Do Alternative Markets Trend Better? ft. Scott Kerson

[00:00:07] Scott

If you believe that all markets have approximately the same Sharpe, then the best thing you can do is trade every single market you can. However, if you believe that certain kinds of markets have higher Sharpes than other kinds of markets, then, actually, it’s optimal, from a portfolio optimization perspective, to abandon markets that have an inadequately low Sharpe even if they’re diversifying because you’re taking risk away from things that have a higher Sharpe.

It’s really about that skill versus breadth trade-off and our belief in our ability to steer the portfolio towards the skill end and away from the breadth end where necessary that gives rise to the portfolio we actually trade.

[00:00:51] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we will 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.

Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:46] Niels

Welcome to another episode in the Open Interest series on Top Traders Unplugged hosted by Moritz Seibert. In life, as well as in trading, maintaining a spirit of curiosity and open-mindedness is key, and this is precisely what the Open Interest series is all about. Join Moritz as he engages in candid conversations with seasoned professionals from around the globe to uncover their insights, successes, and failures, offering you a unique perspective on the investment landscape. So with no further ado, please enjoy the conversation.

[00:02:22] Moritz

Hi, everyone. Welcome to another episode of Open Interest on Top Traders Unplugged. I’m Moritz Seibert, and today, I’ll be speaking with Scott Kerson, who runs the quantitative trading arm of Gresham Investment Management. Gresham Investment Management is a commodities-focused asset management house managing more than $7.5 billion for institutional clients, and one part of the offering is the so-called ACAR, A-C-A-R, or Alternative Commodity Absolute Return strategy.

This is one of the strategies Scott is responsible for. With a launch date of March 2017, it is among the ones with the longest track record in the alternative market space. So today, Scott and I will speak about why Gresham believes alternative markets to be superior to traditional markets when it comes to trend following trading strategies. We’ll also speak about their approach to research in this space and how they see this segment of the CTA industry developing going forward.

So without any further delay, Scott, fantastic to see you. Welcome to Open Interest. Great to have you here.

[00:03:23] Scott

Thanks, Moritz. Good to see you too.

[00:03:26] Moritz

Great. Scott, before we start, as is custom, could you kindly give us a little bit of background on yourself? What brought you into the trading space and the systematic trend following arena in particular?

[00:03:38] Scott

Thanks, Moritz. It’s really great to be here and honored to be a part of the program. Hopefully, I can impart something at least vaguely useful. My introduction to quant trading and ultimately to the genesis of the ACAR strategy is somewhat circuitous and took a while to get there. I actually didn’t start my professional trading career as a trader. I started as an academic economist. That morphed into commodities research and that morphed into fundamentally based discretionary trading.

Eventually, that led to my first experience running a quant model which was, at the time, Barclays Global Investors (and now part of BlackRock) in the early 2000s. That was an interesting experience because at the time I don’t think I was ready to be a quant trader and I struggled to reconcile my view of the market with the model’s view of the market.

One thing I learned from my mentor, at the time, was that there are a lot of different successful ways to manage money, but you have to figure out which one you’re going to do and you’ve got to stick with it and stay in your lane and I wasn’t there. That led me back to prop trading through the financial crisis of ’07, ’09. The crystallizing moment for me around the application of quant to commodities trading was really the exit of the GFC.

Part of that was related to bank and other prop capital which was shrinking heavily. But part of it was related to (and quite importantly) the notion, my belief at the time, that discretionary trading was going to become increasingly (at least it was my frequency and my approach) cannibalized by algorithms. I had a number of reasons for that related to market evolution, technology, presence of HFTs; all the stuff that was going on if you put yourself way back in time to early ’09.

My conclusion at the time was what I really had to do was strip out all the emotional aspects of trading and go back to a straight systematic approach, and going back to my BGI mentor’s phrase, “to get in one lane and stick with it.” That was really where I started to dig into quant trading at a much more fundamental level. I ended up at GLG, part of the Man Group, as head of commodities.

At the time, Man Group had split. It was split between the discretionary GLG business and the systematic AHL business, which we quickly realized, well, if we’re doing systematic commodities trading within GLG, we should really morph that into AHL which is the systematic arm. I took over the commodities books for AHL, this is about 10 years ago, 2012.

Really, the crystallizing or the root of where I’m at now really owes a great debt to the AHL team that I joined who had the insight, not long prior to my arrival, to launch what is now known as AHL Evolution fund. The underlying hypothesis or investment thesis, if you will, of AHL Evolution as I see it (I don’t want to speak for my former colleagues and firm) was that the same classical trend following techniques that AHL had made its bread and butter, over decades really and helped invent really in the modern sense, was a fundamentally sharper signal in a certain class of markets than others.

I think it’s worth emphasizing how now we’re not the only ones doing this, but 10 years ago, that was actually a fairly radical insight. Because if you rewind to that period of time, the prevailing wisdom (and this is I would say virtually pervasive across the space) was that, within medium-term trend following, the individual market information and individual Sharpe or information ratio at the market level was so low that really it was almost impossible to distinguish between markets.

The best thing you could possibly do, from a portfolio optimization standpoint, is max diversification. If you have relatively little information about any individual market, max diversification leads you to essentially as many markets as you can possibly trade.

[00:08:28] Moritz

AHL Evolution, when did AHL Evolution start? Do you remember? Was that 2012 or even earlier?

[00:08:34] Scott

I believe it was earlier. Again, I’ll qualify this by saying I wasn’t at AHL at the time. But my understanding is that Evolution actually didn’t start, although it technically started as a fund, it didn’t start as a fund for the outside world. It actually started as a way to access markets that couldn’t be otherwise accessed by AHL Diversified (the flagship trend follower), and in particular, over-the-counter swaps markets. So it’s an interesting historical artefact that the alt market space owes its historical roots to an idea which was actually consistent with this overall max diversification approach. I was just that classical trend followers like AHL Diversified couldn’t trade OTC. There was additional diversification. These are additional markets.

What happened over the subsequent years was, in a certain sense, we ran a real time experiment which was that we had the same researchers, the same codebase, the same portfolio construction applied to two different kinds of markets; the more operationally intensive, less standardized, less traditional markets like swaps markets in particular. We got to watch the same set of tools applied to those markets and applied to the traditional markets.

What we learned was that, actually, the portfolio level Sharpe, if you viewed Evolution as a sub-portfolio, the ultimate performance of trend signals in those markets appeared really to be structurally different. If you remember the period ’09 to I’m going to say roughly ’12 or ’13, I might be a little off by the date, classical trend following had a pretty tough time. Yet during that exact same period of time, the alternative markets version of this, as embodied by Evo, did very, very well.

So when I arrived in 2012, I was given the following proposition, the traditional commodities markets, things like front month WTI, gold futures, etc., had a really pretty wickedly painful run. At the exact same time, and again, it’s worth emphasizing with the same signal, the same approach, same everything really, same people doing the research, same execution that’s doing the trading, those same signals applied to the commodity sub-portfolio of Evo which at the time was very small and very narrow.

It consisted largely of German and Nordic electricity. Those particular markets performed radically differently than the traditional commodities markets. So the same lesson that they had learned in fixed income and increasingly in cash equities and EM FX and other spaces seemed to be true of commodities but it was a very narrow experiment. Commodities were, I think it’s fair to say, something of a backwater.

Coming in as a quant and as a commodities economist, my marching orders were to take that insight and see how far we could push the envelope into non-traditional commodities. So that team, my team spent 2013 to ’16 essentially building out the commodity sub-portfolio from something like three or four markets to something like 40 markets in rough numbers.

What we continued to learn was that the further we dug into the alternative commodity space, the more diversification we got within the alternative commodity space, and the more we outperformed the traditional commodity space. What I think is really interesting about that (and I know we’re going to talk a little bit more about research philosophy later), but what I found particularly interesting is that my view, at least, was that that had less to do with a particular selection of markets and more to do with an approach to selecting markets and a type of market.

It wasn’t this market or that market, it was that our process, which we repeated over and over and over again was just interesting in itself, because in a certain sense, the track record the commodities portfolio was less the track record of a single portfolio every several years and more a track record of a sequence of portfolios that were actually quite different year on year but were consistent with an underlying approach and an underlying concept of what an alternative market might be.

[00:03:19] Moritz

Let’s get into this in a bit. Actually, conveniently, you just answered a question that I wanted to ask, which is, when did you first get in touch with these alternative markets? Because you wrote this paper in 2019 called, “Trend Is Not Dead: It’s Just Moved to a Trendier Neighborhood”, which people can find on the Gresham website. Because you’ve launched in 2017 at Gresham, I want to ask, when did you first become interested in these alternative markets and what intrigued you? But you just answered that it was around the 2012 period with AHL in taking Evolution to the next step, so to say, with markets.

Speaking about these markets, because we’ll be speaking pretty much exclusively about alternative commodity markets today, what is an alternative market to you? What exactly, if there is an exactly (I guess maybe the boundaries are blurry) what differentiates an alternative market from let’s just say a traditional market? What is that? Because for some people, something that might be alternative to you may not be alternative to me and vice versa.

[00:14:22] Scott

It’s a great question, Moritz. I’m going to give you a partially wooly answer to that, and that’s because I don’t think there’s a single definition. This was a much easier line to draw in 2013 because, at that time, AHL was the first CTA to trade every single one of these markets. When we would go to a freight broker, to an iron ore broker, to an electricity broker, and we would say, “Hey, we’re interested in doing the following,” they looked at us like we had two heads.

That actually got us really excited big because that was the clear signal that nobody else was doing this. So you could have said at the time, there was a pretty simple definition, working definition, or sufficient condition you could almost say, which was that, if it was not in a traditional CTA portfolio, it was definitionally alternative.

I think that has morphed over time (I know we’re going to talk later about the future of the space and how the space has evolved since then), but I think at that time, that was a pretty neat and clean definition. If it was in the big book, it wasn’t in the little book. That leads to what, to me, was both an unsatisfactory answer as well as to, ultimately, why I decided to spin out and launch the ACAR strategy, and that question is, well, wait a minute, why is that?

The ‘why is that’ is I think an inherently known quant kind of question to ask. What we tend to do is just run by the numbers. But again, as I mentioned, I started as an academic, not as a quant, and I spent a lot of time on the prop side. It was never intellectually satisfactory to me to just accept this received wisdom that, well, they’re not like this, they’re like that, and they seem to work better.

It always made me want to ask, but what is it? What is it? Since it goes directly against the grain of decades of conventional wisdom around max diversification, why is it that we have chosen, consciously, to restrict our diversification and trade this other class of markets? Ultimately, you mentioned that paper and I should give a shout out to my chief scientist, Dr. Tom Babbedge, who’s really the architect behind a lot of that paper.

The insight there and the core of what we do in the ACAR strategy is rooted, most fundamentally, in I think two observations. They’re really not actually specific to commodities. Commodities just happened to fit this definition rather than the other way around. Those two observations are, firstly, the efficacy of the classical trend signal has everything to do with the underlying distribution of returns of the markets you trade.

More specifically, it has to do with the preponderance of relatively large moves over the right kind of frequency. So just as a stylized example, suppose you have a three month, whatever you want to call it, half-life duration, average hold trend signal. Then what you need, for your trend system to work, is you need the market you trade to generate trends over a three-month horizon, and I’ve just, again, just sort of stylized.

What we see, time and again, is (and it doesn’t really matter whether there’s upward drift, whether there’s downward drift), that it’s not really about serial correlation returns. A lot of these metrics that, I think, quants point to, they’re actually not at the root of it. Really, the root of it is how fat the tails are and the duration of those tail events. That was observation one.

I think observation two was that, actually, this max diversification argument is completely valid but was erroneously applied. So when people would say (and we would question this ourselves), “Why do we restrict potential diversification,” that actually belies the point that you can achieve at least as much diversification. There’s always a caveat, and the key caveat here I think is capacity constraints.

But if you’re willing to restrict your capacities such that you can risk budget enough; that you can allocate your risk budget sufficiently to enough small markets and enough small interesting markets that share these distributional qualities, you can actually not only generate more diversification than you would in a traditional market CTA, but, and this is really crucial, more consistent diversification.

One of the bugaboos I have, and I think all quants have, but I particularly have my list of bugaboos of what we do as an industry, and one of them that my team hears day in day out is the importance of looking at conditional distributions rather than unconditional distributions. The unconditional distribution of diversification is, essentially, what’s the long run average pairwise correlation of your assets, something like that. But that actually isn’t really what matters in the real world.

What matters in the real world, much more frequently than the long run, is what the conditional distribution is. What we find in traditional markets is they tend to cluster. So, when things go wrong, they all go wrong together. What that means is that if you just plot something as simple as the rolling pairwise correlation of a multi-asset portfolio including FX, equities, bonds, commodities (in the traditional asset sense), what you’ll find is that those correlations tend to spike.

What you’ll find, if you do the same exercise with the alternative commodity space in particular (it’s true of alternative markets generally but specifically true of commodities), is not only is the average pairwise correlation lower, but the variability of that correlation is lower and more stable.

[00:20:26] Moritz

Let me just ask you, Scott, you said on our prep call that you are really the only exclusive alternative commodity market CTA. Whereas the other alternative markets CTAs (and we can name some of their names, Florin Court, you’ve mentioned AHL, there’s a bunch of others, Systematica, I think), they, I guess, would differ from what it is that you’re doing in the sense that they would also trade, say, some of the exotic FX markets or maybe an onshore Chinese government bond futures market, things like that.

So you have this exclusive focus on the commodities. Is this because of Gresham because Gresham is a commodities house or because you figured out, through research, that the alternative commodity markets, that is actually where the action is and where you can best apply your strategies?

[00:21:17] Scott

Yeah, it’s very much the latter. It’s really rooted in what we talk about as the conviction versus concentration and trade-off. I mentioned earlier that I was always looking for a more intellectually satisfactory answer as to why these markets. This is not at all a statement that all those other alternative markets aren’t interesting, because they are, and those competitors that you mentioned, I have the utmost respect for and they’ve done a terrific job and the results speak for themselves. They’ve made their clients quite a lot of money in those markets.

The choice to focus on commodities was really rooted in my belief that I understood why commodities had the right properties for trend following, and I was willing to trade off concentration for conviction. That was the most core thing. The second key observation, we talked a bit about correlation in diversification of course, was the observation that commodities actually aren’t one asset class.

If I trade coal onshore in China and I trade electricity in the West Coast of the US and I trade liquefied natural gas delivered to Asia or the EU, those are just structurally different things. They’re different points in time. At a molecular level, they’re different things. That lends itself to what we call structural diversification. It was really that combination.

[00:22:46] Moritz

Let’s, maybe, speak a little bit about the number of the markets. Let me preface this with, so you have this exclusive commodities focus. You’re trading, for instance, TTF and I guess UK gas, but you’re not trading Henry Hub because Henry Hub is kind of like the natural gas market which other CTAs would be trading as well. You’d be trading the onshore China commodities, but you’re also trading, I think you mentioned, commodity equities, which I think was standing out.

Is there anything alternative about these stocks? Why did you add them to the portfolio?

[00:23:21] Scott

That’s a good question, Moritz. The commodities equity sleeve was not present at launch, it was actually a relatively recent addition. It’s quite a small portion of the overall risk budget. I think it’s fair to say it’s not within the core thesis that I outlined before. The reason that we entered that space was actually not because we wanted to trade equities. It was because we wanted to trade commodities that were accessible in no other way. For instance, construction aggregates, cement, concrete, things like that, uranium.

There’s a whole host of commodity markets that fit our definition of an alternative market but simply have no futures market.

[00:24:02] Moritz

No, I get that. Coming back to the number of markets that actually exist, I think you said to me on the prep call there’s something like 140 markets that you trade. I presume this includes the equities. I’m asking you because I’m not active in the alternative markets at that point, but when we look at or when we think about Florin court, for instance, and Doug has been on our podcast and other podcasts.

He speaks about they are trading 500, 600 or so markets and they’re finding 40 or 50 new markets every year. That got me puzzled. Where are all these gems hidden? What is it? Why are you at 70 and he’s at 500? How large is this space really, and where can you find these markets?

[00:24:48] Scott

Just to clarify the number of markets, we trade about 140 pure commodity markets accessed by futures or forwards linked directly to the price of the commodity. The equities sleeve has about another 70-odd items in it which are really these sector-based things. But I think the core of what we’re doing really is that 140, and those are pure commodity markets just to be clear about that.

The evolution of that number, if you went back to 2013, that number was like 3 at AHL. By 2016, it was something like 40. When we launched, it was kind of something like 50. It has grown, roughly, linearly from there until where we are now. Where are those markets? One thing is some of them have always been there. They’ve just been either too difficult to access or insufficiently liquid, and those properties have grown over time as the markets themselves have developed.

The other is, really (and this is something that we talk about in terms of the long-term future of ACAR), a new commodity market we believe will always come about, and the reason it will come about is just a fundamental byproduct of human progress. We talk about things like decarbonization. Decarbonization has led to the development of a whole bunch of carbon futures markets that 10 years ago didn’t exist.

I have maximum conviction in the idea that, 10 years from now, we’ll be trading a bunch of markets that will look back and say, actually, those didn’t exist either.

[00:26:32] Moritz

One other thing is this gnawing point that I’d like to discuss in a non-confrontational, very friendly way, but, I love adding markets to the portfolio because every incremental market has a little bit of a diversification benefit in the overall context. You specifically don’t do that. You restrict your portfolio to A, only the alternative markets and then B, only the commodity markets within that space. I guess most of the alternative markets probably have a commodity linkage. From a math perspective, you would get max diversification by trading all these markets.

So let’s chat about why you don’t do this, or what your counterargument to that is, where you say, no, you shouldn’t be doing that, you should be tossing out all these traditional markets; the DAX future and the S&P and Henry Hub and not trade them in the trend following context and only do the alternative. That’s the active decision that you made, right?

[00:27:34] Scott

Absolutely.

[00:27:37] Moritz

I can’t get that to tie up yet.

[00:27:39] Scott

I think the mathematical tie out to that is that if you believe that all markets have approximately the same Sharpe, then the best thing you can do is trade every single market you can. However, if you believe that certain kinds of markets have higher Sharpes than other kinds of markets, then, actually, it’s optimal from a portfolio optimization perspective to abandon markets that have an inadequately low Sharpe even if they’re diversifying, because you’re taking risk away from things that have a higher Sharpe.

It’s really about that skill versus breadth trade-off and our belief in our ability to steer the portfolio towards the skill end away from the breadth end, where necessary, that gives rise to the portfolio we actually trade.

[00:28:27] Moritz

So you’re not saying that the traditional markets don’t work in a trend following context. The last two or three years have, actually, been relatively good years or pretty good years for trend following funds. There are some funds, even this year, traditional market trend following funds in 2023, that have a great year even though the industry average is kind of like let’s say zero or slightly down.

I think what you’re saying is you’re not saying that stuff doesn’t work. There is, I guess, a small alpha or edge in the traditional markets trend following space. But what you’re saying is we’re removing the traditional markets from the portfolio in order to make room, additional risk budget room, for these markets which have better trending properties or better Sharpes as you said.

[00:29:13] Scott

That’s exactly right. We are firm believers that there is a positive alpha to be harvested in traditional markets by classical trend following. I’m very much a believer in that and wouldn’t want to be represented in any other way. But I think your point on risk budget is exactly right.

Another way to put that is if I give a unit of risk to a given market that has an opportunity cost and I get a benefit from diversification and then I get a cost in Sharpe degradation. We believe that there is a balancing point at which it is rational and optimal to cut that boundary.

The other salient point is, by restricting (and this is both true of our decision to restrict ourselves to the commodity space as well as to the alternative commodity space), you end up with a trend following portfolio with all the friendly properties that people love about trend following; endogenous risk management, positive skew of returns, but we end up with a pure trend portfolio that has a relatively low correlation to other trend followers.

As you’re surely aware, most trend followers are, amongst themselves, relatively highly correlated. So our approach results in portfolio returns which have an interesting diversification property vis-à-vis classical trend following. Our belief, actually, is that they fit together quite well.

[00:30:38] Moritz

Right. Am I right to assume that, when you speak about trend following, you’re actually using established or known trend following strategies? Of course, you have your variation of that, but is it systematic, price only, you’re not using any fundamental or alternative data that relates to these commodities you’re trading? It’s kind of like you would be trading a trend following strategy like many of the other CTAs would as well, just on other markets.

[00:31:03] Scott

I think that’s exactly right. Of course, every shop and every research team will, at the margin, have small differences in the way they apply classical trend following, but we are very much in the mold and are actually quite dedicated to maintaining what I would call a neoclassical trend approach. The underlying code would be pretty familiar to, I think, most people who do what we do.

[00:31:28] Moritz

Do you need to be slightly or maybe even substantially longer term in your hold periods given the markets that you trade because you may not find it as easy to get in and out, kind of like screen liquidity, type bid offers, because you need an OTC broker or something like that? Or do you trade further down the curve in some of these markets where there’s less liquidity today and you would only be moving into liquidity as time goes by? Do you need to follow a very long-term approach with these markets?

[00:31:57] Scott

It’s definitely fair to say that we trade, on average, more slowly than we would in more traditional markets, and more slowly than traditional CTAs. But I would push back a little bit on the notion that that’s a liquidity or, as you said, difficulty of getting in or out. It’s much more a function of cost. The friction cost, at the simplest level, the bid offer of the stuff we trade tends to be substantially wider.

In order to combat that, you want to reduce turnover. We don’t do that as a discretionary decision, we let the models choose the optimal speeds. Those optimal speeds subject cost curves tend to dictate longer horizons.

[00:32:43] Moritz

Well, I guess the bid offer spread correlates with liquidity. It is wider because these markets are generally a little bit less liquid, right?

[00:32:52] Scott

That’s absolutely right. I think the trigger point, if you will (in your phrasing), was the difficulty of getting in or out because we actually reverse engineer from liquidity our size constraints such that we can always get in or out of what we need to.

[00:33:10] Moritz

With the markets that you have in the portfolio, I’m not exactly sure what they are, but I presume you want every single market to have an equal chance of contributing to the risk or the P&L and the expected profits of the portfolio. So I guess, at some point, capacity becomes an issue. When you look at your portfolio, am I right to say that your fund is closed, that you’re actually at capacity?

[00:33:32] Scott

It is closed at the current time. That’s right.

[00:33:35] Moritz

What is the capacity of these markets?

[00:33:40] Scott

Capacity is one of those funny things. I mentioned earlier I’ve got sort of bugaboos about quant trading. One of them is that people talk about capacity as a point estimate, and I think that’s just not correct. Really, what capacity is, is a surface and it reflects the objective function of the manager and the trade-off between management fees and performance fees. You can always run a larger fund at a lower Sharpe, broadly speaking.

Our decision to restrict ourselves to commodities and to alternative commodities dictates that we respect much tighter capacity constraints. I think, at the core of what we do is a discipline around capacity and a willingness to run a business at a smaller asset base than I think most of our competitors would be comfortable with.

[00:34:30] Moritz

Maybe another thing not about capacity but the overall size of that space, when you take Gresham, when you take Evolution, when you take Systematica, Florin Court, in your estimate, what is the sum total or the total AUM of alternative market CTAs today?

[00:34:47] Scott

It’s obviously a little hard to know exactly, but by our numbers, I think a good rule of thumb would be to say that the space has grown by an order of magnitude from the time of AHL Evolution launch to where we are today. So, if we call that roughly a decade, I would say, broadly speaking, the number of funds and the asset base has grown by something like a factor of 10. That probably is, today, I’m going to put a finger in the air and say that’s something like 20 billion.

[00:35:24] Moritz

Well, I think that’s a big number. I wouldn’t have thought it was that much, but very interesting. Now, let’s speak about one of the things in our prep call you mentioned is that you’ve discovered other alphas that trend in these markets; carry, mean reversion, other things that do work. But I want to tie this into your research philosophy and how you run your business because you’ve told me that deliberately you decided to not focus on them.

You have no interest in trading carry and mean reversion in these markets. You specifically focused on trend following, even though, I think you said, there’s money to be made there in these other things. So tell us a little bit about that.

[00:36:04] Scott

Yeah, I think we’re happy to concede that there are reasonably well understood non pure trend alphas in CTA space. The reason that we’ve shied away from those is, I think, one, you mentioned research philosophy. At the core of our research philosophy is it’s all about out of sample, not in sample. We simply have a much higher conviction in the robustness of the classical trend signal to work, on average, over time through a variety of environments than we do with some of the other versions. That’s point one.

I think point two is really more related to a practical matter, which is, because we’re so capacity constrained, we have to think very, very carefully about leverage and turnover. If I start trading things like, for instance, spreads like relative value carry, pretty much inherently, those will increase gearing. As I increase gearing, our position size has to get larger for it to deliver a given amount of risk, and that becomes more costly to the fund.

[00:37:08] Moritz

Of course, when you trade the single market exposure, you have more bang for the buck. You don’t need to trade as many contracts relative to, say, a spread position on the calendar.

[00:37:19] Scott

That’s exactly right. I think probably worth mentioning one other thing, which is that there’s a key feature of the classical trend approach, which is positive skew. There are very few strategies, and this is true in discretionary as well as systematic, there are very few strategies that deliver positively skewed returns.

The more you move into relative value and higher leverage strategies; spreads, mean reversion, those tend to have negative skew. We actually believe that positive skew, along with low correlation to other investment styles, is really one of the key features of what we do.

[00:37:56] Moritz

Just going back a little bit, what would you say are the key barriers to entry for that business? You have, I guess, a team at Gresham and Gresham has that commodities background, maybe market access, but still the majority of CTAs out there, they don’t trade the alternative markets. They focus on the traditional markets because they are easier to access. Why doesn’t everyone follow you and say I’m going to be eating Scott’s lunch now?

[00:38:27] Scott

Well, I suppose I would say that an order of magnitude increase in assets and managers over a decade suggests that there are definitely some people that are looking to share our table at lunch. You mentioned difficult to access. I think operational intensity is, really,
a big factor. That could be that you can’t use algos and so there’s much more high-touch trading. That’s, kind of, a big part of it.

It could be that you need documentation and swap agreements in place. It could be that you need far, far, far more brokers to get a given trade done because every market has a specialist broker. There’s a whole suite of issues, really, all the way down to broker relationships themselves. Because if you trade a relatively thin market with relatively few participants, it kind of matters whether you’re the first call or the third call from the broker.

So I think operational intensity is right at the top of that. But I think a close second or close cousin of that would be the cost. As I mentioned, we trade relatively high-cost markets. If you don’t have adequate conviction in higher Sharpes, it, actually, becomes suboptimal to trade more expensive markets. I think a lot of people will not, unreasonably, look at the cost profile, look at the bid offers of these markets and say, well, actually, I just don’t believe there’s enough alpha there to compensate for that cost and will shy away.

[00:39:54] Moritz

Now, we’re not going to be speaking about performance specifically on the podcast obviously for compliance reasons but in the bigger scheme of things. The alternative market, CTAs, say, over the last five to six years, I think on a risk-adjusted basis, they have outperformed the traditional market CTAs.

Now, this year, 2023, is a relatively tricky year for trend. How has that shaped out for you guys? Did you again outperform everybody else because these markets just performed differently or was it kind of like filtering through to your portfolio as well in terms of it’s tough trading this year?

[00:40:32] Scott

Without speaking too specifically around performance, I think it’s fair to say that we’ve suffered commensurately with a lot of our peers and that this year has been a tough year for trend. I think it’s been a tough year for trend, really, in almost any asset class. As you rightly mentioned, there’s a very wide dispersion and some of my compatriots have had exceptional years. But I think, on average and across the alt space, I think it’s fair to say that we’ve all taken our licks this year.

[00:41:10] Moritz

Are there any markets that stand out? In the traditional space, they say, okay, people made money this year being in sugar. being in cocoa, you know, some trade orange juice, we’ve been short the bonds or are still short the bonds, you don’t have them. But is there one market or a couple of markets that, when you go to Christmas, you will remember it for 2023, like oh, yeah, that’s been a stellar performer and that’s the dog of the portfolio?

[00:41:36] Scott

At a higher level (I’ll include markets that we don’t trade), the underlying story has been whipsaw. We’ve had a lot of very sharp, very short trends with very sharp reversals. If you had to sketch out the worst-case scenario, people often ask a very good question, which is, what kind of environment is going to be tough for your strategy? The answer is, actually, not sideways.

Sideways is a little bit expensive, but not really, you just kind of drift. What’s really expensive is sharp ups with sharp reversals and sharp downs with sharp reversals. That’s been true, really, across a number of different asset classes this year. I think the poster child for that would be fixed income.

Look at the events of March, look at November, everybody who has a large, fixed income book really struggled because of those reversals and those reversals were really rooted, in my view, in a tug of war between macro headwinds, Fed policy, etc. I think that theme of tug-of-war is true in a number our markets as well. China would be a good example. We’re relatively large in onshore China markets.

China too has been involved in its own macro tug-of-war. Is China a 2% growth economy or is it a 6% growth economy? Is the government going to clean up the real estate debt problem quickly or is it going to take a long time? I think all of those have led to moments of euphoria and despair that we’ve been, if you will, perversely tuned to from a speed perspective.

[00:43:18] Moritz

Now, as we’re about to close this down, Scott, one of the things that I think you mentioned to me you’d like to speak about is your vision of where the space is going from here going forward. What’s your outlook on the alternative markets CTA space?

[00:43:36] Scott

It’s one of those really interesting questions. It raises this fundamental tension between staying super disciplined and sticking to your knitting and retaining consistency in approach tempered with the self-awareness, if you will, that markets evolve, and market efficiency increases over time.

I think it would be naive to suggest that any investment style, short of maybe you’ve got a proprietary location (co-locating your servers next to the floor of the exchange or something like that), but it’s closer than everybody else. But in the broad sense, any strategy, I think, can only be expected to become more competitive and more populated and alpha to degrade over time.

I think we, as quant traders, have to take that challenge head on. I think our answer to that is that, as I mentioned, development of new and interesting alternative commodity markets, it goes hand in hand with the most basic nature of human progress and technological innovation, and we don’t think that will change. But what it also means is that we have to be willing to let go of stuff that we’ve done in the past.

You mentioned UK nat gas, so we do trade UK nat gas. We let go, some time ago, the front end of that curve because we believed it actually had come to behave like a traditional market. But we pushed our exposure out into other packages down the curve; seasonal packages, areas of the curve where we believed that producers and consumers were driving the price rather than speculators driving the price.

I think we, as a space, need to be sensitive to the idea that what drives the higher Sharpe, if you believe this of an alternative market, will become less true of certain markets over time, and we’re going to have to let some of that go.

[00:45:39] Moritz

Well, Scott, thank you so much for joining me today. I think this has been a really interesting conversation. We covered a lot of stuff. Listeners, you can find Scott’s contact and social media information in the show notes. As ever, should you have any questions be that to Scott or myself, please send an email to info@toptradersunplugged.com where we’ll pick it up and respond.

So thanks again big time for listening guys. I’ll soon be back with another episode of Open Interest, so please stay tuned. If we don’t hear from each other prior to the holidays, well, happy holidays, Merry Christmas, and my best wishes for a great year 2024.

[00:46:12] Scott

Happy holidays to you too, Moritz. All the best.

[00:46:14] Ending

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