator friends and now even the ETF friends we have come in and pushing prices down a lot.

So it was with great, well, it was with surprise, but also with a little bit of a smile on my face that I read an article this weekend that I shared with you, namely that another previous guest of ours on the show, the one that was on our series for the CTA series, the French firm CFM, that they have gone the other way. They have simply increased their performance fee from 20 percent to 30 percent, as reported by Bloomberg, I think, and many other outlets. One of the things that they say in the article, and then also actually from the chairman of CFM, who’s also been on the podcast, is that he says, well, what we do, there aren’t that many people in the world who can do what we do and deliver these types of returns.

So that’s kind of one of the reasons why they are justifying this increase of fees. I’d love to hear, since you’ve been on the allocator side for a long time, I’d love to hear your thoughts about it and whether this might be a new trend.

[00:35:57] Alan

Yeah, I think it’s, I mean, it’s not completely kind of out of the blue in the sense that, OK, maybe for CTAs, the trend has been for more, you know, certainly over the last decade, lower fees. But we’ve had the multi-strats, the rise of the multi-strats over the last decade or whatever. It’s a high cost model.

And even in the macro world, you know, some other managers I’ve heard of raising fees lately. But certainly, to the extent that a firm like CFM’s flagship, Stratus, which is multi-strat in approach, it’s not like a pod model, not like a multi-manager, multi-strat, but it is multi-strat in terms of lots of different types of trading. It’s not just trend following.

So clearly, they’re positioning that in that context, that there are types of strategies which are more, I don’t know if you call it all weather, but certainly aiming for consistent performance year in, year out. And that does, the Bloomberg article, I think quoted the kind of performance over the last four or five years has been positive every year. And, you know, so they’ve done well in years when CTAs have done well, and they’ve done well in years where they (CTAs) haven’t done well.

So, they’ve clearly got very consistent performance and at a high level performance is, you know, very good. You know, I always think this is supply and demand. If people are willing to pay for it, you know, obviously they are doing something that appeals to the investors utility functions, you know, to talk about it from an economic perspective.

You could say, well, it should all be about absolute return, but certainly plenty of allocators like that consistency of return as well. And we’ve seen that with the huge asset flows into the multi-strats as well. So, I think this is more of a phenomenon of the multi-strat development in influencing how people are thinking about pricing for these types of products, more so than a kind of a pure CTA perspective.

All of this depends on the ability of these firms to continue to churn out the performance consistently, because as soon as, we know in the CTA world, as soon as performance becomes more challenging, then fees become, becomes a conversation. But as long as that’s the case, and I think, I think it is very much an institutional type offering as well.

To your point, it’s not mega high vol, they’re not shooting for 20%, 30% returns. They’re shooting for more like, I think this is like a 6% or 8% vol product and they want to generate, probably 8% to 10% on average, and maybe in a good year, a bit higher, but you know, effectively, you are paying for that consistency at the absolute level of return.

[00:38:32] Niels

Yeah, clearly. I mean, there definitely seems to be pricing power in consistency, that’s for sure. But I thought it was a nice welcome just to see something going the other way and not always the race for zero, which seems to be what’s going on in the, in other parts of the CTA hedge fund world.

Let’s jump to another, let’s stay in our world, let’s stay in the managed futures world, to some extent, because you brought along another paper from another guest that we’ve been talking to, namely, from ROW Asset Management. And it’s talking about the dual mandate of managed futures strategies. It’s called something with skew spectrum.

[00:39:12] Alan

Skew spectrum.

[00:39:13] Niels

And so, why don’t I let you guide us through that paper and your kind of key takeaways from that?

[00:39:22] Alan

Yeah, well, I mean, it’s a paper that’s very much kind of reflecting the conversations we had during the SocGen CTA series conversation that we have, and the guys at ROW actually allude to our series. And really where it is, the background on this paper is, it’s a follow-up on the Cliff Asness paper, which you might recall was probably about two years ago now about the dual mandate of managed futures in terms of generating returns, but also generating what you might call crisis alpha, for want of an expression.

Cliff Asness, in his paper, was accusing the industry of kind of a lot of trend followers of moving away from pure trend into things like carry and saying, you know, that they were aiming for smoother returns, but that was coming at the cost of kind of less kind of risk mitigation.

So, this paper kind of addresses that, and it highlights that that kind of view isn’t necessarily the case. And, you know, I suppose to get to kind of some of the key takeaways at the start, one of them is that, you know, what we naturally talk about carry, and carry is something we’ve talked a lot about in the last while I was talking to Nick about it a while, but when we talk about carry, there’s always this kind of a perception of it being a kind of a risk on, a convergent strategy, or picking up a risk premium.

And it’s very much a negatively skewed, that you’re picking up the pennies in front of the steamroller, and one day you’re going to get rolled over and have a big loss. And that’s certainly true with respect to currency carry, but not all types of carry. And one of the interesting things that they do highlight is how commodity carry can be very much a divergent strategy from that perspective. And that’s performed very well in times of stress as well.

Commodity carry, depending on how you’re constructing it, can be more a reflection of supply and demand imbalances and picking up on that, much more so than picking up a kind of a risk premium. But anyway, so what they do within the paper is, it starts off with a quote from Marty Lewick talking about convexity and how to get convexity.

And they look at, well, you can get convexity by buying straddles. That’s the most obvious way, two-month straddles. You could also do that by replicating a straddle, which is kind of replicating the delta on a straddle, which is you increase your long exposure as the market goes up and decreases and go short as the market goes down, which is very much like trend following, but like fast trend following.

And they look at that versus fast trend, medium-term trend, and long-term trend. And they look at the performance of these different versions in terms of their skewness and also in terms of their absolute return. And they’re looking at skewness.

So, skewness is something like quants really focus on (maybe it’s less intuitive to some allocators), but it’s really the idea of, negatively skewed strategies are like equities. You tend to pick up frequent gains, but then your tail is much more on the left. Whereas positive tail or positive convexity or positive skewness is more convex in terms of more outsized positive returns episodically, and particularly in periods where equities sell off.

So, from that perspective, positive skewness is a positive feature in terms of reactivity and risk mitigation. And they look at the different ways or the different options that a trend follower or a managed features manager has in terms of managing the two, I suppose, competing objectives of absolute return and risk mitigation. And, basically, highlight that if you went with the straddle, obviously you get a lot of skewness. If you replicate the straddle equally, that’s possibly skewed.

Fast trend following is also possibly skewed. You move out to things like slow trend following, and it’s a negatively skewed strategy when you’re measure it in terms of days. If you measure in terms of months, less negatively, it’s probably a bit flat. And then if you measure it in terms of quarters, it is a positively skewed strategy. So that’s an important observation.

So they make the point, as well, that not only can you, as a managed features manager, add carry, and that could potentially help you, but you also, if you’re a pure trend follower, you also have a lever that you can pull in terms of you can generate more smoother returns by trading slower, but that’s going to come at the cost of reactivity.

So, the point is that I suppose that the guys at ROW I think are making is that, yeah, a lot of trend followers or pure trend followers will say, hey, look at these diversified trend followers are adding non-trend. Clearly that’s going to dampen their risk mitigation qualities. That may not be the case because you have strategies like commodity carry, but also trend followers can do the same.

If you trade slower, you can also dampen your risk mitigation and generate more consistent returns. So, it’s not just a matter of trend versus non-trend. There are a couple of levers you have to think about as trend versus non-trend and the impact of speed.

So, from my perspective, I think the key takeaways for me were one, as I say this, I think it does point out that that perception around carry as always being kind of a convergent strategy, that’s kind of a misperception that people have fallen into. It’s good to keep that in mind.

Now the question around skewness is more interesting. You could debate, is that positive skewness at short time horizons, how important is that? And it comes back to utility functions and investor preferences.

A lot of the research that we read, say from Quantica, and we’ve discussed a lot of their papers, they’re always talking about things from a quarterly perspective. And they’re saying like long-term asset allocators think in terms of quarterly time horizons. So, does it really matter that you’re going to have these periodic, more negative daily events?

So, I think that’s something that’s debatable and maybe depends on the type of allocator that’s interested in the strategy. But it’s certainly a valid contribution and I thought it was interesting and does highlight that, in terms of pairing these strategies with equities, that they do show that if you combine trend with commodity carry and add equities, you can get a better outcome than just adding trend. And you can get a better outcome in terms of kind of the skewness characteristic as well as the absolute return.

So, I’ll pause here to get your perspective on all of that.

[00:46:11] Niels

No, I mean, there’s not a lot I can add to that, except maybe for one thing. Something that I probably knew deep down, but I never thought about it in that way. And it goes to the little bit to this, how quickly do you want your trend follower to react and offset some of the losses you may see elsewhere in your portfolio? And when I spoke last week, with Graham Robertson from Mann AHL, he reminded me that they had done some research on this after the Silicon Valley Bank event. And what it turns out, which is not a surprise, I guess, is that often the sharpest and sort of meaningful corrections that we, as trend followers, will experience in our performance actually also comes at a time where we are making the most money.

So, when things are good, yes, we can have a really bad week and lose more than we would otherwise. But it comes in a context of it being a period with strong trends and heightened volatility most likely. So, that’s also worth keeping in mind.

And I agree with you, of course, that people who are worried about protection for five days versus five months, then obviously, trend following may not be the place to be. And it doesn’t mean anything. I mean, if you’re a pension fund investor, if you’re any investor, you shouldn’t worry about five-day returns.

You should worry about five-year, ten-years, twenty-year returns. And there, you know, the evidence is just so, so strong in terms of the value that trend following brings to a portfolio.

But I appreciate you digging into this and it’s always good to see some of our peers produce new papers and research that highlight some of these points for sure.

Now, Alan, you brought along another paper, which interestingly enough, I wouldn’t say it’s kind of on the same topic as the question we got regarding what do allocators look for but, nevertheless, you did bring along a paper about building a hedge fund allocation and what are the considerations that that involves. I think this was a joint paper from JPMorgan and GIC, as far as I recall.

So maybe you want to talk a little bit about that as well.

[00:48:56] Alan

Yeah, well, this is an interesting paper. It’s called Building a Hedge Fund Allocation, Integrating Top-Down and Bottom-Up Perspectives. And it’s a collaboration between people at GIC, so the Government of Singapore Investment Corporation, so huge sovereign wealth fund and JPMorgan Asset Management.

So, I really thought it was a very good paper. I was surprised, in a way, to see it, because you don’t associate with this kind of thinking with large institutions, because very often we feel like we’re making this case all the time and it’s going unheard. And equally with JPMorgan Asset Management, I mean, we discussed their long-term capital market assumptions, I don’t know, maybe at the end of last year, the start of this year, and we were definitely highlighting that the small allocations to CTAs and trend-following, and strategies like that. So, they seem to have come around a little bit, which is good to see. I mean, it is very interesting the way it’s phrased at the outset, that they say that we’re witnessing kind of a regime shift from a macro perspective.

You know, all the things we’ve talked about: escalating geopolitical tensions, fragmentation, higher inflation, interest rates, volatility, et cetera. And so all of these make asset allocation via long-only return streams, across public and private markets, more challenging. So certainly, we would agree with all of that.

And investors are looking to generate more returns from alpha, not beta. So, it’s an interesting way of putting it. And from that perspective, hedge funds are particularly interesting at the current juncture.

And, you know, they say well-designed portfolios can help mitigate losses, improve returns, and enhance macro resilience. And we did actually talk about another paper from GIC, last year, at one point about building portfolios for macro resilience. So, this is something they’ve been talking about for a while.

So, the paper is split into three sections, one around kind of looking at different types of hedge fund attributes and return characteristics. And the second bit is the role-based, making role-based hedge fund allocations. And the third part is about implementation. And they touch on manager selection.

In the first part, they look at just under 1,000 hedge funds over a 13-year period. And they look at it from three primary attributes: from the perspective of correlation to equities, resilience in market drawdowns, and alpha generation.

And, you know, just going through some of the stats, over half of the hedge funds had a correlation of less than 0.5 to equities. Okay, not surprising. And then obviously, as we would expect, managed futures and commodity and macro managers were the least correlated.

And then unsurprisingly, long bias equity managers and event-driven and credit, more correlated. Equally, you know, multi-strats, and they had 30% to 40% of multi-strats in RV funds had a correlation of 0.5 or higher. So again, these types of strategies, were very popular, but not necessarily strong diversifiers.

Within managed futures, all of the strategies had a correlation of less than 0.5. So, they look at then performance in terms of capital preservation during equity market declines. And again, you know, what you would expect, managed futures doing well in that scenario, and relative value credit event-driven, less so. But equally, from the perspective from alpha generation, they found good alpha generation in managed futures.

Again, the alpha was probably a bit higher in the multi-strats, but also you pick up more beta there as well. So, this is kind of their section one is the preamble, just looking at all of the different strategies. And then they used a clustering technique to group the managers into four groups based on the manager’s characteristics from those three perspectives.

And they come up with four clusters and they label them loss mitigation, equity diversifier, equity compliment, and equity substitute. And the loss mitigation obviously are the ones that have the greatest diversifying potential, whereas equity substitutes are very equity-like. Interestingly, they found managers from each of the kind of industry classifications in each of those four strategy types.

So, they found managers in managed futures, which I was surprised, as equity substitutes, but I guess there are different types of strategies. So yeah, fair enough. And they found that in aggregate, the majority of hedge funds were more correlated to equities, whereas about 40% they would classify them as diversified funds.

Managed futures tended to fall into loss mitigation and equity diversifier into those two categories. But also, you had a lot of commodity managers in the loss mitigation category as well. I think it was more than the managed futures, which I’m a little bit surprised at, but I mean, it’s not a huge sample size. I think it’s 900 funds. And I think it amounted to like 10 commodity managers. So, it could have been driven by just those particular managers selected.

And they basically found that within each of the kind of industry classifications, they all mapped to all of these four categories. So, highlighting the kind of dispersion that you see across managers. So, then they did two approaches to constructing portfolios.

One is what you would call a standalone hedge fund portfolio, which is, I guess, the way people often operate. And if I’m working with investors, it’s very often, what does the hedge fund portfolio look like? And you can either do that on a standalone basis, but then if you can bring the conversation back to, well, what should it look like in the context of the overall portfolio, you obviously get a different outcome.

And that’s what they show in the paper, that if you just build a standalone hedge fund portfolio, you’ll still allocate more to the loss mitigation strategies because they are more diversifying, and the equity substitutes operate like equities and tend to be uncorrelated with the loss mitigators. So, if you did it on a standalone basis, they found a 59% allocation to loss mitigation. I think it was 19% equity diversifiers, and then 22% to equity compliment.

So, I think that’s 100. So that was the first perspective. But the second perspective is that if you bring it into a 60/40 portfolio and re-optimize, then you go 100% to loss mitigation. And not only that, you can actually lever up your equities a bit more. So, you can allocate a little bit higher to equities because you’re getting a better correlation benefit.

So, I suppose a key result is a couple of things. Take an integrated approach, it tends to favor diversifying strategies. No surprise to us. But as I say, not everybody realizes that. And I suppose a takeaway is you don’t need to get equity beta from hedge funds. You can get equity beta from equities and get diversification from hedge funds. So, an important point.

The final point then, or the final section, is around hedge fund allocation. So, to talk about manager selection and the importance of understanding the strategy and that it’s actually going to play the role that you’d expect it to play.

So obviously, a strategy can behave a certain way for a period of time, but that can just reflect what’s going on in the market. So, you have to actually know that, for example, the point about CTAs had been long bonds for a long time. But obviously, by virtue of understanding the strategy, you know that they can turn short.

But equally, they can be chopped around in periods as well. So, understanding things like that. In terms of the optimal number of managers, which is a question that comes up from time to time, they say 15 to 20 is the optimal that they came up with. Diversification benefits decline after that. Now they say you could have more for tactical purposes. Obviously, you might lose a manager for whatever reason, or managers could be in transition. So that might argue in favor of slightly more. But from a pure quant perspective, that was the number that came up. But they did highlight the challenge around terminating a manager.

And for allocators who allocate to, say, multi-manager on a futures program, this is always an important factor. If you’re allocating to managers and there’s an incentive fee, if you terminate a manager in a drawdown, you’re giving up basically the free ride you have back up to the high watermark. So, there’s a natural inclination, oh, let’s get this manager, look at that other manager. They’re clearly better. But they have to be not only better, they have to be better than that loss you’re giving up on the negative accrued incentive fee. And so that’s an important consideration that I think people overlooked that they highlight.

And then to talk about a little bit about static versus dynamic. And they also talk about the case for emerging managers. So, there’s a point earlier, there can be a case for having emerging managers, particularly if other managers are closed or just from the perspective of building capacity, but also for some of the things that we talked about being more specialized, more niche, smaller and more nimble, et cetera.

So, I thought, you might say, okay, nothing dramatic in all of that, maybe nothing that we haven’t touched upon before. But I do think interesting that it’s coming from an entity like GIC and JP Morgan, where these ideas are certainly becoming more mainstream. Whereas I would say, historically, there’s been that idea of building out, people think from the perspective of diversification, and they also apply it to a hedge fund portfolio and say, we have to be diversified.

We have to have some of those kinds of divergent and some convergent strategies. But that forgets the fact that you’re building this portfolio in the context of the overall portfolio.

Taking the other side of it, obviously we all know as well that pure loss mitigation type strategies can be a tough hold, there’s drawdowns. So, they didn’t delve into the behavioral challenges of that they can be challenging to the whole in a period where equity beta is doing well.

For some people, we’ve talked about this before, that can be a reason for kind of sweetening up a hedge fund allocation in terms of having some strategies in there that are a bit more consistent in performance, even if it’s not justified purely on quant perspective. So that’s something that they didn’t, really talk about at all.

And also, it’s interesting that we’re still talking about trend following and managed features from the loss mitigation kind of perspective. Whereas, as we were talking about the last time, it also has that market timing element. It has this risk on elements to it at times as well, which people shouldn’t overlook.

So, I thought it was a very worthwhile paper. I would definitely recommend it. And I’ll definitely want to share it with my own network because I think there’s some valuable pieces in it. But there was nothing dramatic that we probably wouldn’t have said already, but I think it’s highly significant when an entity like GIC puts out something like this.

[01:00:15] Niels

Yeah, I mean, with so many things, In investing, it’s not like you come up with completely groundbreaking things every week or every year. A lot of the advice that people gave, decades ago, is still very valid. So, I appreciate that very thorough review of that paper.

I think I’m going to leave it there because I know we had one more topic, but it’s a topic that I kind of touched on last week with Graham. So, I think I’ll leave it there and just say, if people enjoy these deep dives and also appreciate all the effort that Alan and all the other co-hosts put in every week, please head over to your favorite podcast platform, Spotify, Amazon, iTunes or Apple, as it’s called nowadays, and leave a rating and review. It really does help. And we so appreciate that.

Next week I’m joined by Mark. He’s back. So, if you have some questions that would fit his expertise, by all means, send them to me. Email is as usual, info@toptradersunplugged.com and I’ll do my best to weave them into the conversation. With that, from Alan and me, thanks ever so much for listening. We look forward to being back with you next week. And in the meantime, as usual, take care of yourself and take care of each other.

[01:01:38] Ending

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

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