No Pain, No Gain ft. Katy Kaminski

[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 Katy Kaminski and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor. Katy, it is wonderful to have you back this week. How are you doing? What’s going on where you are today?

[00:00:40] Katy

Good. Things are good. I can’t believe it’s already getting closer to spring, so that’s positive. Yeah.

[00:00:48] Niels

It definitely is. Katy, it’s been a few weeks since we spoke. We have a great lineup of some interesting topics, maybe something that we don’t talk about too often. And there’s going to be a little bit of a backstory that I think people will enjoy. But before we tackle all of these topics, I’m always curious in between our conversations, at least on the podcast here, what’s been on your radar? What’s kind of, I wouldn’t say top of mind, but what do you find interesting outside maybe the world of trend following?

[00:01:24] Katy

I think markets recently, there’s been some interesting idiosyncratic trades and things that have been interesting. One has been just watching cocoa prices, for example. That was a big move. But I think really the fun one to watch, with this upcoming next few weeks, is going to be the Bank of Japan and just how it’s just really gone to the beat of its own drum for the last two or three years, and now is talking about hiking potentially after all the hiking seems to be done.

I don’t know. I think that’s something to watch. It’s been a very interesting idiosyncratic story. I always love idiosyncratic stories because they’re trends but they’re also different from everything else. So it’s kind of interesting.

[00:02:17] Niels

We’re recording on Friday around noon, your time, and an interesting observation is that (I can’t remember which part of the Japanese economy) I just saw a headline where the latest wage rise in Japan is something more than 5% over the next year. So that’s massive. It’s even higher than what we’ve seen in Europe that’s for sure.

But then I’m looking at the other thing you mentioned, that’s cocoa. I see it’s up more than 5% just today. So there’s still a little bit of catch-up if you are a big cocoa fan in terms of inflation. But that’s not what we’re really here to talk about, cocoa or Japan. We’re going to jump in and talk a little bit about trend following first, as we always do.

March so far has been a lot quieter than maybe January and February. Still a very solid year for most trend followers so far. What’s interesting about this year, I’m just going to throw a few things at you and then we’ll see how you respond to that. But one of the things, speaking of cocoa, it is interesting to see that some managers probably have made all their money in cocoa, and many other managers have obviously a much more diversified P&L stream and more broad-based. That’s one thing I’ve noticed that’s interesting.

But the other thing that I’m kind of interested in hearing your thoughts, and that is, when there are strong trends in a few markets like we see at the moment (cocoa is one, there are a couple of others that have moved quite a lot), I get the impression from some of the conversations I’m having now, at the moment, that investors tend to zoom in on these two or three big trends and they kind of already start to worry what happens with performance when these trends reverse, because we know at some point, they probably will.

Does this automatically mean that all the performance that trend followers have generated so far this year, it’s all going to disappear? It’s all going to be given up, so to speak? Of course, I’m exaggerating a little bit, but there is some truth to it on the other hand. So I’m kind of curious what kind of conversations you are having at the moment and whether you see a little bit of the same tendency or pattern among the investors.

[00:04:44] Katy

I agree. Investors are always wondering when trends are coming to the end. Obviously, there is worry about that. We always worry about it. It’s part of trend following itself is that you never know what’s going to trend so you have to keep looking for everything that might trend.

I actually would say that what was cool about the recent environment is the biggest trend in the markets has been equities, and the only thing that people have been talking about is that, besides us, on the space of commodities where we’ve seen not just cocoa, but nat gas, emission contracts, corn, soybeans, soy oil, those have all been sort of big movers. I think we like idiosyncratic trends because they provide diversification.

So my view on that is it happens from time to time that it’s the idiosyncratic trends that are interesting. Let’s take the currency block as well. So the Japanese yen trade and even the Mexican peso trade last year, those have all been idiosyncratic trends as well. They at some point start ending and maybe, who knows, maybe they’ll end soon. But the good thing is things are always changing and trends are always moving.

So the next trend might be something less idiosyncratic. In fact, it could be equities continuing. So, I’d say that I always think of it as trend is about opportunities and finding them and sometimes they’re idiosyncratic and kind of different from the norm, and that’s diversifying. But there are always new trends that form as others consolidate.

[00:06:22] Niels

Well said. Now, in terms of current trends, my own trend barometer finished at 52 yesterday. That’s positive. That kind of confirms and supports the tailwind we’re seeing at the moment in terms of performance. I mentioned we’re recording Friday, that means that as of close of business yesterday, Thursday, so far, performance is pretty good but quiet.

Up 80 basis points BTOP 50 so far in March, up 6.14% for the year. SocGen Trend up 64 basis points for the month and up 6.64% for the year. SocGen Trend Index up 47 basis points, up a whopping 8.22% so far this year, and the Short-Term Traders Index is up 59 basis points, up 1.15% So far this year. MSCI World equity index of 1.36%, up 6.73% for the year. World Government Bonds completely flat so far this month, and the S&P 500 Total Return up 1.14% so far in March, up 8.33% so far this year.

All right. With that done, we are going to talk about some of the topics you brought along and that we both had spotted. But before we dive in too deep into this, I thought it could be useful and interesting for our listeners to learn a little bit more about your backstory and how you actually ended up in the trend following world as you have a slightly different background, I would say, than many other people in our industry.

So tell us a little bit about Katy Kaminski’s path to where you are today.

[00:08:07] Katy

So, I was in academia and I was at MIT, and then I moved to the Stockholm School of Economics. I decided to go into the industry and was really interested in managed futures, and so I ended up starting in the industry at a CTA fund of funds which was a Swedish CTA hedge fund of funds. So my first job in managed futures was at a CTA fund of funds in Swedish, in Stockholm. By the way, I’m not Swedish. So that makes it extra fun there. Just a little twist to that.

It turns out, it was right in the middle of the great financial crisis. I started like October, November 2008. What was really fascinating about that is here’s this bright-eyed, bushy-tailed academic that goes into the industry and we’re literally in the best environment for managed futures ever. Managed futures was just knocking it out of the park.

What was so interesting about that is it was such a terrible time in history and people were just struggling left and right. And here’s this academic going, what is going on here? How is this strategy doing so well and then everything is falling apart? And so myself, I was just kind of shocked and interested and very curious. And I thought, “I don’t really know why this is the case. This doesn’t make sense to me. I got to figure this out.”

And so by starting in the industry, in this space at that time, it’s sort of jumping off at a point where the strategy was really at its best. And so that led me to be really interested in trying to understand how managed futures strategies worked and be able to explain them during periods of crisis, and hence a lot of the research that I did eventually in crisis alpha, which also led me eventually to write a book on trend following that you know well back in 2014, and eventually move, shortly after, into the manager space.

So I’ve been on the manager side in the day-to-day of managing trend following portfolios for over 10 years now and I think it’s just what has inspired me. Being at the CTA fund of funds inspired me to explain it and be able to communicate about managed futures because I myself, as an initial allocator, was just trying to figure out, how do I compare funds? How do I explain the differences in their performance?

What causes dispersion? What decisions do they make that make them successful or have different return profiles? And it led me to being very interested in that field because I wanted to know, both from the outside and when I was on the inside, be able to communicate some of the things that we think about on a daily basis as systematic investors.

[00:11:19] Niels

Yeah. I want to dig maybe a little bit deeper into that in a second. But I’m actually curious of one thing that I think you very elegantly didn’t mention, and I don’t know what the answer is. But when was the first time you actually heard about managed futures and why did you like it before you got into working with it? That’s kind of curious to me.

[00:11:46] Katy

I taught futures trading and options trading at the Stockholm School of Economics, and I just thought futures contracts were the coolest thing to ever exist. I was like, how is this so cool that you can actually trade lean hogs and this and that without actually owning them? And you have this amazing access to leverage, and you can build portfolios that give yourself risk-adjusted positions to all these interesting things in a very capital-efficient way.

So that’s my nerdy why is that I taught derivatives trading as a nerdy academic first, and I was just so like, this is the coolest thing, this is what I want to do. And that’s really what got me an appreciation to it is really sort of starting from the fundamentals.

[00:12:40] Niels

That’s quite fun. You don’t come across many academics that have that aha moment, I would say. But luckily, we have you, Katy. But then going back to your journey there, now that you have been on the manager side for quite a while and obviously a PM, and so on and so forth, but also, you have this unique ability to speak to investors, which not all research people are necessarily equipped to do, and that’s fine. That’s not their wheelhouse.

If you were going to point at one or two things that you really took away from the experience of being an allocator. As you said, yeah, you had to kind of figure out what makes a manager different and so on and so forth. But if you were going to give some advice, if you were going to stand up in front of a number of allocators and say you need to think about these three things that’s going to help you a lot, it’s not going to give you all the answers but it’s going to give you kind of a good starting point. Is there something that you can think back on where you said, yeah, these were really important building blocks for me later on in my career?

[00:13:45] Katy

This is a really good question because it was sort of a quest that I went on as an allocator. Back in the day, there weren’t really good benchmarks and so I started really trying to build factors and ways to understand different decisions involved in building systematic portfolios, particularly the trend that would help me to explain differences and tilts that different managers might have to help me understand how they might be the same or how they might be different.

And in that research, I started really understanding that there’s a couple of key aspects. Number one, it’s really about where do your systems place risk. And secondly, how do you construct a portfolio of put all the pieces together? And even more interesting, how do you think about risk over time? So not just the cross-section, but also the time series.

I think those two things, based on how you have your risk allocated the way that you construct your portfolio, as well as the way that you measure and think about risk-taking over time gives very different profiles for managers, and it’s just about specific tools to be able to decipher those choices that help you to understand differences between different approaches.

I think that came about just from trying to understand how to communicate, how to classify and also understand the different choices that managers make in building their systems.

[00:15:26] Niels

Absolutely. You mentioned a book that people should definitely go and buy, and that’s “Trend Following with Managed Futures” that you wrote together with Alex Greyserman back in 2014, and which many people regard as the Bible of trend following. And so I definitely highly recommend that.

Now, you’ve mentioned already some of the things that I think ties very nicely into what we’re going to talk about. I think portfolio construction in itself, if you’re a multi-asset portfolio manager, is important. We’re going to dive a little bit deeper into portfolio constructions within our little industry.

You brought along a few topics I think actually based on papers that you have written in the past which people may not be familiar with or maybe they need a little bit of a refresher, which I certainly do. So I am going to let you guide me through this. But let’s maybe start with risk variations within portfolio construction, and then we’ll take it from there and see what happens.

[00:16:29] Katy

That’s great. When I was going to speak to you today, Niels, I was excited about going into some. I thought about what are some of my favorite papers ever, not just like what is the recent paper, but like what are good papers that explain some of the things that are important to think about for investors from the inside. There’s a paper that I wrote in 2019, I think it was, on risk variation and trend following.

What this paper is really about is thinking about how risk is allocated cross-sectionally across asset classes and also time series in terms of the level. So, this particular paper talks a lot about depending on how you design your system, trend signals, if you just have raw trend signals on all of the assets you trade, you need to think about how are we going to allocate the risk across say stocks, bonds, currencies, and commodities.

This paper really talks about two very polar different views of this. One is the equal risk per asset class view and the implications of that. The other is the time-varying cross-sectional risk view. What this means is that in the equal risk view, you take the signals for each asset class and then you rescale them to this equal risk for each asset class that has an implicit assumption that the opportunity set per asset class is roughly equal.

There are some pros and cons of that. We can talk about this in a minute. The other approach is really the time series or the time-varying risk approach, which is much more of a classic trend approach where you maintain the level of your signals and you allocate risk as a function of the opportunity set based on measured trend signal strength. In that sense, you’re going to have a lot higher risk variation across asset classes.

In a year like 2022, you might have 40% or 50% of your risk in fixed income and very little risk in equities. Whereas the equal risk approach is going to have the same risks for each asset class but scaling. So you have very different effects in these two approaches. For time series, you’re really having an ideological view that trends are very clumpy, that they come in certain areas and not in others sometimes, like what we just talked about, that you can have cocoa and equities be interesting now, whereas you are finding challenging signals in the Euro shorts or other contracts which we know have been challenging lately.

Whereas the equal risk approach is really about having a cross-sectional view in that asset class about the trend. So for example, if you looked at currencies, if you had the same risk budget, you’re really sort of looking at the relative strength. So it’s more of a relative tilt in an equal risk approach. You can see that I could take the same signals but change the risk approach and I can have very different results. That’s something why I’m talking about from the allocator’s perspective, those things can look very similar even from a signal perspective.

But if I have a very different risk approach, in terms of how I think about risk variation, I can have completely different results. And so sometimes they’re the same. So if they all have similar strengths, they’re similar. But if you have clumpy returns, you might end up more exposed to cocoa in the time-varying approach and less exposed to cocoa in the approach with equal risk allocation or equal risk variation.

[00:20:20] Niels

A question springs to mind, because you’re kind of alluding to that although many people might think of trend following as one and the same, but actually, when you look at returns, there can be massive dispersion. Clearly, one of the drivers for that is exactly as you say, how we manage risk and how we allocate risk.

My question is actually, I’m going to try and ask the question without showing my hand here, Katy, in terms of my own opinion. But what do you think drives the biggest dispersion? Different types of signal generation or different types of managing and allocating risk?

[00:20:59] Katy

Risk.

[00:21:00] Niels

Yeah, I agree. Market selection of course obviously all things being equal. Let’s talk about two portfolios that have the same markets, because clearly if they have different markets, that can also make a difference. But yeah, I agree with that. I think this is a little bit of a hidden gem. Maybe it’s also because it’s harder for investors maybe to wrap their head around because they can look to (I’m just using this as an example), one says, yeah, I use these moving averages. Someone else says, no, I use this price channel. And they can kind of visualize how they might be different. But once you start into nitty gritty about different ways of allocating risks, selecting parameters, and blah, blah, blah, it becomes complicated. I certainly feel for the challenge that investors have nowadays to fully embrace some of these things. But I want to hear your opinion about this.

[00:21:54] Katy

Yeah, this is why I got so excited about explaining risk, and risk allocation, and CTA style factors because it was really about where do you end up. Because where your risk is, if you had more risk in bonds in 2022, it was a better year. If you had more risk in cocoa than something else maybe last month, that’s great. Or if you had more risk in bonds, it was harder in February.

So depending on where your risk is and how you construct your portfolio, it has an impact on how performance is over time. The other thing I also wanted to add, because let’s not make this more complicated, what I was talking about is how risk is across your portfolio with the different assets you trade.

The other thing that’s important is the level. So, are you thinking about targeting a consistent risk? Are you pretty tightly bound to that? So constant risk targeting. For example, in this paper we talked about this versus what we called signal risk targeting. So constant was targeting is you say, okay, let’s target an ex-ante vol of 15%, period, versus signal was targeting where you allow your system to scale up and down as a function of the overall signal strength.

This is going to be important about the other fun paper I want to talk about today is that if you have a constant risk target over time, in some sense, that can be a little counter-trend in the sense that when your signals are strong, you scale down, or when your signals are weak, you scale up. So somehow, you can take a trend system that’s pure trend, add a constant risk target, and you unravel some of that pure trend behavior.

So that also was very fascinating to explain to investors for me because obviously if you’re looking for pure trend, you not only have to think about the risk allocation, but you also have to think about how are you getting to the risk? What is getting you to the total risk of your portfolio and is that what you want? Do you want constant risk, or do you want to punch your trend portfolio over time?

[00:24:06] Niels

As you explain that I have a few friends, I can already see sitting listening to us cheering and clapping and saying yes, that’s what we mean. It’s not really trend when you start adding these things. You have countertrend in there. And of course, that is true. But then my point would be, I don’t think very many managers any more use constant vol targeting. I think it was a phase, but I think people realized that that’s not really very productive for what we do.

[00:24:36] Katy

Yeah, and it depends on if you have a very heterogeneous set of signals. So if you’re just doing trend, then it’s clear what that means. But if you’re maybe doing something more complex like economic trend or other stuff, then maybe that makes more sense. But I think the level of risk that you take over time, this is an extreme example, because what we wanted to do is tell the two extreme choices.

I think most people are somewhere in between. They’re doing a little bit of both. Maybe they’re curbing some of the signal risk targeting, they’re not going on raw signals. They’re kind of smoothing it. But the point is that variation and how you take the varied risk has a huge impact on the size and the features of your returns.

[00:25:20] Niels

Yeah, nice, that’s very important. Skewness, why is that so interesting? You’ve written also about that, I’m sure.

[00:25:31] Katy

Well, I love skewness because it’s such a great topic. It’s in every dinner conversation.

[00:25:36] Niels

I don’t really meet many people who will say that I love skewness, but you’re one of them, Katy.

[00:25:41] Katy

I love skewness, especially positive skewness. So skewness is one of the exciting features of managed futures in the sense that there was this great paper by CFM a couple of years ago where they talked about skewness and risk premia. This paper was really awesome because they classified different alternative risk premia strategies into positive and negative skew, and they explained there’s very few that have positive skew, that would be trend following and maybe long vol, and many other strategies have negative skew.

That’s very consistent with the concept of convergent and divergent strategies in the sense that divergent strategies tend to have small losses and occasional big gains and convergent strategies tend to have lots of small gains and occasional devastating losses. And so if you think about equity markets, they’re negatively skewed. Whereas trend following is one of the few strategies out there that has this nomenclature or this moniker of like positively skewed. And everyone’s like, Oh, let’s find some positive skewness.

So the challenge with the term skewness is mathematically, it’s just the third central moment. So you can think about it as how uneven your distribution is. And if you have something that has big positive returns, it’s going to have positive skewness instead of negative skewness.

So, what was always fascinating to me, and this is where I actually got it wrong, like totally wrong. Because I had this intuition, and this makes sense, so follow me here where I got things wrong. I love talking about things I got wrong, and I had an aha moment because this was an aha moment. So basically, if you look at a trend signal, trend signals are small until there’s trend that’s building, building, building. And as the trend extends, you extend your position as a function of the size of the trend.

So by nature, you’re going to have a P&L stream that is going to look often, on average positively skewed. So if you look at the skew of an individual P&L stream for trend, it’s like boring, boring, boring. Let’s do cocoa. Boring, boring, boring. Whoa, big! Right? And so, you have these positively skewed return series and you think like, okay, I just put a basket of all these positively return streams with positive skew together and bam, lots of positive skew.

No. That’s badly incorrect. Intuitively, it sounds great, right? It’s a good story. Like you add these positively skewed things and you get something positively skewed. If you do the math, you’re basically fighting against the central limit theorem. So there’s no way that you can have positive skewness in a basket of positively skewed things. And I was like, oh, goodness, so the positively skewed signals don’t create positively skewed returns.

So it turns out that the positive skewness, this crisis alpha that we see in managed futures, has to do with a basket of strategies coming together, it’s going to be normally distributed. But if you have a strategy whose risk, in terms of total risk, varies over time with a positive return, you can get the positive skewness in moments when many different assets have positive returns at the same time.

So what’s happening there is if you let your risk vary over time as a function of the strength of those signals instead of targeting it or keeping it fixed, you’re getting this positive skewness from following multiple signals at the same time, so allowing your risk to move with those signals. And that was an aha moment for me because what it explained is that managed futures skewness is something that I would call skewness by chance.

So, it comes from time to time and it tends to be in times which are extremely disruptive. So during a crisis, during the inflation event we had in 2022. So it’s that risk variation, at the portfolio level, that actually gives you the positive skew. And so as an investor, this is why this was important to me, you need to think about when do I want the skew?

So when you speak to a manager, you need to say, how do you vary your risk? And let me understand better risk-taking what type of risk-taking constraints you might have in an environment where I might want more positive skew. So, I think that, to me, was really an exciting point, that it’s not about the cross-section, it’s really about the time variation over time, and when you have these punchy returns and allowing your risk actually run with the signals that actually gives you the crisis alpha and those positive skew events that investors get excited about. So I think that to me was an exciting aha nerdy moment, I guess.

[00:31:06] Niels

Yeah, I can see you get very excited about discovering this. Let me follow up with my basic type question relating to this. Over the years, I’ve noticed that in particular, maybe short-term strategies would make the point that trend followers had lost their skewness, their positive skewness. But of course, the short-term managers still have it. But I think many people would be aware that that’s depending on what time frame you look at.

So can you explain why one can make the argument, but actually, it might be because they’re looking in the wrong place?

[00:31:55] Katy

Yeah, the frequency matters. So if you’re looking on a daily basis, you’re not going to see the positive skew. But you’re going to see it over a longer time horizons, which is why investors are interested in this particular point because the frequency that they’re often comparing equities or traditional investments with managed futures is more in the monthly to several-month basis as opposed to the day-to-day.

So, you see that skewness with the changes and brisk variation, which is not a daily thing, it’s more of over a cycle, you see risk increasing as a function of the environment and signals and risk levels increasing with trend conviction, if that makes sense.

[00:32:38] Niels

So it kind of makes sense that if you’re a short-term trader, your skewness is in the short term. If you’re a longer-term manager like a trend follower, your skewness will be over two or three months rather than two or three days.

[00:32:51] Katy

But you actually brought up a really important point, Niels, and that this is just one thing that I think about when I think about crises or these environments where these strategies tend to do well. Back in some of my original research on crisis alpha, there’s a couple of key principles. Number one, reactivity. Number two, unbiased. Number three, pure trend.

Those are three things that are really important to be able to capture a really challenging environment. So out of the sample, COVID, what mattered? Reactivity, pure trend. During 2022, what mattered? Unbiased and the reactivity didn’t matter because it was so persistent, and pure trend.

So you can see that depending on the environment, there are a couple of characteristics about a trend program which matter for us to be able to capture the type of move. COVID, it was important to be reactive and fast. Whereas 2022, it was important to be unbiased and not have constraints on your short positions in fixed income.

[00:33:59] Niels

Not that I’m going to teach you anything about crisis alpha, but I do recall our conversation about it about a year ago. And you mentioned one other thing which you may mean as part of what you mentioned, and that’s just this thing about being opportunistic, meaning you we don’t know if it’s going to be oil that generates the alpha or whether it’s going to be cocoa or bonds for that matter. So I just want to throw that in there as well.

[00:34:25] Katy

Yes, you’re absolutely right. You listen so well, Niels. Actually, opportunistic is number four. And sometimes I don’t use the word unbiased because it’s kind of related to opportunistic in some ways, but really, it’s about being liquid, being able to react, having access to all the opportunities that you can that could give you long or short opportunities.

But wow, you’re right. That’s another good way of putting it. You’re a good listener, Niels.

[00:34:54] Niels

I appreciate that. So we already talked a little bit about cocoa. We talked about people starting to get a little bit nervous about the cocoa trade if they see their manager being long cocoa still and all of that stuff. It kind of nicely leads us into another paper that you didn’t write, but our friends over at Man wrote very recently. I thought it actually was quite an interesting title. They call it Preparing For Pain Ahead Of Time.

Of course, we would suggest all investors do that because one way they could do that is just to make a meaningful allocation to trend following, but that’s obviously our slightly biased view on this podcast. But you had a brief look at the paper, I had a brief look at the paper. What were your main takeaways from what they’re describing, because they’re kind of describing two different kinds of pain, and so on and so forth. But maybe you are better at explaining this than I am.

[00:35:56] Katy

Well, I really liked a couple of the points that they made there that is a good reason why we sometimes get set up for more pain in the future. They talked a little bit about how you have two different ways of remembering pain. There’s the semantic pain, semantic or episodic events and how you think about them.

So they really talked about your memory of difficult environments like 2008 is actually you remember it as perhaps more predictable, and you don’t really have that visceral memory of pain of it. You actually rationalize it, and you know that it was painful, but you don’t really have that vivid understanding of how really painful it really was. And I think that is true for everybody in the sense that things look good, we don’t want to think about it.

For us in managed futures, why I love being in managed futures is we do the best when things are terrible. And that’s a really weird way to live your life because you’re always thinking, what pain could come? It’s a little bit removed because your strategy likes those situations, but you probably won’t. And so, you’re kind of always thinking about, what are the people underestimating? What do they not remember clearly?

I think people have very quickly forgotten, I was thinking about this the other day because people have forgotten how bad it was in 2008 and how it really felt. People were worried. I was thinking about this in February just because if you look at China, China is down 50%. We in the US are probably not thinking about it but that would hurt.

If you think from this paper’s perspective, if you’re holding assets that are down 50%, that’s a pretty hard thing to bear. People notice it, but they’re not thinking about it that way. So I think anytime you’re in that scenario where you’re actually down a lot and you don’t know how that’s going to recover, it’s significantly more painful than we actually remember.

[00:38:15] Niels

Yes. I want to throw one thing in that comment where you said, well, we tend to do best when there’s pain or when things are not going so well. But I also want to remind people that we can actually also do really well when things are doing well, which is what’s happening at the moment. All-time highs in equities, bonds doing okay, and so on and so forth.

I think that side of things is sometimes forgotten a little bit because people tend to want our returns through difficult times in equities or bonds. But I really think it’s what I love so much about what we do or can do for investors is that there really isn’t one specific regime that is required for us to do well, which will lead me to another conversation I’m going to record next week, so I won’t spoil the insights to that, but it will come.

[00:39:16] Katy

Niels, I agree with you 100%. Thanks for bringing that. We were just talking about pain right now. I think we do well when things are extreme. Not when it’s hummed on, but usually when it’s like, whoa, things are great. And so that’s why right now is actually good for managed futures because the S&P 500 is up 25% since October. That’s pretty extreme. So we love the extreme for good or for bad.

But of course, where people think about us often is the extreme where it’s not good. And you’re right. We don’t maybe talk about that as much because that’s where investors especially pay attention, but they should be paying attention now too.

[00:40:05] Niels

They also talk about different types of pain actually in the paper. They talk about pain from high volatility or big drawdowns, and then there’s this predictable and unpredictable pain as well. They even mention, and this is definitely outside my expertise, they even mention childbirth, Katy, in this paper. Any thoughts on that?

[00:40:28] Katy

I don’t remember.

[00:40:30] Niels

Well, that’s the point, that we tend to forget these things.

[00:40:34] Katy

I don’t remember. Yeah, I think that’s a really good point because I was actually giving some lectures before about neurofinance. They talk a lot about these types of things. I also liked in the paper they talked about emotional pain. And I think to be honest, losing money is really emotional pain. Because it’s not like you hurt your arm or your leg. It’s like it hurts and your gut hurts. You’re like, Oh, that hurts.

I remember at this lecture once on neuroscience and finance, they were talking a little bit about tell people, if you have emotional pain, you should take a Tylenol or an aspirin. And I was like, wow. Because the pathways in your brain, you’re actually perceiving emotional pain like physical pain. So rejection and social rejection, and things like losing money, they have the same pathways in your brain as they do as if you broke your arm.

So I think that’s something that I like about this paper too is they acknowledge that investment losses and challenges, it’s not for the light-hearted. That’s why it’s not always an easy career. There’s a lot of volatility.

[00:41:57] Niels

Absolutely. They also mentioned, and maybe that’s going to be my last point about this paper. But they also mentioned another kind of pain which is not obvious necessarily, and that is not necessarily from losing money but actually from not making money because you just gave up on your idea and then the stock took off.

Now, in trend following, that wouldn’t happen because we’re stupid enough to just stick with it until the trend really has turned the other way. But of course, for many investors who do it for fundamental reasons, they might. Actually, a very good example, I know we’ve talked a lot about cocoa in this conversation, but cocoa didn’t make money.

In fact, cocoa lost money for trend followers for probably 15 or 20 years leading into 2023. So can you imagine the pain of being a trend follower only trading cocoa? You would have stopped.

[00:42:51] Katy

You would have stopped a long time ago.

[00:42:53] Niels

But since it’s a small part of our portfolios, we could let it run and just wait for that moment where something “crazy extreme” happens. It just happened to be at the beginning of 2023, and now we see how crazy and extreme things can get and who knows where this will eventually end. So yeah, lots of valid points. I liked the paper, “On Pain”, as it’s called. “The Road Ahead” number 27 from Man.

There’s another paper that admittedly I have to say I have not read. But I did have a conversation with one of the authors last year, namely, Yao. It’s from AQR. Because AQR, they are leaders in many ways. They’re a big firm in our industry. But now they have for a while, it’s not new, but they have for a while branched out to a slightly different kind of trend following which I wouldn’t say I fully understand, but I’m kind of hoping you do.

They call it economic trend. So I thought maybe we could just touch on that a little bit before we try and put everything together at the end and look in our crystal ball.

[00:44:18] Katy

I think these two are very related. Classic trend following is really about allowing price and price movements to dictate your positioning and following those price movements. That’s why it’s often linked to macro changes, because we tend to capture the middle part of the trend in the sense that once the trend accelerates, we get into it. And then we often see some reversals at the end, so we capture the meat of the trend.

That’s why even when you look at trend following strategies compared to macro strategies, they have about a 50% correlation. Why? Because we’re trading the same themes. We’re getting in and out a different times, but the macro changes in the world are dictating our returns. Thus, we have a 50% correlation with macro trading.

So what I think this paper that you mentioned is really kind of getting at is, are there ways to characterize these changes in a related but more fundamental driven view with this ideology that trends occur and information takes time to distill and process, thus we underreact to changes in the macro environment, eventually figure them out, but the data takes time to evolve for us to know what’s happened.

They use things like CPI, GDP, other things in this paper, but think about the CPI as a simple example from 2022. If you had followed the CPI index as a trade, you would have been right too, right? You would have been in the same positions as us. You’d have to abstract from that CPI movement to what I should buy or sell, which is what they do in this paper to some degree.

But you’d end in the same positions but by different means. And we’re ending up there because we’re just saying, we don’t know why this is happening. In fact, we don’t care. It turns out, we’re following the CPI. So what is interesting about those two approaches, they kind of end up in the same place some of the time, and it’s really about large-scale changes in macro views and fundamentals.

But there’s no question that fundamentals and a slow reaction to them are playing a big part in any of the trends that we trade. Take cocoa as an example. That’s not just a fluke. There’s been some major supply chain issues in cocoa that have been unheard of. So are we trading those positions based on what happened in the market? No, because we’re following the price. But you could easily imagine a fundamental-based model that’s following that economic trend based on supply that would get you in the same position.

So for me, it’s really about different ways of characterizing the same problem. We’re using different signals, but oftentimes may end up in some similar trades, but slightly different in terms of the timing. So I think they’re very compatible.

[00:47:33] Niels

Yes, they are. The only thing, and of course they’re full of smart people over there and I’m sure they’ve figured out how to do this. It reminds me a little bit, if I was going to say one sort of thing from my experience. It reminds me a little bit a few years ago when something called systematic global macro was very popular. It actually sounded very good, and logical, and the performance looked fine and the money flowed in like crazy to some of these funds.

I can’t remember which year it was, but then things started to change, and markets weren’t quite reacting the way these models were expecting. So we kind of saw a bit of an implosion in that particular strategy. That’s the only thing I kind of worry about because I think the world is a bit crazy and changing in ways that many of us, we can’t expect that the relationships we’ve seen in the past are the ones we’re going to see in the future.

So that’s my only concern, because obviously, in some ways, we all have to rely on certain relationships from the past. I see a little bit the same with the vol space, where the relationship between the VIX and the S&P was pretty solid for many years, and a lot of these strategies were designed in a specific way using some assumptions. But those assumptions have changed. They may come back, but they have changed for a while. And therefore, many of these strategies have struggled you could say.

So the jury is out there, I guess. But yeah, it’s an interesting approach for sure. I’m not saying that it doesn’t work for sure. It’s just different from what we used to do in terms of price.

[00:49:21] Katy

Well, Niels, what I would agree with you on this is anytime you overparameterize something, you’re in some sense giving a sum of a convergent view on to how the economy works. I think that the difference right now is that it is working right now. The fundamentals are really seeming to drive long-term trends right now.

But you hit at a point, there’s been so many times in the past, I remember 2014 as an example in the oil trade. Basically, very few macro traders were able to really understand the impact of shale production on energy prices and they weren’t able to take views on that short energy trade. Trend just doesn’t care. Obviously, you can tell which side I’m on.

But I think trend is always an important strategy because it doesn’t require the future to be the same as the past. And I think that is a very important walk forward, non-academic view of it, that the world could be completely different for the next five years, and if you stick to the past, you might be right, but you might be wrong. So having a more agnostic approach which says let’s just follow where things are moving, and we’ll be a little bit more resilient to extreme environments.

[00:50:48] Niels

All right, Katy Kaminski, let’s try and put all of this together. Let’s try and wrap up in the last few minutes that we have left. What excites you where we are if you look into 2024?
Are there any things that you pick up people being nervous about, are you nervous about anything? It’s a pretty pivotal year for many reasons, not least because there are so many elections, but there’s a lot of other stuff going on. Tell me a little bit about what you’re thinking.

[00:51:17] Katy

I get excited about nerdy stuff, but when it comes to markets, I tend to get nervous. Maybe that’s me. I think I’m a little nervous about equity markets just because anytime things are great, it makes me nervous. It makes me wonder. Maybe that’s just being a trend follower.

I think I was looking at some reports recently where concentration in momentum positioning was consistent with similar features in 2000, and I think that made me really nervous. So I’m nervous about it because anytime equities do well, I get nervous. They’re doing well now, so that makes me nervous. But at the same time, it has been really exciting to see commodities be a very interesting thing to trade.

I think that to me says that inflation is still a key factor. Higher inflation and rising inflation tend to be very disruptive, hence a positive environment for trend. So I’d say that it’s a little mix. There are the worries about the classic equity trade, but the excitement about inflation and commodity moves recently.

[00:52:32] Niels

You know what’s been interesting, because we have been in some extreme environments in 2022 and then maybe 2023 was a bit of a transition year. And of course, some people came out criticizing and saying, oh, trend doesn’t work anymore. Just look at how the returns are, it’s all terrible. And then comes 2024 and trend is doing really well.

I’m actually quite impressed with how our industry and the strategy has handled these changes and these transitions. what excites me most is right now, as you kind of allude to, unlike equity markets where it’s very narrow, I see a very broad-based “rally” in the trend following portfolio.

Now, there’s a couple of standout markets like the Nikkei, like Hang Seng maybe, like cocoa as we’ve talked about, and one or two of the grains. Sure. But actually, they’re from very different sectors anyways. So that’s what excites me, that it’s broad-based. Now, it doesn’t mean that we won’t give back some of this. We will at some point. But we just don’t know when that point is.

I also remember, in early 2022, when managers were doing well right out of the gate, people were starting to “take profits” on trend way, way, way too early. So I’m kind of hoping that people have realized that the power and the most benefit they get from their trend allocation is one, make sure it’s meaningful, and two, don’t have an opinion about it, and three, just leave it alone.

That’s kind of what I’m hoping for, that they have realized some of the lessons from 2022 that if you start being too clever trying to time things, you can get it wrong. The whole point about seeing what trend can do in a “multi-asset portfolio” is based on leaving it alone to do its job and not have an opinion about what goes on inside trend. It’s probably the only part of anyone’s portfolio where they should not have an opinion.

Even though I get what you’re saying that you’re nervous because equities are going up and you might look at your positions and yes, and of course it’s hard for us because we look at the positions every day. But in a sense, we should also really try and just not worry about it and say, yeah, this is exactly what we’ve designed it to do, catch these periods.

As we know, trend following often does well when there’s a bit of conviction in the portfolio. Even though I just said that right now it’s still pretty well balanced, there are a couple of things that are kind of high conviction if we call it that in the portfolio, and that’s fine. We need that to deliver outsized returns.

[00:55:31] Katy

I think that’s amazing, Niels. What I would say to that is that it is what I do also like about being a trend follower, because there’s my emotion and there’s how I feel, but how I feel doesn’t matter. What matters is what are the trends. And sometimes, I’ve also learned that the more uncomfortable I am, the better the trends tend to be, because it means other people are uncomfortable too.

It’s a weird thing to say, but in a weird, stressful environment or when things are changing, it’s always uncomfortable. And so I’ve learned that when I do feel uncomfortable, sometimes it’s the better trends that occur, which is interesting.

[00:56:16] Niels

Next to my trend barometer on the website, I should publish Katy’s uncomfortable barometer. Hopefully, if they are in the same direction, people should really load up on trend.

[00:56:28] Katy

Yes, I think that’s true. Or you could ask people how uncomfortable they are.

[00:56:32] Niels

Exactly. Katy, this was fun. This was super insightful. I think people will really like your insights and the history and what led you to becoming a trend follower and really a strong believer and a fantastic advocate for the industry. Is there anything we forgot to bring up or I forgot to bring up?

[00:56:57] Katy

No. It was a great conversation and I’d definitely love talking more about risk sometimes. I look forward to the next time.

[00:57:07] Niels

Exactly. We may do this again in a few weeks, which of course we will. But next week, I will be doing this with Alan.

So if you want Alan to tackle some of your questions, of course, he comes from the allocator side like where Katy started, then this will be a good opportunity to send me an email info@toptradersunplugged.com, and I will do my very best to pose the questions.

If you love these conversations and you want to hear more of this, then do help us find new people to join this little community. You can do that by sharing the podcast with friends, colleagues. And also, you can do it by rating and reviewing it on your favorite podcast player. We appreciate your support.

From Katy and me, thanks ever so much for listening. We look forward to being back with you next week. Until next time, as usual, take care of yourself and take care of each other.

[00:58:07] 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.