Is Cocoa becoming Too Hot for Trend Followers? ft. Rob Carver

[00:00:00] Intro

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

[00:00:23] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Rob Carver and I, Niels Kaastrup Larsen, where each week we take the pulse of the global markets through the lens of a rules-based investor. Rob, wonderful to have you back this week. Hope you’re doing well. How are things in the UK?

[00:00:40] Rob

It’s okay here. It’s a bit cold and damp. Niels is actually in Asia this week. So looking at the window of your hotel room, I’d say you’ve got considerably better weather than I have at the moment.

[00:00:51] Niels

Well, you’re absolutely right. I’m in Singapore today. It’s nice. It’s warm. So what can I say? Today I think I have the better weather.

[00:01:02] Rob

Not so much when it gets humid later in the year, but at the moment, definitely.

[00:01:05] Niels

Yeah. Absolutely. All right. Enough about the weather here. We’ve got questions. We’ve got some topics that are important for us to talk about today. But as usual, as you know, I’m always curious to find out what’s been on your radar besides the topics in the last few weeks since we last spoke.

[00:01:26] Rob

It’s been quite a good year for me. I guess probably a lot of CTAs haven’t done as well as some CTAs have done. Some astonishing numbers out there from a certain kind of fund which we’ll touch on later. I’m up about 12.5% for the year so far, which I’m quite pleased with. So obviously, annualized, that would be some silly number that I won’t bother trying to analyze. It’d be really amazing if it carried on for the rest of the year, but I think that’s unlikely, sadly.

In terms of my positioning at the moment, a reasonable amount of risk. A lot of risk in bonds in particular, also in FX and agriculture. I’m short bonds, I’m short bunds, and I’m short Buxl. They are the longer maturity German bonds. I’m also short US 30 years. So, some short positions there. I’m also short Swissy and gold. Short the safe haven assets there, so that’s interesting. And then on the long side, my biggest long position is probably I’d say in equities and also in agricultural.

My biggest long position of all is cocoa, which I guess we’ll also touch on later on because how can you not talk about cocoa on this podcast. I think it’s now the rules or something, right? Because it’s just been the story of the year. A lot of people who never think about futures markets, especially about cocoa, have been talking about it. I’m also long yen versus euro and some stock markets. So some interesting positioning there.

I guess maybe pro-risk plus positive equities, short bonds. That seems kind of a pro-risk trade, or maybe it’s also a pro inflation staying high in interest rates staying high trade. I’m not sure 100% what’s going on there so it’s quite interesting. The other thing I like to do is look at how markets have moved over the last few months. It’s quite interesting to do that. There are a couple of different ways you can do that.

You just look at the actual price movement itself, in which case cocoa is the winner for the last three months. It’s up some 167% according to my math at least. Even on a vol adjusted basis, it’s still up a lot. It’s still up 3.5 vol units, which is an awful lot. Up there with it is coffee. Coffee is also getting more expensive. A market I thought I might see on this list of things that are moving around a lot is tin.

I don’t know if you’ve seen but there’s been some chatter about tin on the LME. So tin is up, not an astonishing amount, but it is up. But what’s interesting is that, apparently, somebody who shall not be named, we don’t know who it is, perhaps somebody out there knows, has got something like 40% of the open interest in May tin at the moment. A bit more worrying.

It’s not just that it’s 40% in the open interest, he’s apparently in getting on for 100% of what’s actually available in the bonded warehouses for delivery. So this looks like your classic short squeeze. Those old enough or have read the history books will think about the Hunt Brothers and silver way, way back in the late ’70s. So keep an eye on Tin. Tin could be interesting. I don’t have a position in Tin at the moment. So I have no interest in this particular story. But there could be something going on there. Who knows? We’ll find out.

[00:05:02] Niels

Yeah. Sounds like it. Also, I don’t know if this is related to the news that the LME was changing some rules about not allowing Russian metals to be part of the storage. Is that related to that?

[00:05:19] Rob

It might be. Yeah. I must say, I’m not an LME or a Tin guy. I’m a metals guy. I actually started trading LME about a year ago, so I’ve not really paid much attention to it. The LME is a very strange market actually. It’s a very weird market. Any market where you have physical delivery is going to behave a bit differently anyway. But the LME of course is where we saw the issues with Nickel and trades being canceled.

So it always strikes me that the LME is a bit wacky, a bit weird, a bit strange, a bit crazy. I’m a little bit like a certain person who we said we wouldn’t name on the podcast who is currently on trial for criminal charges, which I think is a first for an ex president. So yeah, the LME is a bit like the Donald Trump of the futures world. I hope that they won’t be too offended by me saying that, and I hope that Donald Trump won’t be too offended either. But yeah, it’s fun. It’s a fun market. Interesting things going on there.

[00:06:15] Niels

All right. Well, you’ve already used up your political view quota for these episodes, that’s for sure. So let’s move on swiftly. I thought these were interesting observations of course. I also had maybe part of the trend following review that we do which we can jump into, just the fact that there are a lot of interesting things happening at the moment in the market.

Now, I wasn’t looking at necessarily year to date. I was also noticing that if you take so far this year, CTAs have been quite highly correlated to equities. And then you have a month like April where it actually seems like in a very short space of time, it’s flipped and we are negatively correlated to equities. Now, of course, it means nothing. It’s just one month. But I think what it does showcase is maybe this thing about how difficult it is to know exactly how a non-correlated return stream is going to behave.

Of course, we know how important non-correlation is from a portfolio construction point of view. But I think this is also what people struggle with, which we may come back to later in one of the topics you brought along, with the fact that they don’t really know exactly how our performance is going to be related to the asset classes that they follow. Nevertheless, stocks and bonds are down for this month together like we saw in 2022, which of course is interesting.

Now, staying with the trend following update, we’ve already talked about it. The market that seemed to have helped trend followers even into the second quarter is of course cocoa. The yen has certainly been struggling the last week or so again. Short-term US interest rates also quite interesting as far as I can tell. Of course, we know that that’s because rate cuts are being faded further by the markets with the comment on the inflation numbers that we’ve seen. And then of course, as you mentioned, grains, gold making new all-time highs. Quite interesting.

My own trend barometer is picking this up. It closed last night at 59. That’s a pretty strong reading. So that confirms what we’ve seen performance-wise. As of Wednesday, because of the time difference, I don’t have the Thursday numbers for the industry. But the BTOP 50 Index was up 1.1% for the month, up 10.5% now for the year. SocGen CTA Index up 1.55% for the month, up 11.37% for the year. SocGen Trend Index up 1.48% for the month, up 13.89% for the year. And the Short-Term Traders Index is having a great month, up 2%, up 3.25% for the year.

I think yesterday actually was a good day for trend followers and CTAs, so we could add a little bit to that. In contrast, MSCI World equity index down 4.6% so far in April, up 3.5% still year to date. World Government Bond Index down 1.55% so far in April, and the S&P 500 Total Return down also about 4.5% in this month and up 5.5%. Of course, the equity sell-off is actually continuing today with the increased tension that we’re seeing happening just as you and I speak with some chatter about Iran being attacked by Israel. But who knows whether that’s true or not.

Let’s jump to the questions. The first one is something that I hope you can help with. Paul wrote in a little while ago. He said, “You mentioned you use MATLAB to backtest your strategy.” So he’s referring to the company I work for, DUNN Capital. That is correct. We use MATLAB. “Do you have a book to suggest where I can learn MATLAB. I’m currently using a backtest on Portfolio Visualizer, but that has limitations.” But since you’ve written books about backtesting, maybe you even know where to go if you want to learn how to use MATLAB.

[00:10:24] Rob

I haven’t written books about backtesting, but I’m going to write about backtesting at some point. I have written books related to backtesting. I’ve never written a book that talks about specific languages. I’m always wary to do that because it means the book is going to go out of date quite quickly and you have to keep issuing new editions, which is good for the publisher, but quite a lot of work for the author. And I’m not a believer in hard work if I can avoid it.

Having said all that, I personally haven’t used MATLAB for backtesting for, I don’t know, it must be 20 years, possibly something like that. At AHL, where I used to work as everybody knows, their single stock trading strategy was originally developed in MATLAB, and I had some involvement in that, in its early days. So that’s when I was using MATLAB for backtesting.

But that was subsequently, like the rest of their platform, authored into Python. Your MATLAB experience is a lot more recent than that, so I’m definitely going to pass this question back to you.

[00:11:25] Niels

Well, I’m not a quant so I have no idea where you would go and find such a book. But I guess from your answer, Rob, maybe the best thing we can say to Paul is you may have to google this. But what you’re saying is also that actually, perhaps the industry is moving further towards Python rather than MATLAB.

[00:11:46] Rob

Yeah. I can tell you the reason why we moved away from MATLAB. This may not still be the case, but MATLAB is obviously a commercial product, whereas Python is open source. We actually had this problem (this is when multiprocessor cores first came out, now most people do stuff on the cloud), but we had a big, local cloud of multiprocessor cores and the MATLAB people wanted to charge a license fee per core, which was going to cost us tens of millions of dollars, which for something we could get for free seemed a bit of a push. So that’s the reason we moved away from it.

I’m sure that MATLAB updated their licensing policy since then. Otherwise, they’d be out of business. So they probably don’t do that anymore. But that’s the one reason why. But the other reason is that not as many people use MATLAB. If you’re looking to hire a developer, you’re hiring from quite a small pool of people, whereas certainly Python is maybe the first or second most popular programming language in the world.

There’s a huge pool of Python developers. So you’re more likely to get someone that’s a good quality if you’re looking. That’s probably a reason why a lot of places now don’t use MATLAB. But still, as you say, you guys do and there are others that do. It’s a perfectly good language. In some ways, it’s superior. For example, its data visualization is a lot nicer than Python’s.

But I don’t get hung up on these what programming language is better arguments. I’ve used dozens of languages over the years, and they all have their strengths and weaknesses. It’s really down to what you’re comfortable with.

[00:13:28] Niels

Good stuff. All I can say is whilst I’ve been in Asia the last couple of weeks, I have not seen any pythons, which I’m perfectly happy with. But that’s not quite the same, I guess. All right. Let’s move on to one of the other interesting topics when it comes to you, Rob. Again, I’m going to mention you’ve got a very small quota of bashing this topic.

But Byleth, I think, I’m not entirely sure how to pronounce the name, he wrote in, “I was listening to a podcast some time ago where Rob mentioned that he advises a crypto fund. I would be interested to hear what his experience is with trend in crypto and if there were any major lessons learned with respect to designing trend strategies compared to TradFi strategies from his book.”

I guess it’s a fun conversation to have maybe for you since Bitcoin, I think, is having its fourth halving today or one of these days at least.

[00:14:29] Rob

It’s funny, everyone assumes that I automatically have become some kind of crypto expert just because I’m doing this little bit of a side project. But actually, I still hate it and I still don’t know much about it. But yeah, I think you’re right. I think the halving is approaching. The main consequence of that, as I understand, will become more expensive for miners to make Bitcoin.

The Bitcoiner’s view is that that will make the price go up because supply and demand, the supply is going to fall, therefore, if the demand stays the same, then the price will go up. I’m not sure I buy that. We’ll see how that goes. I think the main consequence will be a lot of Bitcoin miners going out of business and probably merging with other ones or moving to areas with cheaper electricity, but you know, whatever.

So TradFi, it’s pronounced TradFi Niels, which stands for traditional finance, which is what the Bitcoin people call us, basically. So now you’ve learned something. You’ve learned how to pronounce TradFi today. One of the reasons I’m not an expert in crypto still is that I don’t really believe there’s much fundamentally different about trading crypto versus trading other asset classes. There are things that are different.

For example, unless you’re trading futures on the CME, the counterparty risk is a massive issue potentially for you. There are basically no regulated safe crypto exchanges, is my view. There are exchanges that are safer and have some kind of joint regulation around them, and there’s ones that are completely wild west and you shouldn’t touch with a bargepole. There’s certainly no crypto exchange out there that’s as safe as the CME backed by the clearing house that the CME is backed by. So that’s something to bear in mind, definitely.

The other thing is of course that while Bitcoin and Ethereum, you look at their distribution of prices and it’s a bit weird. They’ve got quite high volatility and they’ve got flattish tails, but they’re not completely outlandish. But as you descend down the market cap universe into these weirder and weirder coins, you get things looking out by like 100 times in a day, which just doesn’t happen in TradFi.

So there’s risk of what you might call a meltup. In other words, you have a short position where the price jumps against you. There’s equally a risk the price can go to zero on the other side. That happens too. So it’s a very dangerous world. We have to be very careful about making assumptions about things like normal distributions which are heroic assumptions at best but in crypto are particularly heroic.

The question I think he’s pointing out is whether there’s something special about the way that trend following works in crypto. Again, I’m not convinced. Everyone says trend following and crypto work really well. And they say, “Look at this graph. Here’s my backtest. All I’ve done is take a simple moving average and applied it to a bitcoin price, and look, it’s a great backtest.”

Well, that’s true. But that’s because the raw material you’re starting with is already pretty good. It’s something that’s gone up a lot over the last 10 years. So you start with something that already looks pretty good. The trend following filter kind of sort of smoothes that out to an extent. So, it reduces the drawdowns and it means that you aren’t quite as quick going in on the up swings.

Because the price has mostly gone up, you’re mostly long on the trend following filter. So it’s not really changing the character of the series or adding much value in any respect. So it’s not really that different from, I remember somebody showing me an amazing backtested account curve. And I said, ” What instrument is this?” And they’re like, “This is a few years ago. This is on Eurodollar interest rates”.

I’m like, well, the underlying assets pretty much gone at the straight line for the last 30 years so it’s not really a surprise that you’ve got a trend following thing looks amazing on it. You haven’t done anything special here. There’s nothing magical about this. The thing about crypto, like the Chinese proverb goes, it’s probably too soon to tell up. Bitcoin has been around for 15 years, but only really tradable in reasonable size for perhaps half of that.

So you can’t really use the first seven years of that bitcoin price in a backtest. You can’t really do that with any meaningful value. So then you’re left with a few years of time, which isn’t really enough to draw statistically significant judgments to say, oh, yes, Bitcoin definitely trends better than X, Y and Z because there’s something special about crypto. It’s just not the case that I think you can make those kinds of judgments.

There are basically no instruments where I think you can see statistically significant differences in performance that are meaningful enough to start saying things like, oh, yes, we should definitely only trade this particular trend speed in crypto because there’s something special about it. I just don’t believe that at all in a general sense.

[00:19:27] Niels

It’s kind of like if they had introduced futures on cocoa two years ago. People would look at it now and say, oh, yeah, that’s a great market to trade. But they forget the 15 years that came prior to that where trend followers lost money on cocoa big time.

[00:19:41] Rob

I think it was one of the worst markets for trend following in 15 years. In many ways, it’s quite nice what’s happening to cocoa because it’s a real good counterexample of when people say to me, shouldn’t you optimize your portfolio based on historic performance of how your instruments have done with your strategies, in other words, put more money into things that have trend followed better than other things in the past. Well, no.

Because even 15 years of appalling history isn’t statistically significant. I don’t believe there’s anything fundamentally weird about Cocoa that would have justified not allocating to it just as much as I allocated to something else in my portfolio. Of course, that too was proven right by the fact that this market has done nothing for ages. It’s just suddenly ballooned and gone out of nowhere. That’s just the way these things work. So it is quite a nice counter example to use for people who really want to overfit their strategies.

[00:20:42] Niels

Yeah, definitely. We’ll obviously come back to cocoa a little bit later.

All right. So the last question came in from Tauras. He writes, “Some questions for Rob Carver for his upcoming appearance. What are Rob’s thoughts on seasonality and relative value strategies. Trend and carry get a lot of attention, but seasonality and relative value get ignored. Any opinion on the Harry Browne permanent portfolio and risk parity as long-term passive portfolios for retail investors?”

[00:21:14] Rob

Well, let’s start with seasonality then. So seasonality is an interesting one. There are quite well-known reams of academic research about seasonality, particularly in equities. So you get things like the end-of-year effect, the start of the month effect, the Friday effect, the 25 past 2 on a Tuesday effect. Actually, the full one is a very British one because it’s buy in May and don’t come back to St. Leger Day, which means you need to know that St. Leger Day is a horse race and it happens on a particular day. I think it’s in September.

So basically, you should not hold stocks between May and September for some bizarre reason. Most of these things start off as data mining exercises where people plot all their returns. They say, “Oh, look. Something weird is happening here.” I’m being very cynical here. I apologize to all the people out there who have done the research on this. Because then what you do is you say, “Oh, well, there’s an obvious explanation of why this is happening. It’s because of with the end-of-year stuff, it’s because of tax. It must be because of tax.”

So they say it’s because of tax. And then something unfortunate happens, which is people find the same effect or a different effect in other countries. So they look at countries with the same end of the tax year and find a different effect, or they look at countries with a different tax year and find the same effect, both of which were inconsistent with the tax behavior.

So then you come down to some kind of wishy-washy behavior where it’s like people like to end the year… and there’s some logic behind that. When I worked for an investment bank, all of our P&L bonuses were calculated on a calendar year basis. So if you were having a really good year up till November, guess what you did in December? Absolutely nothing. You just sat on your hands and didn’t want to lose any money.

If you’re running a discretionary fund and you want to win one of those nice award prizes that they hand out in fancy places, and they’re often based on the calendar year performance, well, guess what? If you had a really good time period up to November, you just shut everything down to an absolute minimum and you tell your investors that you perceive some mysterious risk ahead of you and that’s why you’ve wound back your risk.

It may mean missing out a bit on the upside, and then you collect that award at the end of the year. So there could be good reasons why year end stuff happens. There could be good reasons why month end stuff happens. It might be that a lot of big long-only funds used to just wake up in the beginning of every month and rebalance their portfolio and that produced quite predictable effects.

If they were just doing straightforward rebalancing, it would mean you’d get a nice mean reversion effect on monthly returns which you could trade, which would be very beautiful indeed. Funds don’t tend to be as stupid as that now. They don’t tend to do all their trades in a very predictable way on one day of every month, which is basically just asking for short-term traders to just pick their pockets.

Commodities, I guess, are more interesting because there could be good reasons for seasonal effects in things like cocoa. I don’t know what the cocoa growing season is, but I imagine there is one. Presumably, that would affect the prices of commodities. Of course, it’s not really for commodities, because we trade future deliveries in different parts of the year. In theory, the seasonal effects should be completely built in already.

So if you look at natural gas, there’s a very predictable seasonal pattern there. You can’t really make money about knowing the fact that it’s going to be cold in winter in the Northern Hemisphere and warm in summer, and that’s therefore going to have an effect natural gas prices. That’s a known. You can only make money out of things that aren’t baked into the price. That’s basic finance.

So this stuff is out there, and in some cases, there are good explanations for it. I don’t generally use it myself, although I have researched in the past and I have actually run strategies with some seasonal models in them. But I’ve never been a massive fan of them. Because I guess to do them properly, you probably need a lot of variables because to do this sort of exercise from a really proper hardcore statistical effect, let’s say you want to pick up an end of year effect. Well, then you really need to have at least 12, one for each month, or maybe 365 indicator variables in your regression or whatever tool it is that you’re using. So that’s an awful lot of parameters to fit, and it’s going to be very likely that you are going to pick up something that spurious, so you need to use statistical techniques to remove that. By the time you’ve done that, there’s not really anything left that’s of a massive amount of value.

I think that there are people out there doing this stuff pretty successfully. No one really knows, but my suspicion is that Renaissance are quite good at finding weird seasonal patterns and exploiting them. Because they’re so good at the data analysis, they’re not data mining. They’re managing to find things that are generally there. They may not last for a huge amount of time, but they can pick them up.

[00:26:26] Niels

Am I right in saying that these types of strategies, seasonality for example, that that’s more convergent in profile?

[00:26:36] Rob

Well, yeah. Generally. You’d expect them to be because the effect has to balance out over the year. So it must be the case that if stocks have gone up a lot for the first 11 months of the year, you’d expect them to go down the last one. Because these things are constrained to produce a flat net profile. So yeah, you’re right. They are generally speaking going to be convergent.

A classical trend follower wouldn’t be a big fan of them anyway. I’m less sniffy about what I put in my strategy. I’m happy to put a bit of convergent stuff in there if it makes sense, but seasonality I’m not so keen on. What was the next one? Relative value, I think, wasn’t it?

[00:27:15] Niels

It was relative value. Yeah. A little bit. And then some comments on the permanent portfolio, Harry Browne.

[00:27:20] Rob

So relative value is an interesting one because it’s a phrase that has many different meanings, like what’s relative to what. So in its most basic form, you could say, is it absolute relative value or relative relative value? Absolute relative value is value. Basically, it’s saying, is this thing cheap or expensive? Relative relative value or relative value if you prefer is saying, is this thing cheap or expensive compared to something else? Okay, well, what is the something else?

There are very different characters of a strategy. So you can think about something while you’re trading two things that are almost exactly the same and have a very, very high correlation. For example, the classics so called on the run, off the run treasury bond trade where you’d buy the treasury bond that was 29.5 years old and you’d sell the treasury bond that was 30 years old and just been issued because people liked the new treasury bond and they’re prepared to pay up slightly for it.

So that’s convergence in two things that are massively correlated. The higher things are correlated, the more leverage you need to juice up the trade, to earn the returns you expect from the expected high Sharpe ratio. Of course, that leads to potential tail risk, which is very nice. So I don’t do that. I don’t do that kind of stuff. It’s quite specialized. That’s how famous B funds like Long Term Capital Management blew up doing those sorts of trades.

I do things like look at relative momentum, which is a form of relative value, which is saying not just how is this asset doing for its own momentum, but how is its momentum versus other assets. Same with carry. I also do a kind of slow mean reversion, which is a convergent strategy. Sorry, Niels. But that’s what you’re saying. If the last couple of years say S&P has outperformed NASDAQ, I’d expect those two to converge and for that pattern to invert itself.

So yeah, I do a bit of that. But it tends not to be as high-performance as the absolute stuff. That’s because every time you strip out a risk, and obviously relative value is stripping out the overall directional risk, the overall beta of the market, every time you strip out a risk, you also strip out an opportunity for return.

What’s interesting about trend following is that, according to my analysis, about 70% of the returns of trend following individual assets are actually coming from a secular asset class trend, and the rest is coming from the relative value trend between instruments. So if you just trade the relative value and nothing else, you lose about 70% of your performance. If you only trade the asset class trend, you still get 70% of that performance back and you miss out on a bit. Of course the best thing is to trade them both, and that’s effectively what we do.

I’m not super familiar with the Harry Browne portfolio, but I know similar portfolios where you basically do things like put a quarter of your money in US equities, a quarter in domestic equities, a quarter in gold and a quarter in bonds. There all of these kinds of things. Risk parity is a more sophisticated version where you say, well, I want to allocate my risk equally between asset classes.

That means on a cash basis, I’m going to have a much higher weight to bonds because they’re safer and a relatively higher weight to say gold, and a lower weight to equities, which is riskier. And then typically, what a risk parity fund does is then leverages that up. There’s been a bit of chat on Twitter about something called return stacking, which sounds terribly exciting and interesting. But it’s kind of a variant of that, essentially just leveraging up to access other things. Return stacking I don’t talk about it here.

[00:31:02] Niels

Actually, Jason over and Mutiny, they have done their Cockroach portfolio, which I think is a play. As far as I remember, it’s a play on the Harry Browne.

[00:31:11] Rob

Yeah. So there’s lots of ways of combining these things. You know what? I wrote a whole book called “Smart Portfolios” that almost no one reads because it didn’t have the word trading in the title, which was a mistake on my part, because it’s not about trading. It’s about investing, about long-only investing. That’s pretty much on that discussion about investing.

If you’re someone who doesn’t want to spend a lot of time thinking about your investments, you know what? That’s fine. Just buy a bunch of ETFs across different asset classes. Don’t get too hung up on the weightings. Don’t get massively hung up on what’s in there. As long as you’ve got diversification across bonds and stocks and countries and throw in a few weird things as well, you’re going to do pretty well, and you don’t have to spend any time thinking about it. So, yeah, I think those are perfectly good ways to invest.

[00:32:01] Niels

Absolutely. Of course, the best way to invest, Rob, is something we’re going to talk about now because you sent over a one-liner to me as a topic. It says, “Shock horror! I’ve increased my CTA allocation.” So clearly, we need to spend a little bit of time on that. I’m going to let you run with it. I probably have a few questions, but let’s see where we’re going to go with this.

[00:32:28] Rob

Well, Niels, settle down and get your cup of coffee, because actually, it’s quite late in Singapore. You’re probably already on the cocktails there. Settle down because I’m going to tell you a little bit of a story going back some 10 years, over 10 years now to when I left the hedge fund industry and started trading my own money.

I thought I’d set myself up a little play account, a futures account, and I put some money into it. I didn’t want to put massive amounts of money into it because this was running with my own code and I was trading futures with my own money, something I’d never done before. I had done it professionally, but I never actually traded futures with my own money, so I was a bit nervous about it.

So I set this thing off and it’s done pretty well. It’s over the last 10 years exceeded industry benchmarks and also a fund I used to work for, I think it’s probably beaten the benchmark I choose there. But anyway, that’s another story. A lot of this is just luck. But anyway, it’s doing pretty well. I’m pretty happy with it. I’m more to the point I trust it. I have a lot more trust now in my process, in my code, in my operation, in the broker I’m using.

Notice I don’t say I’ve got more trust in the strategies I’m running. I’ve got about the same amount of trust I had at the beginning, which is that I was pretty confident in the backtest, I was pretty confident they’re not overfitted, and I hoped that they would continue to make money in the future. As a quant, that’s all you can do. That’s the best you can do. So I didn’t need to spend 10 years kind of gaining trust in the strategies. It was more about the operational side, the code side, the broker side, trading futures, all this kind of stuff.

So what has happened over time is that this strategy has done pretty well. I basically have a cash ceiling value, and that’s meant that as my overall portfolio has fortunately grown over the last 10 years, my futures allocation has become a smaller and smaller percentage of that. You know what? I’m not a big fan of people who go on the internet and YouTube and TikTok and tell people to do stuff they don’t do themselves right. I think that’s dishonest.

So I always felt a bit dishonest publishing blog articles saying, theoretically, you should have 75% of your money in trend following, or at least 50%. There were psychological reasons as well why I preferred having a lot of my income coming from dividend-paying long-only investments. But I’m like, this is crazy. These psychological biases, you spend your whole life again. This is hypocritical. I like saying to people, don’t get hung up on psychological biases.

Theoretically, the best portfolio is the one that maximizes your Sharpe ratio, and that’s got to be more in the, not just in trend following because my futures strategy is probably only about 50% trend following, but more in a diversified bunch of return streams and risk premia versus just equities and bonds, which obviously limits what you can get, at least theoretically.

I’m not a big fan of discretionary market timing, but I’ve looked at the run up in the stock mark, obviously, briefly interrupted by COVID, but it’s done really well. You feel like, can we really expect to see those kinds of returns going forward? Although I’ve never been a big fan of the US stock market, I think the UK stock market where actually I have a higher allocation will do relatively better.

Interestingly, there’s quite a lot of articles appearing now in the FT saying the UK stock market looks really undervalued, the UK stock market is really undervalued. So that feels like a nice investment. But overall, do I bomb my forward-looking expectations for stocks for the next 10 years? Probably not as good as the last 10 years. So, all in all, I thought I should put my money where my mouth is and I should put some more money into trend following.

There were some kind of boring related tax reasons why I was able to do a fairly significant reallocation last year. I can’t remember the exact figure, because obviously, it changes anyway. But I’m now running at more like, I’m trying to do maths in my head, I’m running at about 35% allocation to my futures trading strategy, which is about 18% trend following and 18% to a mixture of other things, which is getting closer to what I tell other people to do.

I’ll say one last thing which is that I’m obviously a genius because I made this decision about a month ago, and the last month has been very good. However, I would add that if I really was a genius, I would have probably done it about six months ago, which was at the point of maximum recent drawdown, and I would have done really well. But anyway, maybe I’m not a genius after all.

[00:37:41] Niels

I think there’s a few takeaways here. Actually, one of my questions when I saw the headline was, why do you do it now when trend following is hitting their all-time highs? But I think you’ve explained it quite well. I think that makes perfect sense. One question that comes to mind is whether you heard or not my conversation with Andrew Beer where he talked about his experience.

Of course, he does come from a different vantage point, so the numbers will probably be different. But I think what he was saying is, he said two things. One is that he himself had changed his view and was more now aiming for a 3% to 5% allocation. I’m sure he thought about a 3% to 5% allocation to his product, which is of course different from an allocation to the overall space.

But he did say something interesting. He said that he felt, because we were discussing the latest paper from Man Institute about their analysis of what the optimal allocation to trend should be and their average was probably coming out more towards a 40% mark, but he said that he felt that our industry (I’m not pointing fingers at one specific group, because I think lots of people do it) would show what theoretical values…

You obviously are quite close to the 40%. I know some of it is not pure trend but leave it at that. But the people would say that I am hoping that the investors would then say, okay, let me then do 10%. So you’re pitching it higher, and then you hope that they will go with a smaller number, which is still a meaningful number. So I don’t know. Of course, I kind of pushed back saying that I thought we need to say what we mean. For me, it is 20% to 25% for sure. That’s what the evidence suggests.

So is there anything here in terms of, I don’t have you read the paper or heard the compensation. But what would you say if you were in the commercial side of the industry trying to argue for what people should do other than what we’ve talked about so far?

[00:40:02] Rob

I just double-checked, and I’m actually 40%. So I’m bang on that number. Also, just to add as well, you would expect someone like me to have a higher allocation to trend following than the average person because it’s all to exceed the CTA strategy. Because it’s my code, it’s my strategy. So any discount that you’d apply for the fact that you’re giving money to this mysterious black box, for me is not an issue. I obviously have a better understanding of the strengths and weaknesses of the products and all that means that I am naturally at a higher allocation.

[00:40:32] Niels

Let me just clarify. When I say 40%, in your case, you’re doing it yourself. It’s one strategy. But of course, if someone were to say you should put 40% in trend following, I wouldn’t suggest you put 40% with one manager for sure.

[00:40:46] Rob

As I said, I probably have 20%. Yeah, I wouldn’t put that with a single manager, definitely. I’d probably have a maximum of 10% in a single manager. So yeah, I didn’t hear that specific conversation, but obviously, I’m very much familiar with the pros and cons of the discussion having had it over the last 10 years but also previous to that when I was with Man AHL.

The way I like to think about stuff is quite theoretical and abstract. Basically, and I’ve touched on it briefly, but there’s a whole bunch of return streams out there. Let’s call them risk premia because risk premia means that you don’t have to wear an alpha. You can just earn the risk. If you’re willing to earn the risk, and you’re properly compensated for taking the risk, then you don’t even need to be smart.

You don’t even need to do anything fancy. You just need to avoid something stupid and collect your risk premia. Now, if you’re investing in say just US stocks, you’re basically earning mostly one risk premia, which is US stock. Actually, very specifically, given the weighting of the S&P 500 right now, you’re effectively earning a US growth premium because there’s a big overweight to tech stocks in there, they’re growth stocks.

So you haven’t got much exposure to another premia like value. And of course, you haven’t got exposure to any other premia across the world. If you’re investing in MSCI World, which I think is like 70% US now or something. That’s just crazy. A so-called diversified global index that’s, as you say, two-thirds in one country. Okay, it’s the US. Actually, this relates to another discussion we might have time to have.

That’s basically saying, I have an enormous amount of faith in the US, I think the US is going to do much, much better than the rest of the world just because it has done historically. Yeah, okay, that’s potentially the trend following argument. But that’s saying that I don’t care about any of these other risk premia, the only one I care about is US tech. Yes, that’s been an amazing bet over the last 10 years or roughly, but to say that going forward, you should put nearly all your eggs in that particular basket seems crazy to me.

So that’s why I advocate for an individual investor something like a risk parity portfolio where you say, actually, I also want to have risk premium from other countries. Those other countries like the UK have got much more of a value bias for example. So, if you put more money in UK stocks, you will get more of a value risk premia from there. You’re getting different risk premia from different countries, which is good.

Of course, you can then invest in bonds, which is giving you a different kind of risk premia again, which is not always uncorrelated, but will be less than one correlate, and so it’s good to have. So you want to have as many of these diversified risk premia as possible. But you’re missing out. You’re missing out on a huge variety of things you could be in. So just ignoring the fact that we’re trend following, you’ve got no exposure to FX, you’ve got no exposure to commodities. You’ve got no exposure to metals and no exposure to crypto.

So there’s a whole bunch of other asset classes which have different risk premia in them that you’re just ignoring. You’re walking through the risk premia shop, you’re pulling down the US cereal box, and you’re putting a whole trolley full of those and walking out of the shop and ignoring all the other lovely things on the shelves. And then yeah, you’re ignoring the trend following risk premia, which I believe is a risk premia. You’re ignoring the carry risk premia, you’re ignoring the skew risk premia, you’re ignoring the volatility selling risk premia.

Some of these risk premia, they’re like the fatty (I’m really loving this analogy. I’ve just come up with it), some of these risk premia are like the really fatty chocolates in one of the aisles. You don’t have too much of them. That’s like being short vol, for example. You don’t have too much of that risk premia because too much that will, in my analogy, make you fat and in the real world could blow up in your face and lose you a lot of money very quickly. But having a little bit of that in your basket, there’s nothing wrong with that.

So if you were to actually do a proper optimization exercise, you’d probably say, well, really, we only we only want probably maybe 10% of our portfolio to be US equities. And even then, we’d like it to be more diversified than the S&P 500. We’d like to have a much broader range than just tech stocks. Something like an equally weighted S&P 500 would be better. And then the rest of your basket should be filled with all these other things.

That would probably mean that yeah, maybe 20% would be in the trend following risk premia, and that in itself would be highly diversified because it’s across all of these other asset classes rather than just bonds and equities. So that’s the way I think about it. I think if you’re just starting today, the exercise of building a portfolio from scratch without these preconceived ideas, it should always start with 60/40.

Then you’d end up with a much higher allocation to things that aren’t just US equities. Someone who’s doing 60/40 is going to be 40% in US equities, which means they’re going to be like 25%, in the Magnificent Seven or something. I don’t know the exact number, but they’re going to have a ridiculous allocation to US tech. That’s a very undiversified portfolio. If you really, really strongly have very strong reasons to believe that US tech is going to continue to outperform, then fine. But don’t stumble into that position by accident, which is what people are doing.

[00:46:22] Niels

Because I know we have a hard stop today in about 20 minutes time or so, but the next headline you sent me, the next thoughtful headline you gave me as a topic was a bedtime story about vol scaling with a nice cup of hot cocoa. I kind of know where we’re going on this, but you never know with you, Rob. You have your surprises.

[00:46:45] Rob

It’s been a while since we’ve had a vol scaling debate on the podcast.

[00:46:49] Niels

You mean last week?

[00:46:52] Rob

Well, okay. When I say we, I mean you and I. But what I thought I’d do, and I normally [inaudible] vol scaling and I start banging on about kurtosis and skew and trade distribution and outliers, and it gets quite technical and abstract. So what I thought I’d do is just kind of tell you a little story that would illustrate, and it actually relates back to what I’ve just been saying about accidental concentration of portfolio risk.

So let’s imagine that you’re a CTA, and about a year ago, you decided to allocate some money into cocoa. Maybe you already had a cocoa allocation. Who knows? Because you’re not the kind of guy that’s going to overfit. So let’s just quickly pull up the chart and say, where were cocoa future prices a year ago? Let me see. So they were at about say $2,000. Just for round numbers, let’s say $2,000, okay?

Let’s suppose that you’re reasonably diversified, say you’ve got 100 markets in your portfolio. So you’d have a 1% allocation to cocoa. Broadly speaking, initially, cocoa would be about 1% of your portfolio. But let’s say that you also are the kind of person that pyramids your exposure a bit. So as trends increase, you add to your exposure. So you start off with in 1% cocoa. But ignoring any other effects, your allocation to cocoa is going to go up from 1% to 2%. Let me say to 4%. Let’s say you pyramid four times, which is not that unusual.

I’m not having a go at pyramiding because I do something that looks like pyramiding, which is that as trends increase in strength, I allocate more to that particular instrument. But, importantly, I stop when my allocation is twice my average. So I never go above twice that. There are reasons for that that I’ll explain in a bit. So my risk to cocoa in my system would never be more than 2%.

However, this person in this imaginary story is of a more traditional shall we say background than myself. So they’ve bought their coca position and they’ve got a stop loss on it, and now they’re just not going to touch it. They’re just going to leave that thing in there. So they’ve bought this cocoa, it’s 4% of their risk, and the price is $2,000 And they wake up today and the price is more like $12,000, to use round numbers. It’s not quite there but it’s quite $12,000.

The position has gone up six times, and they just hung on to it, because that’s what they do. They hang on to those things until a stop loss is hit, because vol scaling is the work of the devil. I’m being very provocative and naughty. This is all in good humor but I’m hoping to explain a little bit more about my intuition about these things. So apologies. I’m not having a go at anybody.

So now instead of being 4% of their risk, this thing is 24% of their risk; 24%, nearly a quarter. We’ve been talking about accidental concentration. Well, that’s what’s happened. They’ve ended up with a position that’s 24% of their risk. Now, the good thing is of course that cocoa has been going up like crazy. So that’s meant they had an absolutely amazing few months, returns that I can only dream of, double-digit returns. So that’s the good thing.

The bad thing is, to repeat, 24%, a quarter of their portfolio risk, is in a single market. That is the dark side of no vol scaling, if you like. That’s the dark side of holding onto positions, is the fact that the risk will explode and you’ll just let it do that. Whereas I, as I said, would never let my risk in cocoa get to more than more than 2%. The reason why I do that specifically is because if you look at the ex-post (I said I wouldn’t make this a technical discussion, but I’m going to use the phrase ex post now. Apologies.), if you look at the ex-post performance of a market versus its trend signal, it kind of has a sigmoid shape.

In other words, in the middle, it’s a nice positive slope. In other words, the stronger the trend and longer it’s been going for, the more money you put in. So that’s another way of saying that pyramiding makes sense up to a point, another way of saying that, yes, you should do what I do and increase your position as the forecast gets stronger.

But then beyond that, it starts to tail off and then even revert to zero. What that is basically saying is that eventually all trends end and get exhausted. The pattern of that slope varies depending on your trading speed. If you’re trading very fast, it actually happens quite quickly. That’s where we see, particularly in equities, the so-called dead cat bounce. You can kind of see that in the graph.

But for the very slow speeds, it’s still there. So trends rarely last more than a year or so. So from a theoretical perspective this is saying, do I really believe, put it another way, I said earlier, do you really believe in US tech so much that you would put two thirds of your money into that single risk factor? Would I really believe in my cocoa so much that will put a quarter of my risk into it were I switching on my system today, basically? That’s the way I like to think about it.

The answer is no. Absolutely not. Of course, cocoa is an unusual market because it has gone up so much, so quickly. It’s such an incredible bonanza. Normally, these things don’t happen. But actually, that’s kind of what you’re hunting for. You’re looking for these outliers and these edge cases and these big positive returns. But the point is that they do come with risk that, to me, is very high. Implicitly, what you’re saying is that you have a huge amount of belief in the position that I believe is unfounded.

[00:53:23] Niels

Okay, a couple of things. Thanks for that. A couple of things spring to mind when I hear that. One is, of course, people might argue that, well, what’s the problem? If you did what you just explained, you would have made 100%, 200% in cocoa. Of course, we know some people have made more than 100% of their AUM in cocoa alone. So there’s going to be a stop, it’s going to have moved up as well.

So maybe they’re only going to have a drawdown of 50%. So they still meet 50%. No problem, you could say. By the way, from what I can tell, some of the funds who have actually kind of done what you explained and made a lot of money, a crazy amount of money in cocoa, actually on other ways of looking at risk, the risk is even way higher than 24%. It depends on how you calculate risk.

But here are some of the problems that occur. For example, if you’re a manager and you take on new clients, what about the client who buys in on the 1st of May after you’ve made all this money but you still have the potential of giving back 50%-60% of the fund’s value in cocoa, which still makes the trade a good trade for the ones who have been in the fund for a year, but it’s a pretty bad start for anyone who jumps into that at that point. So that’s one thing you might want to consider.

But then there’s another thing specifically about cocoa that I’d love to hear your thoughts about because I noticed that we talk about what’s the risk in cocoa? What causes volatility? It went up 9% yesterday, I think it was, and went down 9% the day before, so it’s volatile. Okay, we can deal with that. But what about things like open interest? I noticed that the peak and open interest was around April 2023, so about a year ago, with 40,000 contracts on ice. Today, it’s around 16,500 in open interest.

So this is not a risk that most investors will see or notice, but it’s certainly something that is a risk from a liquidity or potentially a risk from a liquidity point of view. The other thing I just want to throw in is that we may get reports out from the press or whatever saying trend followers are pushing up the price of cocoa. I want to make two points on that.

Firstly, there was a Bloomberg article on the 5th of April talking about how a very famous oil trader, Pierre Andurand, had jumped into cocoa, which obviously is not an oil, as far as I know. They called in the article that he had quite a bad year last year, but now he’s found this new area to make money. So he, according to the article again, I’m just quoting, I’m not having an opinion about it. But he’s not buying cocoa at the beginning of March, which has obviously been a great trade because it’s up probably almost 100% since the beginning of March. So good for him and for his investors.

But this has nothing to do with trend following, probably nothing to do with systematic trading. So I think that’s important for people to be aware of that what’s actually happened this year, and you alluded to it because you talked about volatility and non-volatility adjusting positions. For most people who do volatility adjusting in our industry, which is probably where most of the assets are held today, they would have been selling cocoa massively since the beginning of this year, probably reduced their positions by, I don’t know, 60%, 70%, 80%, 90% in terms of notional value.

So in a sense, trend followers had done the complete opposite of pushing prices up for cocoa. Specifically, they would have kept the rise down as much as they could. I’m rambling a little bit here, but I just wanted to hear your thoughts on that before we wrap up our hot topic, so to speak.

[00:57:46] Rob

I’ll make it quick. I’ll just address one point because I think it really goes to the heart of the way that people think differently. So it’s down to path dependence versus non-path dependence. And it’s what you say about the investor coming in as a new investor and not having seen the previous rise but then being exposed to what’s going to happen in the future.

To me, that’s the way that the manager should be thinking as well. The manager should wake up every morning and look at their positions, and not say, “Wow, look at this position, it’s made me loads of money. Fine, it can drop 50%. I don’t care. I’m still going to walk away with a huge bag of cash.” They shouldn’t be doing that. They should be saying, do these positions make sense in the current market? Do these positions make sense given what my risk allocation is and my forward-looking expectations for price increases?

Now, I may still think that cocoa is going to go up. I might still have, I probably do actually. But I’d be very surprised if I didn’t have a maximum trend following forecast on cocoa because it’s been going up and it’s continuing to go up. So I still think that cocoa is going to go up as much as any other market. But there are lots of other markets that I might have a maximum trend following forecast in, or a strong trend following forecasting.

There is no reason, then, to justify having a weight to cocoa of 24% in my portfolio. There’s just no way waking up on day one and looking at my positions now, and looking at the market trend, there’s no way you can justify that kind of weight at all. That’s because I don’t think you should think about your portfolio in a path-dependent way. That happens to be fair also for investors coming in from outside late in the day, but also, theoretically, it’s the right thing to do.

I think that comes down to the fundamental difference between the way that other people might think about the markets and the way I think about the markets. But anyway, that seems like a good point to end this discussion. So, yeah.

[00:59:35] Niels

Absolutely. I know we have very little time. I don’t know. Do you want to talk about the last point you raised? I don’t even know where you want to go, and I certainly don’t want to go into anything litigious.

[00:59:45] Rob

Yeah, let’s save that for another podcast by which point there might be some more information about that. So there you go, people. There’s a teaser for the next time I’m on.

[00:59:53] Niels

That is a cliffhanger. All right. Fair enough. Rob, much appreciated. Thanks for much for preparing these topics, answering the questions as usual. People find it incredibly insightful, as do I. If you do, please go to toptradersunplugged.com/review and leave a rating and review for the podcast so that we can continue to grow the audience.

Next week, I’m joined by Cem. He’s back for another fun and insightful conversation no doubt, whether it be global macro or indeed some volatility. So if you have your questions, as always, you can email them to me info@toptradersunplugged.com and we’ll do our best to get them answered.

Before I leave, I did notice myself before I get too many messages saying, oh, you said that slogan right. It’s not buy in May and go away. It’s sell in May and go away. And I’m completely aware of that. I didn’t want to interrupt Rob’s flow. But maybe it’s the heat here in Singapore that made me switch that little slogan. Anyway, we’ve cleared that up now.

From Rob and me, Thanks so much for listening. We look forward to being back with you next week. In the meantime, take care of yourself and take care of each other.

[01:01:01] Ending

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

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.