ETFs, Size, and the Commodity Problem ft. Alan Dunne

[00:00:01] Intro

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

[00:00:23] Niels

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

[00:00:36] Alan

Very well, Niels, thanks a lot. Great to be back. Lovely spring sunshine here in Dublin. How’s all on your side?

[00:00:42] Niels

Yeah, yeah, I’m actually in Denmark right today and it is sunny as well. So, maybe spring is, in fact, coming.

We’re going to be tackling a few big topics, I think very relevant topics today. But before we do that, and I think this section could be quite interesting this week. As always, I’d love to hear what’s been on your radar. I’ve got a few things that came across my inbox.

So, what’s caught your attention?

[00:01:12] Alan

Well, yeah, a couple of things. Obviously, we had the Fed last night which was, you know, I think broadly as expected.

But one thing that did catch my attention is if you look at the projections that accompany the statement and the overall presentation, what you see is that the Fed has reduced its expectation for GDP this year and next year and increase its expectation for inflation.

So, there’s a stagflationary bias within their view of the US Economy, which is interesting by itself, but also interesting that it hasn’t impacted their monetary policy projection. They’re still highlighting an expectation in the dots for two rate cuts.

But what really caught my attention was there is this, if you go to the end of this report, the projections, they have what’s called a diffusion index where they’re asking all of the participants what are the risks to their forecasts, or the risks to growth to the upside or to the downside, and the risks to unemployment and inflation.

And what’s really striking is if you look at these diffusion indices, the risks to growth are very much on the downside. So, almost all participants see greater downside risk to growth. So, that’s at its most negative in terms of that index since the end of ’22, or end of ’23, when there was a lot of real pessimism around growth. It’s the same with respect to unemployment. The risks are to the upside.

But also, with respect to inflation, this diffusion index is also, you know, very high, elevated as high as kind of ‘20, ‘21, ‘22. So, they see the upside risk to inflation as high as it was, you know, back when we had the inflation spike.

So, I thought it was very striking that they’re quite pessimistic. And presumably all of that has been driven by Trump’s tariffs policy and uncertainty around that.

So, you know, it’s not obviously impacting on their assessment of monetary policy or their projection, but clearly the risks are for more of a stagflationary environment if they actually come through. We’ll have to wait and see how long tariffs are going to be sustained and in what shape, etc.

But I thought that was quite interesting.

[00:03:31] Niels

Yeah, you know what, I mean, when you say it like that, and I did not read the details like you did, but it actually sounds refreshingly realistic, actually, and kind of in line with a lot of people that I listen to, in terms of what the real risks are which is maybe not something you always get from central banks. But, yes, and of course, it definitely won’t fit well with the hopes and aspirations of the new US president, that’s for sure.

Not sure if he’s already been out tweeting about the fact that they should have cut, but there we are. A country that has cut, I wouldn’t say a country, but a region of the world that has cut rates recently is another thing you want to talk a little bit about.

[00:04:16] Alan

Yeah, well, I just want to talk about Germany a little bit because I think every time I’ve been on, over the last maybe four or five months, you know, we’ve been talking about the demise of the German economic model, and the challenges at Volkswagen, and how Germany is really stuck in a moment, I guess. And, you know, I wrote a piece a couple of months ago saying there was a need for radical change, not really believing that we would see it. But, actually, it is one of those moments where we have actually seen radical policy which has gone through this week. I think it still has to go through the upper house of parliament in Germany, but it’s on course. And, obviously, that’s this unwinding of the constraint of the debt break in Germany.

They’re committing to €500 billion euro infrastructure fund and effectively unlimited defense spending because defense will be treated outside the traditional spending constraint. So, very positive in terms of stimulating growth.

So, I mean, it does radically change the growth outlook in Germany, we would say. I think the Bundesbank were forecasting 0% growth this year or about that. So that would be obviously revised heavily. You know, it could be 2% growth we could see in Germany all of a sudden for the next number of years.

So, I think it’s interesting to think about. You know, obviously the market is very focused on the immediate impact of this. You know, German defense stocks have been rallying very hard. Bond yields have gone up. But there are also second round impacts of this that I think are interesting as well.

Because, if you think about it, this shift in Germany and it may, may be mirrored, you know, we’re seeing it also in the UK it may be mirrored elsewhere will mean less savings from Europe being exported to the US. So, it’s going to mean it’s going to be a lower current account surplus in Germany and a lower capital account deficit.

And the flip side of that, in the US, means it actually goes somewhat towards addressing the current account deficit issue in the US because there won’t be as much of capital flowing in.

So, ironically, Trump, by forcing the issue with respect to defense, he actually will make some progress at the margin in addressing the deficit issue. The flip side is by pushing up German yields, that means globally there’s less excess savings. So, bond yields globally will be higher. So that is, at the margin, a negative for the US bond market as well.

So, I think it’s interesting to think through those kind of second round impacts as well. It’s just the obvious, okay, this is good for the German economy, it’s good for Europe. It probably also means a higher euro over time as well. This is kind of interesting because we had Matt Klein on a few weeks ago, on the podcast, and he was saying, like some of the solutions to the kind of trade imbalances, it’s not a zero sum, it’s a positive sum. So, this is one example of a positive sum.

We should get stronger growth in Europe. It should address some of those trade imbalances, which is, you know, positive for US and Europe. It just took Germany to take action, which they are doing now.

[00:07:26] Niels

But I guess also, and correct me if I’m wrong here, there are a couple of things happening that are interesting. One is, of course, the fact that, as you say, this could definitely lead to higher German yields, which we know if that’s the case, it probably leads to higher European yields. It’s happening at the same time as we’re seeing the highest yields in Japan for like decades.

So, you would think those two forces together would lead to maybe less demand for US treasuries as well, which could then lead to higher bond yields in the US. So, I mean, I think this is pretty… And these have major implications and certainly also something we may see in terms of pickup in volatility in the currency space where actually, for trend followers, currencies haven’t been a great sector for many years, could lead to some interesting opportunities.

I don’t know if you know this, but is there anyone who has been out talking about, what does all this defense spending actually mean specifically for German GDP? I mean, how much of this defense spending will be going to domestic producers, do you know?

[00:08:35] Alan

Yeah, it’s a good question. I mean, they’ve got the defense side and the infrastructure side.

[00:08:39] Niels

Right.

[00:08:39] Alan

So, the infrastructure fund is €500 billion euros and German GDP is, you know, it’s about €5 trillion and might be a bit more, a bit less. So that’s 10%. So, you know, if that was even over the course of 10 years, that would be immediately kind of 1% of GDP.

And then obviously the defense is on top of that now, you know.

[00:09:01] Niels

Yeah, but defense doesn’t have to go to Germany.

[00:09:03] Alan

It doesn’t have to. But then one of the themes people are talking about is that the car makers will now start producing tanks, not cars.

Now obviously the defense spending isn’t just around tanks and ammunition and stuff like that. Obviously, it’s cyber security. And I think they’ve broadened the definition of what qualifies as defense and security spending.

So, I guess it could include a broader array of expenditure. But certainly, you know, from a spending perspective, that will boost growth. Obviously. yeah, it remains to be seen one, how much seeps out overseas. And two, you know, normally in a traditional kind of Keynesian perspective, there’s a multiplier effect. So, with the spending, you get the direct impact, but then there’s a multiplier impact elsewhere in the economy.

Hard to estimate how big that is, but I guess that’s all behind the shift in sentiment.

[00:09:56] Niels

Okay, well, on my radar, Alan, I wish I had something that was as relevant as your topics, but here we go. So, this story came in my inbox yesterday. It came via the Wall Street Journal, and listen to this, and I’m just quoting the article. I thought it was pretty interesting.

“The stock-market volatility of the past several weeks was good for one thing: A silly exchange-traded-fund concept melted down in record time.

Five weeks ago, Defiance ETFs launched its flagship “Battleshares” fund, (ticker ELON). It gives owners double exposure to Tesla coupled with a “short” on Ford Motor. The bet against the Detroit stalwart, founded by Henry Ford a century before Tesla came into being, is used to help pay for the enhanced wager on the EV-maker’s shares.

How’s that working? ELON (i.e. the ticker) has lost investors two-thirds of their money.”

Talk about timing.

[00:10:58] Alan

Not great timing for sure.

[00:10:59] Niels

Not great timing, anyways, the other thing actually I think it does highlight a little bit is that maybe there’s a little bit too much financial engineering going on in that ETF space. I mean it is on fire even in our little world. And it’s almost like you can create anything within an ETF that solves all the problems even for trend following. So anyways, I’m sure we’ll come to that somehow.

The other thing of course that I couldn’t help not see was the 2025 World Happiness Report, Alan. The Nordic countries do pretty well on this list. I think in the top, what have we here, in the top seven, five of them are Nordic countries.

[00:11:43] Alan

Okay.

[00:11:44] Niels

Where do you think Ireland fits on this list, Alan?

[00:11:48] Alan

I would have thought we’re doing okay, but you tell me.

[00:11:52] Niels

17.

[00:11:52] Alan

17. It’s not too bad. Yeah.

[00:11:54] Niels

So, you’re behind Costa Rica, Kuwait.

[00:11:57] Alan

Yeah.

[00:11:57] Niels

Belgium, you’re not as happy as the Belgian people.

[00:12:01] Alan

Surprised at that. I mean I thought we’d be higher, but maybe it’s just the persistent rain.

[00:12:05] Niels

I think, if they had done this survey on Saint Patrick’s day, it would have been completely different. Anyways, that was my two tidbit contribution to this week.

Let’s move on to something that’s much more interesting which is, of course, as we normally do when, when you’re on is dive into your kind of framework for the global macro picture and what you’re seeing in sort of the big picture.

[00:12:36] Alan

Yeah, I just wanted to delve into one topic which has been very much in the market chatter in the last, not just week, I’d say maybe a couple of months now and that’s around US dollar and all of this talk of a potential Mar-a-Lago Accord. Obviously, we had Steve Marin on the podcast last year and he was still at the Manhattan Institute. He’s since been appointed chair of the Council of Economic Advisors. So, he is seen as quite influential, and he wrote a paper, last November, talking about how the global monetary system might be reimagined going forward.

I suppose the backdrop to all of this is that the US has something of what I would call a trilemma with respect to the dollar. On the one hand, they want a weaker dollar to try and boost manufacturing. That’s been a key, I suppose, part of Trump’s platform. At the same time, they’re keen to maintain the US dollar as the global reserve currency. So, that kind of argues in favor of more of a stable dollar. And at the same time, the most pressing issue that the administration faces, arguably, are these large deficits. So, ensuring that the US dollar is stable enough to attract sufficient capital to fund the deficit. So, you’ve got conflicting perspectives there.

Steve Miran wrote a piece, as I say, last November about addressing, I suppose, what he sees as the problem of US dollar overvaluation, which is then impacting the manufacturing sector via the trade deficit. And it’s kind of split into two parts broadly. One is around the use of tariffs to address it. And he sees that as being part of the solution.

Interestingly, reading the report again, he very much was highlighting how he’s assuming Trump used harvest primarily as a negotiating tool, which has kind of been forgotten a little bit. So, that could still be the end game there.

And then he also then goes into various measures of various ways that the US could address dollar overvaluation through either intervention or unilateral agreements or maybe something more broader.

And the idea of a Grand Accord, which has been dubbed the Mar-a-Lago Accord, and that kind of is, I guess, going back to the ‘80s, there was the Plaza Accord which was in 1985 between the US and its major trading partners. That was an agreement to bring down the dollar after a period of dollar overvaluation. So, it’s, I suppose in the same vein an expectation ran out.

So, the question is, what would that look like? And some of the policies are quite radical. There’s a suggestion that, obviously, explorers the possibility of direct intervention – pros and cons to that; possibility of the Fed printing money and then selling those dollars to buy foreign currencies – issues with that.

But also, I think more generally he draws on ideas that were, I think, originally floated by Zoltan Pozar, who used to be a Credit Suisse. He has his own research shop now. But the idea of linking trade and FX policy more to defense.

So, the idea being that if you are part of the US’s security umbrella, then what comes with that would be the benefit of security. But you have to effectively pay for that somehow either buying treasuries or in some shape or form, you’re part of the club, you pay up for it.

So, a lot of the ideas in this Mar-a-Lago Accord are related to that idea. But you’d have to say, it was written in November and that seems a bit dated now, given what we’ve seen in Europe. Obviously, Europe has taken the message and is now saying, okay, well, we’re going to make steps to look after ourselves. It’s going to take time obviously.

So I’m not sure, could we actually see something on that front now where Europe would be willing to sign up to some grand agreement of… Effectively, what was being proposed was that foreign central banks or foreign counterparts would sell some of their dollars to bring down the value of the dollar, but at the same time they would swap their existing treasury holdings into long term bonds to ease the pressure on the US funding.

So even the suggestion that they would be swapped into century bonds, and even mentioned the possibility of perpetual bonds which, okay, interesting, it certainly solves the US’s problems, but is Europe going to sign up to this? And then the issue is that a lot of the US treasuries are held by China, the Middle East, Japan. So, it’s not necessarily the reserve holders in Europe that are the primary holders of US assets.

And I think my own perspective on this is these are interesting ideas but come with significant risks once you start to meddle with the US dollar. Foreigners hold about $60 trillion in US assets and that’s a function of the fact that the US has run deficits for years.

So, this is kind of one of the flaws of the international monetary architecture that was known. When this was set up in Bretton Woods, in 1945, the US embedded the dollar at the core of the system. Keynes was negotiating on the part of the UK and he wanted this kind of common unit of account, a common currency called Bancor. But no, the US were insistent on kind of embedding the dollar at the core of it, and this was the underpinning of the US as the reserve asset.

But what comes with this is they have to supply dollars to the rest of the world and then they end up with a current account deficit and foreigners end up having large claims on the US. So, the risk is, at some point, that foreigners say, hey, we’re going to get out of the US. And you get, I suppose, an unwieldy decline in the value of the dollar.

So, I think any kind of effort to address it is fraught with risk. Certainly, the idea of like he does float, the idea of even the Fed intervening, printing dollars to buy foreign currencies. It’s easy to see how that would quickly spiral into something more dangerous. But I think it does kind of raise a more general question. You know, we had Bretton Woods, which came in 1945. And then if you go back to, you might remember this, around 2007, 2008, before the financial crisis, economists talked about Bretton Woods 2. And that was the new arrangement.

And that was basically the fact that you had large surpluses in China and the Middle east and those were then invested into US treasuries. So, there was some kind of balance in the system, although it was a big risk factor.

And actually, prior to the global financial crisis, a lot of people were worried about that the dollar was the weak spot, that this could topple over, that this Bretton Woods symbiotic relationship between the US and China could unravel and the impact would be a big dollar sell off.

That wasn’t the case, actually. Obviously, we did have a crisis, but it wasn’t a dollar crisis. And actually, the dollar got stronger during the financial crisis because there was so much debt issuance in dollars that people had to scramble to buy dollars to be able to fund their liability. So, the dollar ironically became stronger. But it has left a bit of a vacuum now as we go into a new era. What does the new international monetary system look like?

But I don’t think the solutions being proposed by Steve Miran, in this piece, are the solution largely because I don’t think they necessarily work for Europe or for China. And it remains to be seen, does the US really have that much leverage over them.

So, yeah, it seems like interesting but somewhat dangerous ideas, I would say.

[00:20:47] Niels

Yeah, sure, but of course, what is interesting about it is that from, you know, you hear from so many different sides. We were actually also having a conversation with Adam Rozencwajg, which is commodity related.

But what they had found was that usually these commodity super cycles, which a lot of people have been expecting, would, you know, take off anytime soon. Actually, they often come with a change in the monetary system. And so, there are many things pointing towards some kind of change. We just may not know exactly what the change will be yet. But definitely worth following and some really interesting insights from you.

And, and of course people should go back and listen to your conversation with Steve Miran if they, if they have a few minutes to spare.

All right, well, let’s pivot to something where there’s always change which is trend following. My own trend barometer finished at 43 yesterday. That’s kind of neutral. We have seen, in the last few days, some recovery in the CTA space, but it has been kind of a six week or so challenging period for trend followers in particular.

Not so much the short-term managers, but the trend followers have had some headwind and there has also been some real reversals, I think, we’re now picking up in our models.

So, overall though the year is not so bad, as some of the headlines that we just saw actually the last couple of days where some of the journalists are having a field day with some sensational news that these trend following funds are struggling. But actually, in many respects the year is pretty flat, down a few percentage points, or not even worth talking about.

But we talked earlier about, for example, currencies, and the dollar, and so on, and so forth. And that’s, actually, also where the action has been and what’s been causing a fair bit of the pain has been in the currency sector. And exactly because of what you explained and what’s caused the things like the Euro to suddenly get a new renaissance and much stronger than it was just a few weeks ago.

The other area that’s been challenging has been US equities. It’s not surprising, the sell-offs we’ve seen in US equities will, you know, always mean some give back of profits for CTAs because we are long by definition when markets are making all-time highs and then when they turn it takes a while for these positions to be reduced, if, indeed, it is a real reversal or whether it’s just a correction. Time will tell.

But I’m sure there’s been some equity exposure that’s been reduced in our space. The best opportunities (and this is what I love about trend following) actually ties in a little bit to one of the pieces we’re going to be talking about, has come from the commodity sector. Things like metals, in particular precious metals have been really great, supported by copper.

Also coffee has done well. In the livestock area we’ve seen things like live cattle do really well. And in the financial sector, something that we also touch on, on your radar so to speak, and that’s exactly been the short exposure that managers would have had to Japanese government bonds and German bunds. So, with these countries seeing significantly higher rates in their 10-year bonds, this is something that we’ve been able to benefit from.

So quite a divergent portfolio at the moment in terms of market action. And, you know, in the long run these things often create some interesting times and interesting opportunities. So, we’ll see.

From your perspective, Alan, sort of looking at it from your vantage point, anything in particular that you’ve noticed in recent time?

[00:24:56] Alan

No, as you say, it’s one of those transition periods that tends to be choppy and difficult for trend following. Obviously, when the S&P is down 10%, and after a prolonged upswing there’s inevitably going to be some challenges there, and it’s that type of environment. We’ll talk about portable alpha and return stacking and all of those later on. This is the point of the cycle where they will be most challenged.

But we’ve seen it before. So, nothing out of the ordinary. And it remains to be seen, will it be back up to new highs or are we ultimately into a transition, into a new phase? And we don’t know yet, but I would say yeah, nothing out of the ordinary but can imagine it still can be a little bit frustrating at this point in time having those types of strategies.

[00:25:44] Niels

Absolutely. All right, let’s roll down the numbers here. BTOP 50 up 29 basis points so far in March, down 33 basis points so far this year. So, as I said, very unexciting in that sense so far, year to date. SocGen CTA index down 16 basis points and this is as of Tuesday, I think, yeah, must have been, and down 2.14% for the year. And I should say yesterday, Wednesday, I suspect was a good day for these indices. SocGen Trend down about 1% so far this month, down about 4% so far this year. And then, as I mentioned, Short Term Traders Index doing better, up 1.42% so far this month, up 19 basis points so far this year.

In the traditional world. MSCI Equity index is down 2.72% as of yesterday and flat for the year so far. The US aggregate bond index is down 10, 11 basis points so far this month, up 2.44 for the year. And the S&P 500, certainly the worst of them all, down 4.6% for March and down 3.22% so far this year. It’s very rare that we get to say those words that the S&P is the worst performing equity market at the moment.

All right, so we probably have two kinds of feature conversations or topics we want to talk about. The first one, super interesting.

I had a chance to look through the summary that you sent me yesterday, but of course you know much more about this. But I have to say I was quite, really overwhelmed with the amount of information, even the summary has some really interesting stats.

And we are talking about the Global Investment Returns Yearbook which is assembled by Professor Paul Marsh, Dr. Mike Staunton of London Business School, and Professor Elroy Dimson of Cambridge University.

And it’s kind of the subtitle is The Definite Source for The Analysis Of Long-Term Performance Of Global Financial Markets. I think that’s a very good description, actually. So, Alan, take us inside this very comprehensive piece of work.

[00:28:10] Alan

Yeah, there’s an awful lot in it, as you say, and this is actually a report that is published annually and it had been part of Credit Suisse, but obviously Credit Suisse now falling in with UBS.

And actually, if you go back in time, the authors that you mentioned wrote a book back in 2000 called the Triumph of the Optimists which was a review of asset market returns for the last century as of 2000. And they’ve been updating it ever since. So, it’s kind of a live piece of work. They have a very large and detailed database of data looking at asset class returns across all the major economies and markets, not just major, minor as well, stemming back as far back as they have. So, it’s really interesting to kind of look at it to help anchor, I think long term return expectations, because I’ll talk a bit about that.

I was doing a bit of work recently, looking at the last five years as that five-year period. So, it’s interesting to look at that five-year period in the context of the very long term. And interestingly, we’re hoping to have two of the authors of this report on the podcast in the next few weeks. So, it’d be great to delve into it in a bit more detail.

I mean, some of the interesting themes that they go into are around, you know, the high level of concentration in the US and how markets have changed over time, how the sectors which, back in the 1900s, the US stock market was largely driven by the performance of the railways. Banks were still there, banks are still here now, but you didn’t see technology featuring, you didn’t see energy featuring as much.

So, it’s very interesting to see how that composition has changed over time. And that’s something that David Giroux from T Rowe Price, who was on recently, something he talked about as well.

Even going back to 2006, technology was a much smaller part of the index. And the index has actually become much less cyclical. The cyclicals, the financials, energy, those sectors have become a lot less dominant in the overall index.

So, it is something to keep in mind when you’re doing comparisons in terms of valuations, et cetera, across different time frames.

[00:30:36] Niels

Can I just intersect one thing, just to give people a kind of picture of that because that was one of the charts I also found super interesting. You’re absolutely right. I mean in 1900 railways were, I don’t know, by eyeballing it, something like 60% of the index, something like that. And, of course today I don’t even know if it features very much on that chart. And so, you think oh yeah, that’s 125 years ago. What’s the relevance?

But as you rightly say, I mean we just pick our points. So, in the ‘70s, for example, this is also something we discussed with Adam Rozencwajg. I mean, you know, energy related equities are something like 30% of the… and so you think back then, oh, they must always, you know, this is how it is. But then you go another 10 or 20 years and it’s completely different.

So, right now, you could say, well investors really should think about what is it going to look like in 20 years or so because it won’t be technology that will be so dominant as it is today. And that’s the relevance I think of sometimes zooming out and seeing these changes because we don’t feel them from day to day, or year to year. But once you zoom out a couple of decades, it really becomes evident.

[00:31:54] Alan

Yeah, for sure, and even if you go back to, I’d say, 2007, the banks and the financials were much bigger. I don’t know what it was, but it might have been 25% or 30% of the index. Obviously, that was at the end of a boom period for banking and et cetera.

But yeah, in terms of returns and that side of things, and this is where as I say, there’s a real value in the work that the guys have done. They do catalog the returns across different asset classes in different countries.

But going back over the full 125 year period, US equities have delivered nominal returns of 9.7%. So that’s that kind of 10% number that people hang their hat on over the long term comfortably, very comfortably outpacing bonds 4.6% and bills 3.4%, and in real terms at 6.6% in the US. And over that 125 year period US exceptionalism is a real thing, if you look at it, because the rest of the world was 4.3%. So, definitely the US has been the place to be over that 125 year period. You might say, well that’s a good reason to believe it will continue to be or you might not depending on your perspective. But it certainly is there.

I mean it is interesting because you can use the data in two ways because obviously, I think a lot of financial advisors will say look at the long term returns, 10% return, don’t try and adjust for that or don’t try and time it. You want to stay invested all the time in the market. But at the same time they do highlight what a rough ride it has been at times.

And some of the big drawdowns, like during the depression, the market fell 79% in real terms, you know, a huge drawdown. And how long did it take to come back out of it, to reclaimed the highs was fifteen and a half years. So, you know, a long, long time.

You know, if you’re facing retirement in the next 10 years or something, or next 15 years, is it good to kind of keep in mind as the kind of the worst-case scenario or even 1973,’ 74…

Sorry, you wanted to ask a question?

[00:34:02] Niels

No, no, no, no. Well, I just wanted to also because this is something, you mentioned these real returns, you mentioned equities, real returns. I’m looking at this and I’m seeing, in the US, real returns of bonds at 1.6% over that period of time. I think it is pretty much, well, it’s a little bit lower in the UK.

And so, my question is really okay, if this is the real return that we’ve generated for such a long period, what makes so many pension funds use much higher kind of expected returns for their portfolios? Why do they own 80% of bonds in Europe? I mean that’s just not a lot of data to support those numbers and that model. And, and I’m bringing it up because I’ve spent, you know, a few hours trying to understand it this week, meeting with people who really know the pension system, at least here in Denmark, from the inside out.

And, yeah, I’m just completely surprised. And also, if you go to Germany, I mean Germany also loves the fixed income portion of the portfolio and you look at this, how are you going to support the pension system with those real long-term, real returns?

[00:35:28] Alan

For sure, and I mean it was one of the things that was striking to me as I went through the full report as well, is, yeah, the numbers around bonds are sobering – I think is maybe the word.

[00:35:42] Niels

I was going to say depressing, but there we are.

[00:35:44] Alan

I mean, I think across 21 different markets, the average real return over the long term was 0.9% in bonds. And of course, what you saw with bonds is that there was huge regulatory forces kind of encouraging people to lock in bond yields, to de-risk pensions, remember, during the 2000s. It has been a theme. Of course, all of that happened. You know, for one, that was a force pushing bond yields down, and then people locked in at really low levels.

One of the upshots of that is when we saw yields spiking, because in the UK they had strategies on that in derivative formats. It led to issues. But it is interesting how, when the regulators get involved, sometimes they push pension funds into things that probably don’t make sense. And what we’re seeing now in the UK is there’s this push to encourage pension funds to go into private market.

So, you wonder, well, how’s that going to play out? So, it’s just interesting. But on your point on bonds, they do a histogram of the annual returns both for equities and bonds.

I mean, when you look at the histogram for the bonds, 2022 really does stand out as a really negative – down over 30%, I think. Whereas, if you look at a histogram of the equity returns, also quite interesting. It doesn’t look quite normal, it’s slightly skewed.

Generally, you get a return of kind of 10% to 20% is the most frequent in the distribution, even more than 0% to 10%, which is kind of what the average is. But then you do have some of these negative outliers too, as well. But yeah, I thought that the data, as I said, on the drawdown, ‘73, ’74, was down 56%. The Tech bubble, the same. The Global financial crisis was down 52%. It only took 5.3 years though to come back. So, I mean, maybe that’s what keeps people…

[00:37:41] Niels

Well, to come back, and what people have to remember is it took, also, a while to get into that drawdown.

Well, I guess the reason I bring it up is that often people say, well, the worst thing you can experience with a trend follower, that’s the length of the drawdown. It’s not really the depth of the drawdown. But I think sometimes people forget that, actually, drawdowns in equities have also been of much longer length, actually, than what you typically see in the CTA space.

[00:38:10] Alan

Yeah, it’s true. And they have some data on, you know, what’s the longest if you invested in equities, what’s the longest, in the worst case scenario, what’s the longest you would have to wait to get your money back if the market immediately goes into a drawdown.

And so that was 16 years in the case of the US. So, worst case scenario, historically, has been 16 years if it went immediately into drawdown, that you would get your money back in real terms, but actually in bonds it was 80 years.

[00:38:44] Niels

Oh, another piece of wood on the fire.

[00:38:48] Alan

Yes, exactly. So, yeah, sobering again.

[00:38:51] Niels

Well, luckily pension funds are long term. That’s what they say.

[00:38:53] Alan

Well, it is, I mean, from their perspective.

[00:38:55] Niels

I’m obviously being facetious here.

[00:39:00] Alan

The point about the pensions is you’re locking in. Anybody who locked in yields in 2020 at 0.5%, or whatever, in the US, is going to get that nominal return, which will prove to be very negative. So, that’s going to be a loser, just in real terms. But that’s what they were willing to accept at the time. They also have the correlation charts that we’ve talked about many times before – bonds, equities.

But it is really striking when you look at it again, how persistently positive bonds and equities were up to the ‘90s and now has turned positive again. And that kind of period between late ‘90s, early 2000s looks like more of an outlier.

And then another one I thought was interesting was just on inflation. Swiss inflation, the Swiss have been the best at keeping inflation low over the very long term, 2.1%. The US over the full 129 years is 2.9%. So probably a good baseline point, I would say, I know the Fed is talking about 2%. The reality is if you’re kind of coming up with an inflation forecast over the next five years, 3% is probably a better estimate, I would guess.

You know, so loads more in it.

[00:40:11] Niels

There’s one thing I want to mention to you. I don’t know if you noticed that. Did you look at the role that factors play in long term wealth creation? They have a chart on that.

[00:40:21] Alan

I saw the factors yeah, yeah.

[00:40:22] Niels

What was striking to me was that both in the US and in the UK, the highest factor, and they look at it over decades, so, they take the ‘20s, the ‘30s, and so on, and so forth. You know, momentum is very well placed in those charts. And, you know, that is, of course, what we also believe in in terms of the momentum factor. So, it’s kind of confirmed, even though these are obviously different ways of looking at momentum and so on and so forth. But it kind of shouldn’t be a surprise that people who try to make money from momentum, you know, should generally be doing okay.

[00:41:04] Alan

Yeah, yeah, it was interesting how that has been the top performing factor. Yeah.

So, one thing I did, kind of separate to this, was looking at the last five years and that was kind of inspired by what we talked about before about the Cliff Asness piece, looking at the 10-year period. I sometimes feel like this is really interesting information that we get from the yearbook. But people say, okay, right, 125 years. I’m managing a portfolio for the here and now.

And even the 10 years is an interesting academic exercise but will feel like too long. I think five years is a good period and we’re just kind of halfway through the decade. So, it’s interesting to look at that and particularly to look back at how much things changed over the course of that five year period. I think it’s still fresh enough for us to remember December 1999 and what the world looked like then, and looking at it now.

Over that five year period, US equities, the S&P did 14.5% annualized. So, just above 10% annualized, which would be kind of your baseline expectations. So, it has been an unusually favorable period. And that has come after, you know, two other five-year unusually favorable periods, 2010 to 2015, 2015 to 2020. So, unsurprising, sentiment has been really bullish because we’ve had 15 years of basically above average returns.

[00:42:29] Niels

And in fact, Alan, Bridgewater found that this has been the best 15 year period ever, since 1970.

[00:42:34] Alan

Okay, yeah, yeah.

I mean, maybe not surprising because the starting point was obviously 2009 where valuations were particularly favorable and we had enormous liquidity provision, et cetera. Yeah, all of that.

I mean, I thought it was interesting, particularly in the last five years, because I saw some people, in various articles I read saying, oh, look at the last five years, the S&P is up 14.5%. And that’s even with a pandemic and higher inflation and fears around debts and deficits and all of that. So, it just shows you just stay in the market always because things always work out fine.

And this is kind of what I would say, an example of what Annie Duke calls resulting, which is saying, just because it proved to be the best outcome doesn’t mean it was the right decision not to diversify away from equity. So, I would make the same argument now. But if you look at the last five years, really the big change, from a macro perspective, was higher inflation.

Inflation averaged 4.2% over the last five years, whereas we had been in, if you go back to the 2010s, it was secular stagnation, low growth, low inflation. So, look how much things have changed. Could you have anticipated that back in 2019?

We did think a resurgence of inflation could be a possibility, but it actually came about. And the other interesting thing is, over last five years there has been a lot of talk of US exceptionalism as we say, but know, US real GDP averaged 2.5% which is about the same as the previous five year period – not bad, pretty good. What was really unusual was the high level of nominal GDP which is driven by the higher inflation.

But also, if you look at what the fiscal deficit averaged over the five years, it was about 8% fiscal deficits because it was skewed by the very high deficits over Covid and they haven’t come down since. So, you’ve had this unusual, you know, backdrop of exceptional fiscal deficits. You’ve had monetary easing and actually despite the fact that the Fed raised rates in 2022, real rates in the US have been negative over that whole five year period on average. So, you’ve had negative real rates, quantitative easing in the early part of it, enormous fiscal stimulus.

So yeah, maybe in retrospect it’s not hard to see why equity returns were so great. And also, interestingly I looked at it from a trend following perspective. The last five years was the best for the SocGen Trend going back to 2000 to 2005. Performance was higher back then, but the volatility of the index was much higher back then. So, if you adjust for that, it was actually the best five-year period.

So again, it does point to the fact that if we were having that conversation in 2019, remember the pessimism around trend following 2019, you would have had found it hard work to convince somebody that the next five years were going to be the best five years for 25 years. So just I think it’s really interesting to do that five-year analysis because you can kind of remember how things were and how quickly they change.

The long term stuff is Interesting too, but sometimes you need to kind of frame it in the current context.

[00:45:45] Niels

Well, we’ll have to bring this up in five years, Alan, to see what the next five years looks like. Well, thanks for that, that’s a great recap. And obviously we’re really… Well, I say we. It’s the royal we. It’s you working really hard on securing two of the very esteemed authors of the paper so that you can really dive into it. That would be awesome.

Anyways, another esteemed paper, if I say so myself, is from our friends over in Zurich, Quantica and they put out some great research and this one, in particular, caught my attention. It’s titled, it’s the Q1 paper, it’s titled When Trend Following Hits Capacity A Case Study on Commodities and then subtitle Exploring the Hidden Opportunity Cost of Limited Investment Universe Diversification. What a title. But actually, in all seriousness, it is something that we have been talking around, in many different ways, over the years.

It’s something that I have felt but have not been able to put hard data on. But luckily, we have clever friends in the industry that can do just that. So, why don’t you kind of take us through what it is they’re trying to test and what they’re trying to assess when it comes to trend following, capacity, diversification, opportunities – how it all ties together and how it all kind of concentrates or ends up concentrating itself around the commodity part of what we do. So over to you.

[00:47:33] Alan

Sure. Yeah, well, I’ll kind of try and talk through the main points. I won’t get bogged down in all of the detail of which there’s quite a lot of numbers and interesting perspectives. I mean, at a high level the paper is around the diversifying power of commodities within trend following.

But the fact that, when accessing commodity markets there are constraints because liquidity is not great once you go into particularly the more diversifying commodities. So, there’s this kind of tension that CTA’s face in trying to extract that, I guess extract that diversification. But at the same time, if you want to grow your assets as a CTA, you’re going to find it hard to do that if you want to fully capitalize on the diversifying power of commodities.

[00:48:22] Niels

And maybe we should just define for people what we mean by diversifying properties. Why do they say that commodities are important in this respect?

[00:48:31] Alan

Yeah, well, I think it’s because commodities are driven by more unique stories, supply and demand stories. So, if you think about it, US equities will tend to be correlated with German equities and Japanese equities. But once you get into the… So, if you’re applying trend following, the performance of trend following in US equities is probably going to be similar to it on European equities, at times.

Obviously, we’re seeing a moment for European equities at the moment, but overall you’re not going to get as much diversifying power as when you get into the commodity space. You’re talking about live cattle, and how we’re seeing moves in those markets; orange juice, huge move down of late; cocoa, big rally over the last few years; gold, you know, gold is rising on, you know, a possible change in the monetary system. Orange juices going on a different set of factors.

So, all of these commodities trade on unique factors.

[00:49:26] Niels

Exactly. So, when you put together a portfolio of essentially different return streams, those that are linked to the commodity markets tend to be much lower correlated with the return streams you get from your financials part of the book. And that’s why the commodities are so important for trend followers to have in their portfolio.

[00:49:46] Alan

Exactly, yeah. I think that’s largely known and I think what you’ll see as well is that all managers will say they traded commodities, but it’s in what size you trade, the likes of cocoa or orange juice, if at all, or even things like corn and soybeans.

So actually, one of the things that was very interesting in the paper was that they look at 69 commodity markets and they look at the liquidity available in all of them. And actually, I think the top 10 commodity markets, the top 10 most liquid commodity markets account for 70% of the total liquidity in commodities.

So, when you’re talking about liquid commodity markets, it’s heavily skewed to the energy. And then obviously gold is in there as well. But it’s things like WTI Crude is most liquid, but Brent is also highly liquid.

So, if you’re trying to construct a trend following program, you want to have commodities, but you want to also have a lot of assets that will tend to bias you towards trading more of the energy contracts. Whereas, it’s in the agricultural commodities where you’ve got even more diversification but the liquidity isn’t as deep.

And what they look at, they say if you were to do a trend following strategy on the full 69 commodity markets, and ignored the whole capacity issue, so, let’s just say you can get as much capacity for the assets that you’re running. The expected Sharpe of that trend following is twice that of the same strategy just applied on the top 10 most liquid markets. So, it just highlights this as we’re talking about the average correlation.

So, if you think about it, the average correlation is much lower when you bring in cocoa, and zinc, and all of these smaller markets, as opposed to if you’re just looking at WTI, Brent, gas, oil, gasoline, which are all obviously derivatives on the same market. So yes, there can be individual stories impacting them from time to time, but they’re going to be more correlated.

So that’s really the crux of the matter. And then, more generally, to talk about if you look at an unconstrained version of trend following versus what you have to do if you move into managing say 3 to 4 billion dollars in a trend following program with about a billion in commodities, they estimate that there’s about a 17% reduction in the Sharpe ratio because of that. So, at 12 vol that’s about 1.6%. So, that was interesting in terms of, I guess, putting some numbers on it.

And I guess people would, broadly, know that this at a high level, that you don’t get as much diversification, as much exposure to commodity markets if you go to the very large managers because of the capacity constraint against that. They’ll say well, you know, you’re getting access to their overall level of sophistication, et cetera.

But it does maybe point to that maybe the sweet spot for a trend following program is less than, you know, $3 or $4 billion, and maybe even less than a billion. So, the other point, then, that they look at is looking at ETFs was another point that was interesting. And you know, basically ETFs are available now, where trend following are available in an ETF structure. They’re typically trading a smaller number of markets. So, you might only be trading, trading 10, 12, 20 markets.

So, the question that they try to estimate is how inferior is that because you’re trading with smaller number of contracts relative to a broader set. They did come up with a number of, I think it was a 4% vol in returns, but that was relative to the diversified set of commodity markets.

So, I wasn’t sure if that was completely the correct way of looking at it because, obviously, an ETF will trade across bonds, equities, currencies and commodities.

[00:53:58] Niels

So, what they write, Allen, actually I think I have the quote here. They write, “for example, trend following ETFs which have recently gained popularity due to their low fees and ease of access are structurally limited to trading only a fraction of the markets available to an unconstrained CTA.

As a result of the lack of full diversification potential, the expected structural drag on performance can be as high as 4% per year before fees, over the long term. This drag can potentially negate or even outweigh the benefits of lower fees when compared to more expensive yet better diversified implementations with more effective use of their investment capacity.”

And so, this is also one of the things that, as I said before, these are some of the things that I felt, but have not been able to really back up with hard data. And why I express my concern for some of these newer products, including replication products is because, here’s the thing, and this is also why, and I’m sure people know my reasons for having this bias, I’m not a big fan of flat fee products in general because there’s no alignment with the manager of doing well. But here’s the thing. When you offer a flat fee product, or an ETF with a really low management fee only, the only way you can really make it a profitable business is to go for size.

And we’ve now just seen, through this research, and of course there will be some people making other conclusions for sure, but through this research at least there is a cost to size and the cost is less diversification in terms of the commodities. So that’s one thing.

But there’s one thing that they don’t actually mention in their paper, something I don’t know if they looked at specifically, but I seem to have read, a while back, another paper that looked at the role that commodities play specifically when there are equity crises, I.E. Where does this crisis alpha actually come from?

Well, we know it’s not coming from the equity side because as we’ve talked about today, equities sell off and CTAs lose money in equities. And it doesn’t always come from the bond positions. It certainly, at the moment, is not coming from the currency positions. And so, as you reminded people about when I went through where the trends have been this year, it’s all the commodities except for a couple of fixed income markets.

So, in addition to potentially having a drag on performance that is pretty permanent and pretty meaningful, according to this research, by not having the ability of trading commodities at full size because you’re going for capacity, you actually also risk, I think, potentially of producing even worse returns at the time when the clients that are buying your trend product or your replication product needed it the most.

And what we also discussed last week with, when Andrew was on, and the week before with Katy was on, in her way of looking at replication, she found that it’s actually around inflection periods that the correlation between the replicators and the benchmarks break down. Again, another way of confirming the fact that, you know, at these critical times, for example, in this case replicators, but maybe also just huge ETFs that are focused more on a fewer set of markets can’t do what the traditional, maybe higher cost, but also more diversified managers are doing, albeit they have to do it with smaller size.

So, that’s the price we pay for not going for size. We would just say, okay, we cannot get this product to a $5 billion or $10 billion size, but hopefully we can deliver a better outcome for investors. And why I find this to be particularly of interest is because we’re seeing such a big push at the moment in the ETF space, in the replication space. And now, with BlackRock coming out, and Fidelity, and all these big people, we know they’re going to go for size, that they have to do it.

And all I’m just worried about, as a practitioner of the opposite, so to speak, is the fact that it’s going to hurt performance. And they’re going to get the headlines in the press because they’re much bigger than a lot of our colleagues in this industry. So, the headlines may not be favorable to the industry because of “a different approach” to delivering products.

That was a bit of a rant, I guess.

[00:58:53] Alan

A little bit.

I would say a few things on that. One, on the crisis alpha, I mean, from memory, I know in my previous role we did an analysis of 2008 and actually trend followers did really well in 2008 and most of it actually came from commodities. So, that supports your point. I mean, and against that you might expect the most liquid commodities, I’m talking energy, oil ,and gold, and copper, and those kinds of markets to be most sensitive to economic conditions.

So, if you did have an economic downturn, that it would be more likely to be reflected in there rather than in the softs which are trading in the supply and demand stories. That’s the point.

But I don’t know, I’d have to look at all of the instances to say whether that’s valid or not, but I think it is a relevant thing to think about. I mean, the one thing I would say is the number that they quote, they quote this 4% degradation that the ETFs could be subject to – 4% degradation in returns. But that’s actually looking at the degradation that goes from, I think, trading 10 most liquid commodity futures, from trading the broader commodities. So, it’s very much a commodity centric analysis.

So, something that I was curious about, that isn’t addressed here, and is another topic, is this idea of trading fewer markets but trading more diversifying markets. So, I know we’ve had some trend followers who are trading fewer markets.

You could trade 20 markets or put it this way, even in the commodity space if you only traded gold, oil, copper, nat. gas, and corn, you’re going to be more diversified than if you trade five energies, and they’re more liquid. So, in the same way you could trade 20 markets. But it’s how you allocate the risk that’s important and how diversifying those markets are. Actually, they give the formula for the expected Sharpe based on the average correlation and the average Sharpe of the market.

So actually, I was looking at it. You could trade 20 markets and based on an average Sharpe of 0.2, and an average correlation of 0.05, you get a sharp of 0.64 which could be way better than trading 100 markets. So, that’s why this debate about the number of markets is a bit…

[01:01:18] Niels

Well, they actually talk about that.

I don’t know if you saw that, but in the report they go on to say, at the other end of the complexity spectrum, trend following programs that aim to trade hundreds of markets, while managing billions of dollars in assets, will likely experience a risk distribution that deviates from the theoretical optimal risk, equal risk allocation approach. While the prospect of accessing a broad range of investment opportunities may be appealing, many of these markets may contribute more to a marketing narrative than to the portfolio risk allocation or overall performance, especially as the amount of capital managed increases.

So, that’s the other pet peeve that I’ve had over the years and never been able to really back it up with any data. And that was the argument that trading hundreds of markets would be better than trading 75 markets, or 67 markets. And I’ve just never seen it in the data.

Luckily, we have good Swiss friends and so, you know, I think the Danes just moved from the second place to the first place in the happiness report.

[01:02:26] Alan

Yeah, no, I’m sure if we read some research from some of the providers who run hundreds of markets, they would have compelling evidence as to why. So, I think you have to bear that in mind with all of these reports as well.

[01:02:38] Niels

I’m sure people who listen to this that they know my biases and so they will, of course, take everything I say, as they should, with a grain of salt. But it’s great research, I have to say.

Alan, we had one more report. I don’t think we’re going to have time for it. This has been too much fun. So why don’t we, why don’t we keep that? Because actually, in about an hour and a half we’re going to record another episode with someone where this topic will be the main theme.

So, without revealing what that is, I think we should wrap it up, and just to say, great, thank you, Alan, for all the preparation, diving into these huge reports to help us make some sense of it.

If you want to applaud Alan for all the work he puts into this, head over to your favorite podcast platform and leave a wonderful rating and review. We’ve had quite a few of them, actually, recently and I do read all of them and it puts a smile on my face every time I read them. So, I really do appreciate that.

With that, next week, I’m not entirely sure who… I’m not recording next week, you are recording next week, Alan, with Mark. That’s why I don’t remember it, because I will be in Asia. So, look out for that episode. It’s going to be fun, no doubt, when Mark and Alan get together, which oddly enough, every time I travel, it’s usually Mark that you end up with.

[01:04:03] Alan

A couple of times.

[01:04:05] Niels

And they’ve been fantastic episodes. So, thank you for doing that in advance. If you have some questions for Alan or Mark, you can email them to info@toptradersunplugged.com and I’ll do my best to send them their way.

That’s it for now. Thanks so much for listening. From Alan and me, we certainly look forward to being back with you next week. And, in the meantime, as always, take care of yourself and take care of each other.

[01:04:29] Ending

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

And remember, all the discussion that we have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also, understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Thanks for spending some of your valuable time with us, and we’ll see you on the next episode of the Systematic Investor.