Is Trend Following Becoming Too Complicated? ft. Mark Rzepczynski

[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 Mark Rzepczynski and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global markets through the lens of a rules-based investor. Mark, wonderful to be back with you this week. How are you doing?

[00:00:37] Mark

Not too bad. Always good to talk with you.

[00:00:40] Niels

Yeah, likewise.

Now, we’ve got a great lineup of topics that you brought along, and we will be tackling them today. But as you know, a little tradition before we get started, I’m always curious to kind of hear what’s on your radar since the last time we spoke a few weeks ago.

[00:00:58] Mark

Well, I’m not going to steal the thunder from all of our topics, but the one thing that actually, you know, caught my attention was something called the false consensus effect. And this is another one of these behavioral biases. And this is a behavioral bias.

This is that you sort of say like, well, everyone that I talk to is thinking the same. Then when I hear a different opinion, it’s that I can’t believe that someone would actually have a different opinion. That’s especially with the polarization in politics, where if your friend group is all a certain political view, then when you say that you meet someone who’s outside that view, you sort of say, “I can’t believe that.
How could that happen?”

Now, we use that as the political example, but that also happens with our thinking about economic events. If you have all the same people reading the same research reports, talking with the other people, you know, all been educated as MBAs for the most part, you’re all reading the same editorials and newspapers, you know, you start to find out that everyone has a consensus and that’s what often drives opinion.

And then what happens is that the market will come up with some new information, or there’s a surprise, and we have a big market reaction because we’ve set up this false consensus that we believe that there’s only one way to think about an issue. And so, I think that that’s really sort of the focus that we see with whether it’s this growth narrative, inflation narrative politics, is that we put ourselves in a bubble. We all start thinking the same. Then, all of a sudden, once there’s new information, we really are surprised, and this is what caused market dislocations.

[00:02:49] Niels

Absolutely. I think you can say that it’s certainly even more relevant today than before because of social media, because now we’re being fed essentially individual news streams depending on who we follow. So, our own view of the world is being reinforced all the time. So, it’s very interesting.

For my part, I wouldn’t say it’s been on my radar very long, but I couldn’t help just mentioning this story. I thought it was quite interesting.

I think it was reported yesterday and this is kind of my quick summary of it. You kind of always hear that you never learn anything in college anymore, but here’s two people who did learn something. Two MIT graduates, two brothers in fact, they’ve been indicted now by the BOJ for allegedly orchestrating a rapid cryptocurrency heist that netted them $25 million in just 12 seconds. The duo, skilled in math and computer science, reportedly exploited a vulnerability in Ethereum’s transaction timing to redirect funds to their accounts before laundering it through shell companies.

And now they’re charged with conspiracy to commit fraud and money laundering and they can face up to 20 years in prison. Now, the unprecedented crime reminds us a little bit of these movies we were watching many years ago. I think they were called like Ocean 13 or 11, whatever it was with George Clooney. But of course, it also comes at a time where the SEC is now considering whether they should approve Ethereum in the ETF space. So of course, I’m sure it has raised some concerns about the security of the blockchain, but I’m thinking, and I have no clue about blockchain, but I thought they wanted to be free of all of this big brother watching you. So, if someone finds a way to exploit that thing, okay, if they’re doing money laundering, that’s a different thing.

I’m sure that you, obviously, can’t do that. But exploiting blockchain, I mean, I thought they wanted just a free world and anyone could do anything, but apparently not.

[00:05:02] Mark

Well, when you started with the idea of a cryptocurrency heist, I thought that was getting an oxymoron, but that’s a separate conversation. But two things. One, the plumbing matters in how we trade markets.

Because the futures markets are fairly efficient in how they work and the plumbing is very transparent, we almost take it for granted. And the second of all is that if you want to have good plumbing, and you want to try to have liquid markets, there is a minimum amount of regulation that’s necessary to ensure that you can be able to have the liquidity that you want, because everybody knows the rules of the game and the rules of the game are very transparent. This probably suggests a broader issue about cryptocurrency is that I’ve talked to a number of people in this area and they actually spend a lot of time thinking about how to create arbitrage opportunities.

The arbitrage opportunities are because there’s, you know, we’ll call it kinks in the system: how you clear crypto, how you sort of move money or things from one wallet to another is not always transparent. And there are ways that you can be able to exploit the opaqueness of how the money moves. This is what they are trying to take advantage of. But there’s a lot of time and effort that’s spent in crypto about these issues. We’ll call it structural issues, plumbing issues that we probably don’t spend this much time on in futures markets which are very transparent in how the system works.

[00:06:56] Niels

Yeah. Well, I mean, true. Anyways, we’ll see what happens.

Now, before we dive into trend following, I thought we would sort of ease our way into it with a little report that came out from the SocGen Capital Consulting Team. They do surveys on a regular basis of institutional investors, and they have these intelligence reports that they publish. In this particular report, that just came out this week, I think they had sentiment data from 472 unique survey responses over the past six months and reflecting preferences of 315 investment firms around the globe.

And we’re not going to talk about the whole report. I’m sure people can find a way to get it. But we did want to talk a little bit about some of the shifts, perhaps, let’s call it that, that we are seeing in terms of investor interest when it comes to strategy.

So, do you want to talk a little bit about what you took away from the report?

[00:08:00] Mark

Well, there are two things that really jump out at you. One is that they reported what are the largest changes in strategy interest versus the fall of 2023. And the number one shift in interest, to the positive, was called fixed income relative value.

And you say, like, well, why are we having this big shift in fixed income to relative value right now? When you think about it, we’ve had very high interest rate volatility if we look at the MOVE index, which would be the bond equivalent to the VIX index, it was extraordinarily high in the fall, and then it has declined more recently, but it’s still at relatively high levels.

So, there’s more dispersion in fixed income than we’ve seen in previous years. Second of all, we’re probably seeing that rates are overall higher. So, I think that there’s more opportunity because there’s generally more volatility when rates are higher.

We’ll sort of say that this is more coming back to normal as we’re in a higher interest rate environment. We’re not going to be at a zero interest rate environment going forward. So that investors are saying that I’m going to try to exploit what’s happening in the fixed income relative value.

Now, what’s interesting is that where is that coming from? It’s coming from currency which they say this has a decline in value, and CTA non-trend. I’m surprised at the flow out of currency or lack of interest in currency, only because we’re seeing that there’s probably greater differentiation across central bank behavior.

I’d expect that currency trading would actually be increasing. Second is that there’s also this decline in CTA non-trend which, I thought that given the more dispersion in markets and I think the overall dispersion across asset classes, there would be more interest in that area. So, I was actually surprised that actually declined.

[00:10:14] Niels

I’m actually not surprised, frankly, that it’s CTA non-trend because it means that there should be interest in trend following. If you look at the last five years, trend followers have put up positive numbers five years in a row. Obviously, it’s off to a great start this year.

And when you say CTA non-trend, I mean, that could be, for example, short term managers and they haven’t really done that well, most of them, in the last period of time. So, I’m not so surprised about that. But I agree with you.

I’m a little bit surprised about the currency. But, you know, even though there is divergence in currency or in central bank policies, which we as trend followers are picking up in the sense that we do see more P&L being generated in the currency sector in the last six, 12 months than it has been for quite a while, it’s a little bit like cocoa.

I mean, it didn’t do anything for a long time. And then suddenly it pops to life. So, it depends on whether currency managers have actually been able to make money from it before they can attract any interest.

But I think trend followers have certainly, I agree with you, been able to extract some P&L from currencies.

[00:11:26] Mark

Now, the currency issue is still also interesting only because generally currencies are less volatile than other asset classes like fixed income or equities. And so, the game, especially on the professional level, is that you’re going to use more leverage in currencies. Currencies generally have not been as interesting in terms of its, we’ll call it, breadth of moves even though we’ve had some strong moves in the dollar in the last year and a half.

But generally, on an absolute basis, volatility in currencies are always relatively low versus equities, commodities, and to some extent, more recently, bonds. So, in some sense, there’s less interest in currencies for a simple reason is that it doesn’t move as much as some of the others.

[00:12:17] Niels

Yeah. Then we have another chart in the report, probably the last one we’re going to be talking about: Exhibit six, strategy interest periodic table.

I always love these periodic tables. It’s like when you see, for example, sector attributions shown as a periodic table, it actually makes it very interesting to see how little predictability you have. Although I will say here, there’s a little bit more consistency in the various strategies.

Nevertheless, I’ll let you talk through what you took away from this chart.

[00:12:52] Mark

Well, the amazing part is that they provided information from the summer of 2021 through the spring of 2024. And you said, well, what is the area of most strategic interest across investors? And it’s discretionary global macro.

And I’m always scratching my head. I was like, well, why is that the case? And it’s almost as though that this is the holy grail of what investors want, but they can’t find.

So, they’re looking for the manager who could be able to sort of say, tell good narratives, move across all asset classes, find the best opportunity and consistently, and make a lot of money. So, the interest is always high, but I sort of half jokes that doesn’t mean that you’re ever going to find it. Sort of like I’m shopping for the perfect gift, but I’m never going to be able to find it because my standards are so high.

[00:13:52] Niels

Are you surprised other than that it’s been the best or the highest, at the highest score in terms of interest, around 50% throughout the whole period? I mean, I think it’s because they’re the best storytellers and they have a lot of personality, some of these discretionary global macro managers, but what else surprises you about the table?

[00:14:14] Mark

Well, just on finishing that thought is that you look at the gap between they report discretionary global macro versus quantitative global macro. And we’ll sort of say, whatever the number is for discretionary, cut it by about 40% and that’ll have the response that you’re going to sort of see for a quantitative global macro. So, these are both areas in which there’s always a strong interest, but it’s not clear that they could be able to find that right manager.

Now that being said, because we always talk about trend following, where does trend following fit in? It’s almost as though that if there’s the Goldilocks of macro strategies, they’ll say that we have discretionary on one side, on the other side we have quantitative global macro. In between is the CTA trend. So, in some sense you’d say, well, I’m looking for this, the Holy Grail of this discretionary global macro guy.

I may not be able to find it. And quantitative global macro, it’s hard to really understand what they do at times. So in between I’ll say, well, let’s get some CTA trend because I’m going to get the convexity I want, I get the global exposure. And I don’t want to say it in a negative sense, It’s a poor man’s global macro, discretionary global macro, but it serves as that substitute in that realm.

[00:15:51] Niels

Yeah. So, CTA trend has actually been quite consistent in this periodic table. It’s sort of ranked between number, I don’t know, three and six in terms of interest among, I don’t know, 12-ish, 15-ish strategies competing quite closely with things like multi-strategy.

Although in the real world, I certainly think that there’s a lot more interest in multi-strat than there is in CTA trend, but that’s just looking at the size of these multi-strat firms, but I could be wrong. Another thing that I think it’s not surprising is that vol trading has just dropped off completely from sort of mid table down to the lower part of the table in the last three surveys they have.

[00:16:40] Mark

Well, we just haven’t had a lot of volatility in some of these markets. So, we’ve had some spikes, but not sustained volatility. Now, the interesting part is that we’ve been highlighting what people like, what people don’t seem to like, or there doesn’t seem to be strong interest is in, we’ll call it, risk premium strategies.

So, when you think about the education of people within finance and where all the buzz and research is, we’ll probably say that you can’t sort of get out of an MBA school and you can’t be a good finance professional without thinking in the framework of what are the risk premia in the marketplace. You’re going to have to learn how to say Fama French three-factor model if you want to get in a degree in finance in an MBA school. But there’s really isn’t that much interest in actually finding risk premia managers who focus on trying to exploit these premia or those types of strategies, which I find very interesting.

[00:17:54] Niels

We’re going to talk about, in a second, some new records being set in the equity markets, but just to round this all off, I mean, actually, besides risk premia having very, very little interest throughout all of the surveys, the one that is very close to that is long equity, despite the fact that equity has been a pretty good investment the last period of time. So yeah, maybe these surveys don’t always get it right. And clearly, with CTA trend not being at the top of the table, they certainly don’t get it right. But there we are.

Mark, trend following update. It’s been a week where the 128-year-old Dow Jones industrial average has crossed 40,000 points for the first time. And that happened yesterday, 873 trading days since the index first closed above 30,000. And that was in November 2020. And it’s up about 40% from its post-pandemic low in September 2022.

But despite of all of this excitement, it’s actually been a fairly quiet week in the trend following world. We have, of course, with high equity prices, we’ve seen some recovery in performance by trend followers led by the stock markets, but also metals and maybe a bit of energy. Although May, as a whole, is still underwater for CTAs when we look at the indices.

During this week, in particular, there has been some fairly large moves in the markets like natural gas, orange juice (for those who trade that), platinum, silver, wheat, copper. Cocoa and some other markets like coffee, sugar have seen some declines, but also of decent size. So interesting, although it hasn’t materialized too much in terms of positive performance, but there are certainly some things going on.

And I’m saying all of this because I also want to mention that Rich and I will try to do a weekly update on the website every week, a little blog post in terms of kind of the weekend trend following. And so, people can follow along on that.

My own trend barometer finished yesterday, which would be Thursday evening at 48. And the numbers for the industry that I have is, of course, as of Wednesday night, because we’re recording a bit early in the day, certainly your time, Marc, and therefore we haven’t got the final numbers for Thursday, but…

BTOP 50 for May, down 2.1%, up 9.2% for the year as a whole. SocGen CTA index down 2.23% for the month, up 9.38% for the year. And the SocGen trend index is down 2.75% in May, up 11.17% for the year. And the Short-Term Traders index down just 19 basis points, up 3.39% so far this year. I suspect yesterday was actually a good day for CTAs.

Anyways, in the traditional world, MSCI world is up almost 5% in May, up 9.45% in 2024. The World Government Bond Index also, on the back of the inflation numbers, I guess, up 1.28% so far in May. And the S&P 500 index up a whopping 5.3% in May, up 11.66% so far this year. Before we jump into your topics, any thoughts on performance, trend following?

[00:21:28] Mark

No, the one thing that I think is always is jumping out at me, and I’ve really been following more closely is what’s happening to the Chinese stock market. It has actually done really well over the more recent period. I think that that was an area that was really a complaint, that they sort of felt as though that growth is going to be much slower in China. The stock market was selling off a tremendous amount of restrictions. And probably, if you look at the last month and a half, it’s done very well and probably the best of any market.

Now, the one thing that you could sort of see how people’s perceptions change is that there has been a greater and greater focus in on the Indian market. There, because we look at what India is going to be representing in emerging market indices, and you look at the increase in the Indian stock market relative to the Chinese market. Surprisingly, is that the wealth creation in the Indian stock market is much greater than what we’ve seen in the Chinese market over the very long run.

So even though growth in China has been very strong, it’s not been translated into wealth creation as measured by stock valuations, which I think is a telling testimony for the differences in government and differences in behavior across different countries in the world.

[00:23:01] Niels

Yeah, I mean, I will say, and I don’t have any evidence for this, but just from memory of what I’ve read in the last month or so, the rise in the Chinese stock market, isn’t it because the authorities have been in kind of helping out a little bit? That’s kind of how I recall the sudden good fortune of the stock market over there, including the Hang Seng, by the way.

[00:23:30] Mark

We’ll sort of say that there’s been some change in perception, but certainly the government and some of the entities which are trolled by the government have been strong buyers. Let’s just say that they’ve seen the light and the opportunity that’s available to them.

[00:23:51] Niels

I was looking at this, or for this, while we were talking, because I seem to have read this morning, actually, that there is a Chinese company that’s about to have the biggest IPO ever on the London Stock Exchange. I just don’t remember what company it was.

I still find it fascinating, not that this is a political podcast, I still find it fascinating that we’re kind of not really embracing the Chinese and the Chinese are not really embracing the West, yet the Western investors seem to be very happy supporting some of these activities by buying up equity when they come out with their IPOs and all of that stuff. And I say that in light of the fact that next month I’m recording with Cem, a conversation with General Robert Spalding, and that is a conversation about China and the book that he wrote about the situation there.

But I’ve also come across other podcasts recently and stuff where it’s pretty, I have to be careful with the words I’m choosing, but it doesn’t seem like it’s completely random of what’s going on in the world right now and that it might well be instigated and benefiting the Chinese.

[00:25:08] Mark

Well, we’re going to be talking about a number of different topics, but probably the one that, on a very long-term basis, is of very relevance here is, we’ll call it, this change in the liberal order. I know that The Economist had their cover about the end of liberalism, and we usually know that if The Economist or Businessweek puts it on the cover, that means that there’s going to be a reversal, that they’re always going to report late.

But, at the very least, what has been the liberal order that we’ve seen post-World War II, and especially in the 1990s and 2000s? We have the rule of law, the rule of international organizations, we’ll call it multilateral treaties to try to reduce trade barriers. The perfect example would be the tremendous success of WTO. And then we’ll probably say, in over the last few years, what we’ve seen is a tremendous destruction in this liberal order, which is based on free trade and free flow of capital.

So, we’ve seen sanctions against different countries. Obviously, there are political issues, but we’re using sanctions or restrictions on one country versus another in terms of trade and capital. We’ve seen tariffs.

They thought that this was going to be unique to President Donald Trump, and yet we’ll probably say the Biden administration has kept many of the tariffs and actually increased them. We’re probably seeing Europe in between sort of China and the US in terms of trade wars and industrial policies. We’ve got capital flow restrictions.

And when you look at IPOs, there should be a lot more IPOs by foreign companies on the New York Stock Exchange. It’s not occurring for the simple reason of regulation that either might be from the home country or regulation that might be imposed by the exchange itself in terms of accounting standards and reporting. So, what we’re seeing is that a movement from multilateralism to bilateralism.

Now, say like, well, how does this impact trend following?

[00:27:45] Niels

Let’s go there.

[00:27:46] Mark

But let’s go there. But what that does is that it’s going to cause more dispersion across prices. There’s going to be more dislocation. There’s going to be more uncertainty, which could potentially lead to trends. There’s going to be lower correlation across, let’s say, equity indices and bond indices. There’s going to be potential for more tail risk, because if, let’s say, that sanctions or restrictions or tariffs, which mean is that some countries may not be able to get as much capital flow that they want, which might impede global production.

So, the end of it is that you want to probably hold strategies that are going to have more convexity. We just talked about that you want to have more global macro. Well, you want to have more global macro if you’re going to expect that there are going to be more shocks that could have differential impact around the world.

How this actually plays out is not really clear, but if you could sort of say that whether it’s Japan, Taiwan, Korea, China, the United States, Europe stock indices, the very least is that if they’re all integrated, then you’d sort of say they should all move together and have high correlation. In a, we’ll sort of say, a new world order, we’ll call it the age of disorder, those correlations are going to go down, which means is that there’s more likelihood that you’re going to have opportunities to trade these different countries separately. They’re not all going to be moved by the same factor. And that’s a good thing if you’re sort of saying that I want to try to get more opportunities across the world.

[00:29:43] Niels

I don’t know, personally, in a sense if I… I mean within Europe, yeah, there’s been some difference in correlation between equity markets. But a lot of it obviously has to do with the kind of companies that you have. For example, the FTSE has always been very energy-heavy.

And then you have other countries that are tech-heavy and so on and so forth. So, there’s always going to be that part. I agree with your thoughts on diversification among equities once we kind of broaden it out a little bit in the world because clearly countries will be hit differently.

But I think the other thing that these kind of trends… We use the word uncertainty a lot. But the other thing that I think it leads to is instable inflation. And I think that’s actually quite interesting also for trend followers because if you go back and you just look at inflationary regimes, it seems to me, without having done too much analysis, but it seems to me that we can have low inflation, like we had say from 80s up until 1999. But it wasn’t stable. And actually, that was a pretty good environment for trend following.

But then we had the low and stable inflation in the 2000s, 2010s. That was much more challenging for us. So, if we are also moving towards an environment where inflation may not come down as low as people hope for. and it won’t be as consistent and stable as people (certainly the central banks would love), that’s also, in itself, quite an interesting environment, I think, and will lead to opportunities. And then I understand why people would say, well, we definitely need a global macro manager and certainly a discretionary one who can foresee all of these things that’s going to happen. But this is where I struggle because I think that’s the hard part.

If so many things, so many moving parts are happening at the same time, you have to be really, really good, as a discretionary manager, to get those moves right. Of course, there will be a few who can do it and good for them. But I much prefer, as I’m sure people would have guessed by now, kind of a rules-based systematic approach to a world that is so difficult to foresee.

[00:32:13] Mark

Well, this is the difference between the ideal manager versus the reality manager. And the ideal manager, in this discretionary global macro world, he’s the visionary. And you could think of a man with a set of binoculars and he’s able to look over the horizon. He could see things that others can’t. Therefore, I’m going to give him my money because he has this ability to be prescient about what might happen next. In reality, that is a world. It’s not a world that I inhabit or most people inhabit.

Most people, they might be prescient about one or two things, but they’re not consistent across the board and through time. We’ll sort of say that most of the studies that look at financial skill would say that the managers themselves believe they have more skill than what we actually do see in reality.

So, if this ideal world we can’t achieve, well, what’s the, you know, economists would say, well, what’s the theory of second best? Well, what’s the next best we could do? Well, the next best we could do is to sort of say, well, let’s follow the rules and then let’s follow the trends of prices.

Then maybe those prices will reveal something about it, about what’s going on in the world. If the world becomes more disordered, then there probably would sort of say that these price trends might last longer than what we expect. And that would be the opportunity.

Let’s think about inflation. This is what you talk about. I think it’s the dispersion in inflation that we’re really worried about. So, it’s like, well, if we put on tariffs on EV cars that come from China, if we put on tariffs on solar panels, well, then the cost of solar panels or EV cars are going to be more expensive in the United States because we can’t get the cheap imports.

Whether that’s good or bad is a separate issue from a policy perspective, whether they’re dumping or not, I’m not going to be able to answer. But at the very least is that the view is that we want to have free trade because ultimately the consumer will benefit because if there is a place where prices are high relative to other parts of the world, we’ll say goods and services will flow to the high cost countries, and then they would drive those prices down so that we’ll have less dispersion in inflation. If we put up barriers, that’s not going to be able to happen.

So, then consequently, we’re going to have trends or inflation is going to last longer in some countries because we don’t have a, we’ll call it, global way to equilibrate the system.

[00:35:10] Niels

You know, talking about this sort of global macro versus trend following, as I said before, I do understand that some people will have lots of charisma and they’ll tell great stories. I can’t remember who once said this or it’s a story that I’ve heard. But if you think about it, I mean, if you have two managers, you have a trend follow and a global macro manager and they come in and they have to do a presentation.

And let’s just say for argument’s sake that the global macro manager will say, well, you know, I think the S&P is going to go from 5,000 to 6,000. Okay, fair enough. He may be right, but if he’s right, then before it gets to 6,000, it has to go to, you know, 5,100, 5,200, etc., etc.

And that’s exactly what trend following models are going to pick up, just purely from analyzing the price, and going to get along. So, that’s what I like about kind of the difference between the two that, yeah, they can be right. But if they’re right, then most likely we’re going to be right as well.

If they’re wrong, then hopefully we’ll have less exposure on because there weren’t really any trends to be picked up in the first place. And how many people have actually forecasted last year that equities were going to make new all-time highs and so on and so forth in the environment where the Fed has high interest rates and all that? Not very many as far as I recall.

[00:36:32] Mark

No, the fallacy of consensus is the consensus was that this is going to be a bad year for stocks. And I will sort of say as someone who has given those presentations about trend following and then also sort of given presentations that I’m looking at trend following pluses, it’s tough giving a trend following presentation to an institutional client. Because, at some level, a discretionary macro guy comes in and he’ll say, well, I can get into the minutia about this policy or this. I can talk about how inflation indices are constructed. I could talk about flows. There’s a tremendous amount of storytelling and narrative that you could have.

The narrative is the proof statement that I’m a smart guy. The trend follower comes in and says, well, can you predict or what do you think the stock market is going to be? And, you know, it was it was probably pounded in my head from John Henry is that and as I truly believe, that for the most part, we’re non-predictive.

I can’t tell you what I’m going to do, and what’s my positioning going to be in a given market?

Well, if the trend is up, I’m going to be long. If the trend starts to go down, as I said, I probably am going to be short. I can then construct a narrative after the fact to say, well, here’s why, but it’s not ex ante that I’m coming up with a forecast.

So, in some sense, the institutional manager will always say, like, this is really not that… How smart is Mark, really, if he’s just following trends? I would have picked the smart guy who, you know, can go into the minutia. And so, it really is hard to give that. Now, I’m not complaining because this is the life we lead, so to speak.

But we’ll sort of say that narrative generates emotion, narrative generates visuals, narrative drives marketing, and narrative is the reason that a lot of investment decisions are made. The narrative for trend following is much more difficult than the narrative for a discretionary global macro guy.

[00:38:59] Niels

So, let me interrupt you here because I don’t know much about this but we did actually speak with Yao from AQR last year about it when he was on the sort of the mini series that Alan and I did with all the big CTAs. But it touches a little bit on what we’ve talked about because we’ve talked about macro and, I guess you could say, economic data.

And now we’re seeing, including from AQR, this macro data becoming or economic data becoming actually the input into some trend following models. So, I don’t know if you followed that. Clearly, they’ve been doing it for a while.

They now have a product that is certainly, as far as I recall from the conversation, more or less kind of 50/50 between price-driven signals and economic-driven signals. How do you think about that? Because it kind of reminds me about something that took place maybe 10 years ago where systematic macro, as it was called back then, became very popular.

It’s very hard to compete because they had the best of both worlds. They had the story, but they were also systematic and they were actually doing pretty well for a while. Suddenly, of course, it stopped working and many of them went out of business.

But anyways, back to my question to you, Mark, and that is how do you think about using economic data as a trend follower?

[00:40:30] Mark

I probably would sort of say that I’m closer to the AQR camp than those that are pure price-driven. Coming from an economics background, I like the fact that there are some fundamental drivers for why prices will move. It makes perfect sense.

It’s very rational and it provides extra information. My view has always been that the macro trends will often drive price trends. The two aren’t always correlated.

It doesn’t always mean that the macro trends will precede the price trends. At the very least, it could be a reinforcing because we’ll say that prices are often forward-looking. They’re expectations of the future while the macro trends that you have might be representations of the past, or the present, and not the future.

But I probably sort of say that there is a clear delineation or there’s a clear link between macro trends will drive price trends. Now, the AQR story is that they’re almost separate. I probably sort of view that they’re integrated or if you think of integration.

Now, this is still not really the same as the discretionary narrative guy who’s weaving a story. What we do find is that, for example, is that the shape of the yield curve will tell us something about future bond trends. The shape of the yield curve will tell us something about equity markets.

We’ll sort of say that consumer sentiment or even PMI surveys will tell us something about the markets. What we do find, for example, is that a lot of equity premium is all associated with what happens in macro announcements. So, if you just look at the FOMC, if we look at what’s happening to unemployment numbers and we sort of look at how much of the equity premium is associated with those announcements, it’s a very strong portion.

Some people say maybe close to 100% in the more recent years. So, macro drives prices, and I think we need to look at those. That’s different than weaving a discretionary narrative story, but I think that we need to sort of look at beyond what’s going on in just price and try to sort of say what are the drivers of price.

[00:43:16] Niels

Mike, just some sort of random thoughts when I hear you talk about that. The first reaction is, of course, why do we need it? Because if the economic data will give us direction, it’s going to show up in the price and we can just jump on the price.

So, okay, there might be a little bit of timing issue and so on and so forth. So, that’s one thing. The other thing I was thinking about is something you mentioned there.

I mean, if I, back in March of 2020 (is it really that long ago we had COVID, but I guess it is), the whole world shuts down. Trade stops.

You know, you can’t go out. The economy basically comes to a halt. And then nine months later, equities are up 50%, 60%.

To me, that just does make no sense. And then you mentioned the yield curve. Yeah. I mean, we’ve had Cam Harvey who basically coined the thing about an inverted yield curve will precede a recession. So, a lot of people have been out saying, well, we’re going to have a recession. It hasn’t shown up after I don’t know how many, two years now of an inverted yield curve.

And then, of course, the argument is, oh, yeah, but it’s the wrong yield curve you’re looking at. If you take another yield curve, it wasn’t inverted. So, all I’m just saying is what I like about price is there’s only one.

And so, for me, price is truth in some sense. Everything else is blurred and not nearly as linear, if I can put it that way.

[00:35:10] Mark

I will sort of say that this premise that I’m driving at, that macro trends is associated with price trends and it gives you added information. It’s been a challenging period. Whenever someone uses the word challenging, that means that you’re making mistakes.

So, your antenna should be raised as soon as I said it’s challenging. You look at the inverted yield curve as a perfect example. It’s predicted every prior recession.

This one, it has not predicted. And, in some sense, yes, the story has been this, well, if we wait long enough, that recession will come. It just took a little bit longer than expected.

So, we’ll sort of say that if you were to use the shape of the yield curve as an indicator for your model, you probably would have sort of cut your equity exposure. You wouldn’t have had a full equity exposure on, given that that model would have sort of said, let’s cut it back. Given the economic data that we saw from COVID from March 2020, the first quarter and second quarter of 2020, again, you probably would have reduced your equity exposure, given the economic data that you had.

So, there are some very strong issues or examples where this doesn’t work. In the longer run, it seems to sort of say that there is added value from work that I’ve looked at. And then I think that this is also sort of shown with AQR is that the two, we’ll call it, macro trends versus price trends, the two are not perfectly correlated when you blend the two together as an ensemble, is that you’re going to do better. At the very least, you’re going to have a smoother return, lower risk, and, in some cases, your Sharpe ratio will go up because you’re smoothing your volatility on one side. It may have an impact on your returns, but the diversification benefit is fairly strong.

So, I would probably sort of say that the idea of systematic macro is still in its infancy and still needs a lot of work. And as I could sort of say that I’ve given sort of two examples where it has not proven to be true. So, it’s a work in progress.

[00:47:29] Niels

Fair enough.

[00: 47:31] Mark

That actually sort of goes into, you know, we’ve got a number of different topics. And I was going to sort of use one of my favorite words that you’ve heard before.

VUCA. So, I’ll tell you how I’m going to tie this to the macro trends, price trends. First, VUCA, which stands for volatility, uncertainty, complexity, and ambiguity. It’s an acronym. It’s been used by management people to help in leadership training and trying to deal with risky environments.

And as a finance guy, I sort of said, like, I really love this. I love the framework, but it doesn’t fit the language of finance. So, I find it a very useful framework to describe the kind of risks that we have.

Now, after I describe all these risks, you may come to the conclusion I really want to just be a trend follower. Or you might sort of say that there’s more to this and I’ve got to sort of like dig a little bit deeper. But we’ll sort of say, well, what about volatility?

Well, you know, let’s look at the environment now. Volatility is actually low. So, this is a good environment, risk environment to put things on.

[00:48:44] Niels

So, equity volatility is low.

[00:48:48] Mark

Yeah, equity volatility. Bond volatility is still high, but it’s come down from the extremes.

We’ll say currency volatility is a little bit higher, but, you know, we’ll sort of say in the range. But when we think about volatility in a VUCA risk environment, this is a lower risk environment, surprisingly. So, after all of the talk about a recession and inflation.

So, now, and in some sense, we can handle that because with volatility, we could always diversify. Now, I measure volatility or when I think of volatility in a VUCA framework, it’s what we call as countable risk. Okay.

If I can count it, I can come up with a standard deviation. If I could come up with a standard deviation, I could sort of get the volatility and I can understand my risk. Okay.

So, it’s countable risk or countable. Uncertainty is what we’ll say is non-countable. So, it’s events that I don’t have a large enough sample for.

So, therefore, I can’t really sort of come up with an objective probability or an objective distribution. So, uncertainty would mean, I got to say, that it’s subjective because I can’t count the event. And so, we’ll sort of say like, well, let’s look at a pandemic.

A pandemic would be an uncertain event because while I didn’t have it before, I couldn’t count it. I can’t sort of say that they’re numbers. A lot of the work on business cycles and we’ll sort of say the yield curve is somewhat subjective going back to our inverted yield curve because when you look at it, the number of times that I’ve had inversion and then recessions is less than a dozen.

So, if I normally said, like, how many samples should I have before I say that’s legitimate to make it a judgment on the probability? And I say, like, sample size should always be 30. If you took any statistics course in class, you say, well, what do I need?

I need 30 in my sample. So, by some sense, if I only have less than a dozen recessions in the post-World War II period, it’s really not a countable event. It’s almost uncountable. We can make some generalizations, but they’re going to be somewhat subjective.

So, right now, we’ll probably sort of say that if we look at uncertainty, uncertainty in the macro environment right now is actually, you know, reasonably low. You know, we’ll say on a subjective basis, we’re not facing a lot of uncertainty.

That may change as we get closer to election. But that makes for, you know, people are more willing to put on risk if, let’s say, there’s lower uncertainty.

[00:51:39] Niels

So, just to interject here, Mark. I mean, when you say uncertainty is relatively low, I think you’re definitely talking from a U.S. perspective because I think people over here, where I am, would say that, no, it’s pretty uncertain at the moment.

[00:51:52] Mark

Let’s just define it. Do you mean political uncertainty or economic uncertainty?

[00:51:57] Niels

I’d say geopolitical uncertainty.

[00:52:01] Mark

Yeah. And we’ll sort of say policy uncertainty is really sort of, we can actually measure now because there’s actually political uncertainty indices. And those numbers are actually lower than what they were two years ago.

Surprisingly is that when you look at political uncertainty in terms of Ukraine or whatever, this is that at least in the uncertainty indices that I’ve seen, you could argue how they’re constructed. You know, it’s relatively low. It’s not that high.

Now, it may be feeling that uncertainty is growing, but, you know, and I probably sort of say that there are a lot of reasons to feel that there’s higher uncertainty, but it’s not showing up in the way we measure this uncertainty data.

The third thing from a vocal world in terms of, you know, how we describe risk would be complexity. Okay. And complexity would be what’s the number of factors or features I need to explain a certain phenomenon? So, if, let’s say, I did a principal component analysis or if I look at equity returns, you say, does it, for me, explain equity returns? Can I explain it with a single factor, two factors, or is it taking a lot of factors?

Now, what we’ll sort of say is, is that the more complex a market is, or the markets are, then the more risk you’re actually taking because you can’t come up with good factors or stories to explain the phenomena. Okay. Finally, ambiguity is a tough one.

Economists would say ambiguity is equal to uncertainty, but I probably make the distinction that, if I come up with a model, okay, does the factor that I use to explain the model (let’s say if I’m looking at a beta factor or some risk factor), does it change or is it fairly stable?

So now let’s look at, let’s say for example, what’s the sensitivity of the economy to inflation? If it’s always pretty stable, we’ll call it the inflation beta is fairly stable, well, then we have a fairly clear system. If that factor is unstable or it’s changing through time, then we have an ambiguous system because you would say, I calculated my inflation beta, but the actual inflation beta I have today is different than what I calculated in the past. Then I have a problem.

So, in a VUCA world, let’s look at this versus trend following. If I have a high VUCA world, okay, so I have high volatility, high uncertainty, a lot of complexity and ambiguity. Well, then I want to probably follow trends and just use price because anything, you know, the other relationships that I might see in the world might be compromised.

If I have a low VUCA world, then, you know, I would sort of say that I can use some other fundamental data and other information that could give me some indication about what is the risk that I face. So, if you believe that we’re high VUCA, then you probably want to just follow trends. If you believe that we’re in a VUCA world that can be controlled or it’s very low, then you’d say, well, then I can put myself in or use other techniques.

Now taking this to the extreme, when you think about it, if I have high volatility, I want to try to increase diversification. Okay. Makes sense. If I have high uncertainty, I probably want to put stop losses in because I’m always worried about the unknown risk that I have. If I face a lot of complexity, well, then I’m going to sort of say that I should try to keep my model simple, but then try to add new factors when appropriate. But realize that it’s going to be hard for me to get it right.

Okay. And if I face ambiguity, my answer is that it’s good to use ensemble modeling, use more than one model. And people do that even in trend following when a trend follower says that I mix long-term trend and short-term trend. What he’s really saying is that the world is fairly ambiguous and I should use a weighted average of these two.

So even in a VUCO world, you could sort of say the person who says I use diversify across markets, I use stop losses, I try to keep my models simple, but try to add complexities where appropriate. And I use ensembles to deal with ambiguity. And that’s how you sort of like address a VUCO world.

So, you know, I think that gives a little bit better framework and how you should develop models or think about models when you sort of say, I don’t want to try to just eliminate risk. I want to think in terms of these components of risk, which are VUCO.

[00:57:47] Niels

Since we’re coming up to the end of our conversation today, we’re going to leave out some of the topics you brought along and we’ll bring them up next time. But just on this topic of sort of trend following model design, and of course, neither you nor I have perfect insight to all of these things. But do you get the sense that our industry and the way we develop models is becoming more complex?

I mean, we came from this world where simple rules would take us quite far and still works today for sure. But do you get the sense that maybe actually, as an industry, we are making things a bit more complicated to overcome some of the things that people don’t like about trend following?

[00:58:41] Mark

I think that’s true. We’re adding more complexity. Now, is it necessary? That’s a longer-term debate.

But we’ll sort of say that the addition of complexity is driven by two causes. One is, how do I sort of just try to become a better mousetrap? And generally, this is that I think it’s almost human nature. Let me add some more features to try to sort of see. Okay, now that I know that there’s a pandemic, should I have some kind of feature that can handle pandemics? Now that I know rates could go to zero or below, do I adjust models because of that? So, there are phenomena that we face that then we say, how do I now adjust to account for that?

Second, there’s a marketing issue. When you look at this, if everyone is running the same models then you’re going to get similar returns. So, I think people want to add some complexity so that they can say, I can just make myself distinct and create an, we’ll call it, alpha gap between other managers. Whether they can do that consistently is another question. So, we’ll say that some managers can’t create this alpha gap or positive alpha through adding other features so I’m going to keep it simple. Others will say, I think I can create an alpha gain or alpha gap in my favor by adding complexity.

Now, given we’re running out of time I’ll talk about one topic, and that is that they always talk about that finance people have physics envy. Economists really want to be physicists because they have the elegance of math. I think that is probably false in that we want to have engineering desire.

Engineering desire is, I think, that we aren’t adding complexity but probably being more ruled by engineers as managers. These engineers are trying to solve the problem that I call engineering under uncertainty. If I build a bridge, most of my stress in what I feel I’m going to face when I build my bridge is pretty well known.

What we sort of face in markets is engineering uncertainty and I think that people add complexities to try and deal with this uncertainty.

[01:01:34] Niels

Yeah, good stuff as usual, Mark, super.

Now, of course, if people are becoming interested in trend following after hearing Mark explain like this, there is a new resource in our resource section on the website, 10 Reasons Why You Should Add Trend Following to Your Portfolio. So, go and find that and check it out.

Next week I’m going to be joined by Alan so if you have any questions for him, from an allocator perspective, just shoot an email to info@toptradersunplugged.com and I’ll do my best to get them in front of Alan and we’ll have a chat about that. And, of course also, as mentioned earlier there will be, hopefully, regularly a weekly trend update, also in the blog post section of the website.

So, lots of good things and reasons to go visit it on a regular basis. From today, I would say, Mark and me, we are delighted that you have been here with us throughout the last hour or so and we look forward to being back with you next week, and until such time, take care of yourself and take care of each other.

[01:02:40] 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.

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