Prepare for a Bumpy Landing 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, wonderful to be back with you in the new year. How are you doing? How are things where you are?

[00:00:39] Katy

Good. Things are good. It’s cold here in Boston, but that’s January, and that’s winter.

[00:00:47] Niels

I’m spending a day in Denmark and it’s pretty cold here as well, I have to say. Now, before we do anything else, there are a couple of important things we need to do. The first thing is, we need to go back in time to after our last conversation, because after I clicked stop record, you told me a really funny story about a doctor near you. So I really want you to share that. It was quite amusing.

[00:01:14] Katy

Yeah. This is a shout-out to Niels because I had an appointment at the allergist. I went to the allergist, and I had to drive far away, and in Waltham, which is not quite in the city. I go to the allergist and I’m sitting there and the doctor comes in and he goes, “Are you Katy Kaminski?” And I was like, “Yes, that’s my name.” And then he’s like, “From Top Traders Unplugged?”

And I was like, “Wow, really? Yeah.” He’s like, “I love Niels, I love the podcast.” And I was so excited because I was just so not expecting that at the allergist. You’ve got fans everywhere, Niels. It was so cool. I was like, Dr. Boris, thank you. Anyway, so that was my story. It just shows you this podcast is fun. People are learning things about investing. Even my allergist is up to speed with Top Traders Unplugged. That’s kind of cool.

[00:02:14] Niels

I had not expected that, Katy, and I appreciate your sharing. But of course, a massive shout-out to your doctor for being a loyal listener. So maybe, when we can reach such a wide audience, we are making a little bit of progress since it is now the 10th year of us talking about trend following on the podcast. Anyways, that’s kind of the fun part.

A not-so-fun part but a very important part that I also wanted to say is that on this day where we’re recording, we’re actually recording on a Wednesday this week, I literally just read on LinkedIn something from someone that I know, have known for a very long time but don’t speak to her very often.

But Tracy Wills-Zapata, who has been in this industry for as long as I have, just wrote a post sharing that her husband, Al, had been diagnosed with a kind of cancer and that she is doing a wonderful thing to raise money and awareness for what I believe is the Expect Miracles Foundation. She is in fact participating in the Boston Marathon this year.

I just want to give a shout-out to Tracy and Al, wishing them all the best, but also encouraging people to go to the GivenGain website where you can find Tracy’s project. I really encourage everyone to support that.

With that said, there’s some other different stuff we need to talk about before we get into the really nitty gritty stuff because I always ask you what’s been on your radar, and I have a feeling this is a little bit different to the usual topics.

[00:03:58] Katy

Oh, yeah. Actually, Niels and I go way back. We met when I used to live in Sweden. Some people don’t know that I have a Swedish husband and I speak Swedish. One of the things we’ve gotten the amazing opportunity to do is spend New Year’s in Copenhagen. This New Year’s was particularly special.

Those who are maybe not familiar with some of the Danish traditions, but every New Year’s, one sits around and listens to the Queen give a speech to draw forth the exciting things that are going to happen. I’ll tell you, my Danish is quite rocky, I need a lot of subtitles, but I was tuning in and around six o’clock, the Danish Queen abdicated on live television.

It was so exciting, 52 years under reign, and it was a moment where my Danish grandfather would have been smiling down upon me from above. So, Niels, how are your feelings about that? Because that’s kind of an exciting and very rare event that we experienced this New Year’s.

[00:05:03] Niels

I have to agree. It’s a very important tradition actually listening to the Queen every New Year’s. Even for someone like me who hasn’t actually lived in Denmark for almost 30 years, it was a massive shock. The coronation was actually this Sunday, so only like three days ago, and there were something like 300,000 plus people showing up to see this, which is a lot for a relatively small city as Copenhagen is.

But what’s even more crazy, in my opinion, obviously it’s a very personal thing, is that this morning, suddenly out of the blue, the new king, King Frederik, published a book. Now, the book in itself is probably a shock to many people that they managed to keep that under wraps and secret.

But what I also found out is that the person who writes the book with him, and who has written one more book with him a few years ago, actually is my former football coach, which I think what a small world. I did not expect that from the guy who taught me how to play football when I was 10 or 11 years old.

Anyway, quite a lot of personal stuff to lead out with, Katy, which we normally don’t do. But I thought, why not make a little bit of a difference and not just talk about all the finance stuff?

[00:06:24] Katy

Well, you said it’s only once every 900 years that there’s been an abdication. A once in an almost thousand-year event, that’s big.

[00:06:34] Niels

Yeah. Normally, the monarchy only changes when someone dies. Actually, it’s a pretty interesting and actually I think a pretty smart thing for Queen Margaret to do is to change while she’s still alive and can give some, hopefully, tips to the new King. Anyways, we’ll see how it all plays out.

Let’s move on to the usual subjects where we both feel probably more at home, namely trend following. Off to a little bit of a soft start initially in the first few days, then a little bit of a comeback the last few days, and obviously coming off a year which was not the most trending year, to say the least. I’ll ask you a little bit about how you see the beginning of the year but let me just run through some numbers that I wrote down.

The BTOP 50 Index is up 42 basis points, SocGen CTA up 21 basis points, and the SocGen Trend index is up 39 basis points. But the SocGen Short-Term Traders Index is down 51 basis point, which actually ties in quite well with my trend barometer because it has one of the lowest readings that we’re ever going to see at 20 yesterday. Since it is a shorter-term timeframe that I use for that, it kind of ties in well with the shorter-term managers struggling a bit.

Of course, MSCI World also down for the year now, 73 basis points. World Government Bonds, actually, I don’t have the data in front of me here. I think it’s off a little bit this year, and the S&P 500 also off a little bit this year. Anyways, any thoughts on the first couple of weeks of trading so far?

[00:08:15] Katy

Honestly, it’s been very back and forth. There’s just nobody who really has a strong conviction in either direction. If you look at what’s happened since Q4, Q4 was just this massive rally in equities. And then you have a huge consolidation period for trend following where fixed income finally hit its peak and we had the catalyst of the US 10-year at 5%, we had a better CPI number.

So, it’s as if trend has shifted to the soft landing narrative and everybody’s sitting around waiting for the world to land, and we’re not landing yet. So it is really what we’re calling more of a bumpy landing scenario. There’s just not a lot of clear trends yet because everyone’s sitting there looking for cuts that aren’t here yet and just kind of waiting to see if they bought overvalued equities as well. It’s not like there’s no clear signal.

Look at the data last week. The CPI data is against the PPI data, and then there’s just not an obvious answer, and the market is doing that exact thing. It’s saying, “Hmmm.” That’s my view on it. We’ll see.

[00:09:36] Niels

Yeah, for sure. It’s a bit of a mixed bag at the moment, and that’s fine. That’s just how it’s meant to be. Now, in terms of our regular programming, we do encourage people to send in questions and I got a whole bunch of them from Paul.

But because some of them were quite detailed and there are certain things that we probably can’t really talk about on the podcast for regulatory reasons, I decided, Paul, if you’re listening to answer you by email, so you should have had it, except for the fact that there were a couple of things more broadly, some themes that you touched on that Katy and I felt that we could certainly talk a little bit about.

So I’m going to, as usual, prompt you with some ideas, topics to talk about, Katy. The first thing that actually was Paul’s question, and that is how you think of the difference between momentum and trend following. So let’s start out with that.

[00:10:34] Katy

I love that distinction because historically, in the academic literature, originally momentum was synonymous with cross-sectional momentum, which is a phenomenon that’s widely documented since Jegadeesh and Titman in 1993.

Now, the thing that’s interesting about cross-sectional momentum is it’s really about persistence in the cross-section of assets, which means that you’re, in some sense, buying the winners and selling the losers with the ideology that that relative outperformance will persist in time. So that’s what momentum trading has built a lot of literature on.

Trend following, which was often seen with disdain by academics partially because there was maybe not as much good data on futures, they’re trickier, finally made its debut in around 2013 in the papers with the title time series momentum, which means that you’re looking for persistence in the time series so that an asset itself will continue moving in the same direction.

It’s sort of like the original version of momentum, an object in motion continues in motion until it’s stopped. So cross-sectional momentum, which is the more popularized term for momentum, is about the relative outperformance. Time series momentum is about following momentum in individual assets across a basket of assets and building a portfolio in that particular way.

Paul, who asked the question, one of his follow-up questions was really about dual momentum. Gary Antonacci, did I get it right? I’ve met Gary and he’s written a great book about dual momentum. What he’s really talking about is combining both cross-sectional momentum with time series momentum. So you’re really not just looking for the persistence in an individual asset, but you’re also looking at persistence across assets as well.

So there are ways to combine those approaches to incorporate both of those views, and that’s momentum. It’s things moving in the same direction. It’s just a question of the term cross-sectional, or time series, that really matters.

[00:12:55] Niels

Yeah. I think probably for the most part, I would say most of our colleagues would use the absolute momentum trend following type thing. But we also know that some of our friends in the industry are using trend following on a relative basis.

[00:13:11] Katy

Currency is also a lot more cross-sectional.

[00:13:13] Niels

Exactly.

[00:13:16] Katy

It’s a cross-sectional asset, so there’s more cross-sectional signals in currencies applied. The thing is, you need a good cross-section. That’s the point. If you’re going to do cross-sectional momentum in bonds and they’re much more directional, it doesn’t work as well. You might need more diversification across your basket.

If you trade only developed bonds, they’re all pretty correlated, so you don’t have a big cross-section. So you need that cross-section for a cross-sectional signal to make sense and assets to be different enough, but similar.

[00:13:53] Niels

All right. The next thing we wanted to talk about, this was something you brought up as a good thing, is something that you spoke about a number of years ago. You were the first one that I came across talking about it and explaining it in a way that I could understand it. And it is this difference between convergent and divergent strategies, which is quite important even though we spend most of our time just talking about one of them. But actually, it’s very important to understand what both mean.

So I’d love to bring you back a few years to, I think, probably one of many talks you’ve done about this topic, and maybe you can share a little bit about this.

[00:14:37] Katy

I love that topic. Convergent-divergent is something that Mark Rzepczynski, actually, pointed this out to me because he writes articles about it. When I read his article, it’s just this like a light bulb went off. I was like, wow, that’s it. Because we spend a lot of time talking about the mechanics, the how and the what, but we don’t talk a lot about the why, the philosophy, the implicit belief in an investment strategy.

This approach, actually, really distilled what trend following was doing, and what certain strategies in investment were doing down to an ideological approach. The rest is mechanics. So I was really excited about this topic. I did a TED talk in a nuclear reactor in Sweden in 2013 on this topic, which was super fun. It was deactivated, so it’s good.

Looking at before coming to talk to you today, there’s a great podcast I did for the CME Group in 2014. I listened to that podcast again and I got excited all over again. So, maybe we can just do a short synopsis of what convergent-divergent just to give some insights for those of you out there that haven’t seen this approach or thought about this as a way to think about risk-taking in financial markets.

What’s interesting about risk-taking is that it’s not really about one risk. It’s about repetitive choices. Every day, we take risks over time, and it’s how we decide to think about those risks that actually defines whether or not we’re convergent or divergent. When it comes to risk, it really is about three things.

One is our beliefs, second is our perspectives, and third is our past experience. All of those things come together to help us to decide, should I cross that street? Should I not? Should I take this position in Bitcoin? Should I not? Those three things come together to help us to decide how to make a decision.

If we divide the world into two very segregated views, one being convergent, the other being divergent, a convergent risk-taking approach is where you have this view of the world as being stable, somewhat dependable, relying on some symbiosis.

For example, if you think about fixed income, you look at economic data and you say, well, look at the GDP, look at this, look at that, all these things add up, we should have cuts, look at the dots. You have a view that the world is stable and it’s in some sort of equilibrium that you can depend upon.

Now, if you’re a divergent risk taker, you have this view that maybe the world is actually non-dependable, and very random, and stuff happens that you just can’t predict and that are hard. You never really know what the next big breakthrough is. So you need to accept that you don’t know. It’s accepting the unknowable.

So these two views are very, very different. Imagine the person who’s convergent who’s like, oh, there’s a symbiosis, everything’s good, and the divergent person who’s like, hey, anything can happen, where’s the exciting next big thing? So, given a convergent risk taker, let’s think about how they would take risks over time.

When they win, they’re like, “I was right, I told you.” It kind of confirms what they thought was going to happen. But when they lose, they think, “Well, this is coming back,” so they double down. They tend to double down when things go against their beliefs and then they take profits when they think they’re right.

A divergent individual is going to have the exact opposite perspective. When they lose, they’re going to say, I don’t know what’s going to happen next, let’s move on to the next big thing because this obviously isn’t that. When they win, they’re going to say, I found something exciting, let’s keep going. So it’s really a very different view about how you think about risk.

What’s really cool about divergent and convergent is they have very different return profiles. Convergent has lots of small wins, and occasionally when they’re wrong, big negative losses. They just got it wrong. They just assumed that there was going to be cuts and they never came, for example, in the finance way.

Divergent on the other hand is going to have lots of small losses, and occasionally, a really big win when they capture something that they didn’t expect. I’m thinking of the yen trade last year, for example. So what’s really cool about this convert and divergent is you can actually think about that in how you approach different types of risk-taking in life. Not just finance, but things like social networking, things like private equity.

Other things are really about, what is your risk profile? How are you thinking about taking risk? Let’s take the example of social networking, which is one of my favorites. Your convergent risk taker is a person who stays with a close-knit group, doesn’t want to venture out and nurtures those relationships. Your divergent social risk taker is your common social butterfly, your person that makes all these new connections. Yeah, meets all these cool new people and eventually finds the next big deal, etc.

So in hedge fund world and asset management, when we turn these two different risk-taking approaches together, you can see that a strategy like trend following is a very divergent strategy because it’s a strategy where you’re systematically cutting your losses when things are not going in that direction of the trend, and when trends are increasing, you’re following that trend regardless of a belief system but just based on that you’re finding some interesting opportunity.

That’s where this huge issue is, as a trend follower, that people are always asking me. I got this asked on Bloomberg Radio yesterday and you probably hear me bulking on it. They’re like, “How many cuts?” They want a number, and I’m like, “Three? Two? Four?” I’m a trend follower. However many cuts there are, I’m going to follow the price. So, it is hard for me to make a comment like that because I can dissect what’s happening but I do not predict and I don’t have a view of the world.

I have a view that the world is changing and that we are going to follow those trends where they are. So I think what’s really exciting, when I learned about this convergent-divergent approach, and thanks again to Mark for writing some articles on it, it just changed the way that I saw trend following as a strategy, it just made sense.

It’s like it works when the world is divergent. It works when things change in ways we don’t like, don’t expect, and don’t want. But it doesn’t work as well when the world is convergent. And guess what? We’ve gone through a very convergent world last year. We got to peak inflation, we stopped cutting, we’re going back to normal.

[00:21:58] Niels

We stopped raising.

[00:22:00] Katy

Sorry. I messed up. We stopped raising the rate. I’ve been talking about cuts so much. I’m just mixing it up, sorry. In our yearly note, I wrote about this. It’s about a year of consolidation. Consolidation, getting back to normal, finding that soft landing that everybody wants.

In a convergent world, divergent strategies take a lot of losses because they have false starts. In a divergent world, like a situation of what happened in Ukraine, what happened in COVID, what happened during this massive flux of inflation, that’s a very divergent environment.

It’s not fun for people that are used to things working like they used to. In fact, it’s very divergent. So that’s why this is a good review of this topic. I was excited to listen to the podcast from 2014. It’s still relevant today, so that’s good.

[00:22:58] Niels

Indeed. I’ll remind Mark about this when he comes back on the podcast in a few weeks, and that he’s a great source of inspiration on that topic. There are a couple of things that are important, maybe, to just add to this, and that is, I just released today, actually, a conversation with Cem and Dave Dredge. They both come from the vol side of things and it’s a really must listen to conversation, I think, when you get those two together.

But what Dave said, and I’ve heard him say it before and it is really important, it’s usually not what you know that is risky that causes you to go belly up. It’s what you think that is not risky and then you add leverage to it. That’s often what happens in the banking system as we saw in March of last year, for example.

It really speaks to this risk of convergent strategies, or philosophies about what you think for sure is right. Why we, of course from the trend following side, completely admit and adhere to the knowing what you don’t know philosophy.

Now, the next topic, because we wanted to start out with three key concepts to talk a little bit about, so we’ve done the momentum versus trend following, we’ve talked convergent versus divergent. But the next thing that you wanted to talk a little bit about is, and I think this is actually quite important because there is some, I wouldn’t say confusion, but there’s some gray area, and that is what does the term pure trend mean, and in this case mean for you?

[00:24:37] Katy

I love that question because I get it a lot. For me, in the purest form, especially if you read my book with Alex Greyserman, we talk a lot about this, this idea of pure trend. The concept that as a trend is measuring higher, you increase your position, so this concept where conviction links to position sizing.

Now, this is a very abstract concept because depending on how you implement the strategy, you might have certain variations of it that can look a little bit different or may not be linear in terms of their response function. But what to me pure trend is, it’s really about following the price moves and really using the market movements in prices as the pure basis of your position sizing.

What that means, ideologically from a divergent perspective, you’re not adding any of your beliefs, convergent beliefs, into the system. So adding things like a carry signal, adding other strategies, from a philosophical approach is kind of like combining a little bit of convergent views with your divergent view. So a purely divergent strategy will be a pure trend strategy that doesn’t incorporate any more views-based assumptions.

The reason this is important is that, historically, through most crisis periods (and this is why I like that term crisis alpha for example), anytime things are really, really difficult and changing and unpredictable and unknowing, historically throughout time, trend following, pure trend following, is usually the best to react to those changes. Not to predict them, but to react in the wake of those changes.

This is why, oftentimes, investors are interested to understand, are you pure trend or not pure trend, because when those moments occur, when things get challenged, when the convergent views are put to question, that’s often when convergent strategies do not react as well to that type of change. So having a pure trend strategy is usually the first line of defense.

I thought it was so interesting, in 2022 and also COVID, that trend was the only strategy that actually did well during the period of COVID. Why? Because it was following short energy positions and long bond positions moving very drastically. It got hit by equity moves, but there were such strong trends that were in the market moves that really were able to be captured by trend and, really, no other hedge fund strategy was able to waver except for even vol, I think. I think vol did okay, but not in 2020.

[00:27:27] Niels

Well, it did okay in March of 2020, for sure, but it very much depended on when you monetized your positions, I think, in the vol space.

[00:27:35] Katy

Yeah. I think that, for me, a pure trend is somebody who’s willing to have that divergent approach and trying to stay consistent with that. That’s the type of strategy that reacts the best, generally, during a period of dislocation. Whether it’s an equity crisis or a bond crisis or a geopolitical crisis or an inflation crisis, it’s about really following the price moves as the market figures out what the new direction is.

[00:28:01] Niels

I’m going to put you a little bit on the spot here because I know that some of our really good friends in the trend following space, who are listening to this conversation, will be upset with me if I didn’t bring up this point. We’re only a few days into 2024 and it is one of those topics that will never die. So here’s the thing. I completely agree with you.

If you don’t contaminate your signal, you can be a pure trend follower. But then the “classic trend followers” will then argue, well, hang on, what about the risk management? If you start using some kind of measure of correlations or measure of volatility as the trade takes off, you may adjust your positions up or down during that trend.

In their opinion, you’re not pure trend, but in my opinion, you probably still are pure trend. But I’m more interested in your opinion.

[00:29:00] Katy

I love these types of questions because there is a lot of nuance. I think when it comes down to your risk management process and how much risk you take over time, because we just talked about this with divergent, for me, risk management has the ability to unravel pure trend following behavior. It doesn’t happen all the time, but it’s always a way that you have to manage your process.

But let me just give an example of one that I really find surprising that some people do, and that’s constant risk targeting. Constant risk targeting means that you take your trend signal and you always take 10% vol, for example, and you target to the 10% vol. The challenge with this, what I find with that, is that when your signals are high, guess what? You dial them down.

When the signals are low, you dial them up and you’ve actually added a convergent risk-taking approach into your approach which basically is converging back to the average signal. It turns out, over long time horizons, they do relatively similar in their backtests, but during extreme environments, they have very different profiles. So that is right.

The question that you’re getting is one of those idiosyncratic, detail-oriented things that we have to think about as trend followers when we build our systems. How do we creep in any convergent behavior based on things like measuring correlations or targeting risk to a certain amount? How do we balance between those assumptions or not and remain as agnostic as we can if we’re pure trend followers?

[00:30:39] Niels

I think that’s true. I would agree with that. However, I think that, in all of this detail, I think sometimes it is not fully appreciated that, I don’t believe that many firms will target a specific volatility of the program. I think some do, I don’t think a lot.

But I do think a lot of managers will have some kind of risk framework that they, I wouldn’t say target, but that they want to stay within and where the positions will still be dynamic, but it doesn’t mean that you can’t capture the big outliers.

So I think that, maybe, there are three categories; people who don’t change their positions whatsoever, and then there are these two groups that may change their positions over time, but one is more, as you said, prone to introducing convergent type risk-taking, while the other one is, in my opinion, as divergent as the classic guys. It’s just a different approach.

Anyway, we’ll get a lot of comments in social media on this, Katy, so we can continue the conversation no doubt.

[00:31:50] Katy

The only one thing I would say is that there’s also prudent risk management, which is really thinking about you don’t want a huge position in Italian bonds, for example, but maybe you want a reasonable-sized position in Italian bonds relative to the others. So, there’s a difference between your risk posture, which is what I would call it, and adjusting risk aggressively. There’s a whole spectrum.

I think you put it very well. There’s the much more extreme less risk management than there is having a consistent risk posture where you understand exactly how much risk you have, say, in each asset class. You’re kind of setting guardrails on the position sizing, which is really about diversification of the portfolio more than trying to limit too much those positions.

Then there’s more extreme constant risk targeting that I was just explaining where your risk management strategy could actually incorporate some convergence.

[00:32:50] Niels

Yeah, I completely agree with that.

All right. The next thing we wanted to do today was to review a few themes from 2023. Obviously, when I say we, I use the royal we because it really means you. I am curious to learn a little bit more about your observations. I know you’re working on one of your brilliant papers coming out soon, which is probably a review of 2023 perhaps.

So talk about that, talk about what are the things you found in preparing this paper, and yeah, go wherever you want to go.

[00:33:25] Katy

Looking back over 2023, it was a very challenging year in many ways. But what’s interesting and most people don’t know is that the impact of rare events was spectacularly large, particularly the SVB regional banking crisis. But second of all, we are still seeing the residual end of that inflation trade dissipating into new themes.

We still also saw a short bond positioning be profitable for parts of the year, against the common norms, only to consolidate in Q4. But in the middle of the year, you really saw that short bond trade still having legs until October. I think it was October 15th or something when the 10-year hit 5%, something like this.

We highlighted a couple of interesting facts. I think the things that always stick out to me are the statistical, empirical properties that we see in markets. First of all, fixed income volatility is up 50%, still, from stationary levels prior to 2020. What’s interesting to me is everyone’s saying, okay, everything’s going to go back to normal, everything’s fine. And I’m like, the stats are not there for you yet. Bond vol is still high, still very high.

Secondly, stock-bond vol correlations have also continued to be positive. So we’re still in a very different regime for fixed income than we were during the Great Moderation and pre-COVID. So to me, as somebody who cares about the data and the empirics, I haven’t seen evidence that we’re back to the Great Moderation yet.

I think we are just waiting to see what the next leg of the fixed-income trade and the next leg of this particular interesting period of history plays out to be. So for us, that’s really some sign that even in the data, in the short-term data, that things haven’t changed back to normal yet for us.

[00:35:38] Niels

I couldn’t agree more, for sure. What’s actually quite interesting is that I was looking at some sector attributions on our side, comparing 2022 to 2023. Of course, most people know that 2022 was an incredibly strong year both for the long bond sector but also for the short rates sector. Actually, looking at it, there was very little giveback. Maybe one of them was actually positive even in 2023.

So I think that’s quite remarkable for the strategy to have been able to ride through a couple of, as you say, some really abrupt reversals both in March and October/November time but still doing okay when the year was over. There were lots of other things that were challenging.

[00:36:34] Katy

Well, Niels, two things we wanted to point out there is that we showed in this paper, March 10th and March 13th were the 2nd and 11th worst days in the SG trend index since inception. It turned out, and we looked at the number of positive and negative days by asset class, each asset class had more than 50% positive days on the year for trend.

But on average, that Trend Index was down, and this is because if you take out those two days from 2023, it actually flips performance for the index from negative to positive, which is kind of like, amazingly, we talked about negative skew, those were difficult days for cross asset sell offs, and that they came very quickly.

You talked about drawdowns. For me, what was interesting about the fixed income drawdowns is they were not slow. They were very long trends with big fall off. Fixed income is tricky. It’s an asset that we’re not used to dealing with on the short side and it gave us some reminders of why the short side is a very particularly interesting side to be on in fixed income.

[00:37:48] Niels

Yeah. I think we might talk about that a little bit later today from one of the other papers. One thing I can add to the conversation here is that on our side, once a year, we run the generic trend portfolio as most managers do, not something that is exactly what we do in our real client portfolios, something pretty close.

We do a simple exercise where we want to see how different lookback periods performed. We started doing this. We go back to the year 2000 where the SocGen Trend Index started. Actually, I will say 2023 looks completely different to all of the other years, where normally you find a cloud of reasonably good, we do it by Sharpe, but reasonably good Sharpe ratios once you get past 100-day lookback.

Last year, it was all red. Nothing worked in this portfolio with the markets we trade once you get past 100 days. There was a very little bit of shorter-term timeframes, I should say, that posted something that probably could be a little bit of a positive year. It just looked so different. So I agree with you.

I don’t know how you looked at the year, but I agree with you, it is a very outlier year, even though the performance, yeah, okay, there was a bit of dispersion between managers; plus-minus 10% or so depending on vol. But overall, the Trend Index was down 4% after having made 28% the year before, so nothing concerning. But then when you look at the details a bit, it’s whoa, this is different.

[00:39:31] Katy

Yeah, it’s interesting that you say that because our CIO, Alex Healy, he was showing me this interesting graph the other day where he looked at correlation across window performance, and it was the lowest in history last year. What that suggests to me is that there was just a lot of consolidation, a lot of turbulence.

It wasn’t an easy year to be following trend signals particularly because of the reversals in Q1 and Q4. But ironically, Q2 and Q3 were quite positive trending environments and, on average, positive days were more than 50% in all asset classes, which to me is kind of a strange combo. So it was a weird year.

[00:40:17] Niels

Yeah. And the recovery from the SVB event was pretty strong. We’ll see. I think probably we may have started the recovery from (I always refer to it) that CPI number in November that just seems to have changed everything even though it was a very suspicious number that we got. But anyways, we’ll see how the recovery goes into 2024.

Anything else you want to add to this or do you want to jump into the fixed income paper that you listed?

[00:40:48] Katy

Another thing I was thinking about at the end of this year, and it’s also in this paper, is drawdown recovery. This was interesting. Anybody can do this analysis, it’s not hard. Basically, take the SG Trend Index, and if you look at the rolling one-year past return and the rolling one forward year return, and you look at averages over different values, so minus 10% to minus 15% is one of the worst periods for the SG Trend Index, plus 30%, plus 20% are some of the good years for trend on a rolling window basis.

If you look at returns, which is not surprising if you think about the philosophy of the strategy, when you’re at the 25% to 30% something range, the average return is much lower than average. So once you’ve caught that trend, some of the persistence on average typically has gotten into the price, perhaps only so far that prices can move.

But on the other hand, when we’ve been in a drawdown, particularly larger drawdowns, we tend to on average have slightly higher than average performance. So it really fits with this idea of waiting for the next big move. That’s how trend is. It’s cutting your losses, cutting your losses until you have a really big divergent change in markets.

So I think that’s what we’re looking for this year is what is the next catalyst, what’s the next big move after a year where you saw consolidation in trends. So I think for us, we don’t suggest, I never suggest timing in managed futures strategies. But there is some humbleness in understanding when you’ve had a 35% year like that’s pretty good.

So it’s really thinking about, or a 25% year, you’ve caught that big divergent trend and there is always usually a period of consolidation ex-post. That’s kind of what Q4 felt like and Q1 last year. So upwards and onwards, right, Niels?

[00:42:48] Niels

Absolutely. Actually, on that note, Mike Melissinos, who works with Jerry, he wrote a nice little LinkedIn post where he looked at, and this is from memory, I think he looked at rolling 12-month periods for the Barclay CTA index. Once it had been down on a rolling one-year period, which had ended, I think, or thereabouts in the last month or so. And then he looked at the following 12-months return or something like that. Anyways, it paints an interesting picture without a doubt. So nice of him to share that.

All right. Let’s move on to the fixed income paper, which I think originally actually thought we were going to talk mostly about, but then all these other great topics came up. But let’s give it a go.

[00:43:36] Katy

We wrote another paper just talking about it was such a huge trend, short fixed income. It was nine quarters of net short signals for trend following in fixed income, and that’s one of the longest runs of short positioning in trend for 20-plus years. So, it was a big short position. What was interesting to that is that if you look at the yield curve and what’s happened, we’re also highlighting that there’s three phases to the fixed income trade.

The first is the inversion, the beginning of the rising rates cycle. The second phase, empirically, is that flattening of the yield curve. Finally, there’s destabilization or the steepening of the yield curve. What was interesting about the original paper that we wrote about this, trend tends to be short, and the inversion does well when things flatten out. It tends to be more likely to be short, but it doesn’t tend to do as well. So it’s a little more mixed, which sounds a little bit like last year.

Finally, when you get into the steepening of the yield curve, you’re going to tend to see long signals and you’re going to see trend being more likely to be long in a steepened yield curve or a normalized yield curve environment. What’s interesting, those are empirical studies connected to our experience over the last three years.

What’s interesting looking at 40 or 50 years of data, we’re seeing the same type of patterns in trends signals, in terms of how they behave today, then we saw over the last 40-year period. So what we were saying, really, in this paper is that we’re starting to see- we’ve seen trend signals shift to long and we’re waiting for that stabilization of the yield curve this year.

You’re probably going to see that story of us being long again more likely than short more often, like it has been for some period of time. At least if empirical patterns persist, then we have something similar to history. It’s just very interesting.

[00:45:42] Niels

Not to get you out of your groove here, but I just want to maybe add one thing, and that is, of course, every time we look at data going back 40 thereabout years, we do know we are looking at an environment that, generally speaking, was a one-way street. So, again, just to emphasize the fact that we don’t forecast anything. If interest rates turn around and start going up again, we’ll just follow that as it comes.

[00:46:11] Katy

In this paper, we actually looked at interest rates going back to the ’60s, and we needed to because we needed to have that very different behavior. A lot of people don’t understand as well, if you look at the ’70s for fixed income, there’s two things that are true. Number one, volatility is higher in bonds, and number two, stock-bond correlation is positive. And guess what? We’re actually there.

There’s some rhyming. I’m not saying we’re in the same scenario, but I’m saying that this is not a weird phenomenon that could be transitory, to use a popular term. It could be a period where we have that higher bond vol for longer. That was one of the things that we pointed out in the end of last year. One one of the jokes I made in 2022 was I said, people realize that bonds have downside volatility.

And then I said, oh, now people realize that bonds are actually risky. So the vol has actually increased quite a bit in bonds and the swings on a daily basis are much higher than they’ve been in so long as well. So, for me, it’s really that this asset class has gone into a new regime, and the next phase of that, if we look empirically, is probably a stabilization, which means we’re likely to be long instead of short, even though the short trade was exciting for nine quarters. But we’re finally in a different phase, it seems like.

[00:47:42] Niels

I don’t know if you remember this, but clearly, there are two things that drive our signals. One is the actual movement of the spot price. The other is the roll yield, so the curve. I don’t know if you remember, but back in the ’60s, I’ve never looked at that, but back in the ’60s and maybe early ’70s, how would trend followers generally be positioned during that? Because I have no idea what the curve looked like back then.

[00:48:08] Katy

This is a good point. Actually, we’ve looked at this. It’s generally not good to be short fixed income because of the roll yield, and because of the negative carry associated with it unless spot prices move drastically. That’s what happened. Look at bond prices. They moved so much. Who cares about the roll yield?

So I think that’s the point. In history, if you look at the roll yield, it’s like a headwind. It makes you a little bit less likely to be short in fixed income. But if NPV values or values of bonds are dropping drastically, the trade-off there is clear. If bond prices move enough, the roll yield doesn’t matter.

That’s what you see in the historical data is that there’s always that negative carry, that negative yield, because selling bonds means that you have to provide the coupon. But if bonds are just crashing, the NPV change is much, much bigger than that of that negative yield. That’s what you see when the yield curve is inverted. That type of opportunity far outweighs the negative carry.

The magnitude is what you have to look at because ideologically, it seems like why would you ever want to short something that has positive coupons. But you would if it’s really plummeting in value, and that’s really those environments where you have an inverted yield curve where bonds are selling off drastically where you would still want to be short.

[00:49:35] Niels

Yeah. By the way, you mentioned earlier the correlation between stocks and bonds, which I think a lot of people, certainly if they came into finance around the year 2000, thought that’s always going to be negative. It’s the perfect match in risk parity obviously. It’s not a coincidence that that got invented in 2003 or thereabouts by Bridgewater.

But actually, I don’t know if it’s from your paper, but I’ve seen other papers or charts where once you do a rolling correlation, three-year correlation, it has been positive for a very long time. It really is those two decades, from 2000 to 2019, that stick out as being the really odd ones out.

So I think investors need to go and just have a rethink of that side of things in their portfolio, whether they’re really getting the comfort level from a “60/40” type allocation that they expect in this new environment.

[00:50:27] Katy

Well, think about it. Where does that negative stock-bond correlation come from? People think when stocks are down, bonds are safe. If bonds are riskier, are they that safe? If your government has tons of them, and a surplus of them, and there’s way too much debt, is it as safe as you think it was? I don’t know. Maybe that’s part of the underlying problem.

In those moments of crisis, it still has been a flight to safety trade, and that’s what happened in Q1 last year with the SVB event. But on a regular basis, bonds are clocking in with much higher vol.

[00:51:04] Niels

It was pretty short-lived because bonds went on to make new lows after the SVB event. So yeah, it does tell you something.

Now, in the interest of time, I just wanted to make sure we cover some of the other things you had. Did you have more thoughts you wanted to share on the fixed income paper? Do you want to move on to, you did some media work last week, you have some general views maybe you want to share.

Of course, both of us and Alan, I think actually will be in Miami in a couple of weeks. So if anyone wants to come and say hi, maybe we should find a little place to have a coffee.

[00:51:39] Katy

Sounds good. Sounds good. One of the things that’s interesting with being a trend follower, it’s so hard sometimes, because people will always ask me, what do you think is going to happen this year? That’s going to be a very discretionary question. But when you look at the markets on a regular basis and you’re following a trend signal, you’re always trying to distill, what does your positioning mean?

So that’s why I always find it interesting to answer those questions, because sometimes, I either disagree or sometimes I am conflicted on what the market is actually telling me right now. Right now, looking at the market going forward, some of the key things that we think, we always tend to think that people underestimate and are overly optimistic. Well, that’s a very convergent view.

So for example that they’re way more excited about the cuts this year and that they’re going to happen fast. My view is if they happen fast, it’s because something bad happened, and I don’t think that’s good. So my general view, and talking with how we think about things, is that there is definitely a lot more volatility on inflation and on growth this year that is going to create a much wider range of outcomes than people actually are anticipating.

So I’m calling it a bumpy landing as opposed to a soft landing or a hard landing. Because soft landing is like when you go to the airport and just glide right in, and a hard landing is, and this happened to me once when I was going to Florida. I remember there was a hailstorm. That’s a hard landing.

But the truth is, when you go flying, it’s usually somewhere in between. You hit some turbulence. So I think we’re in for that. We’re going to have these swings of over-optimism, under-optimism, and back and forth this year as we try to figure out are we actually in a new regime or is everything going back to the Great Moderation and no problems. I’m a little skeptical on that.

[00:53:49] Niels

Your little aviation analogy reminds me of a flight I had only a few months ago. It was so bumpy that we had to do a go-around. He simply couldn’t get the plane down on the runway. So I’m not sure what we call that. It was both bumpy and with a go-around. Maybe that’s actually what we will have.

We’ll realize that maybe inflation is coming back, and we need to do a little bit more work before we can have this return to more calm waters. Time will tell. Anything else, Katy, that you want to talk about today?

[00:54:26] Katy

Our view on this year is that we’re in a period of drawdown recovery, it’s been a period of consolidation, and we’re, in some sense, waiting for the next big signal and the data is not telling us anything clear yet.

[00:54:40] Niels

What about commodities, by the way? A lot of smart people have been calling for the next big bull market in commodities. It’s not quite playing out that way, but that’s not to say that it couldn’t happen.

[00:54:53] Katy

No, it hasn’t come yet. It hasn’t come yet. Trend signals, on average, are short in commodities still, but there has been this tug of war between geopolitical tensions and demand dissipation in the energy sector. My view is that we should watch the commodities because if they start popping back up again, it could give you an idea of a cycle starting again.

That’s kind of what generally happens is commodities go first, filters through the system. I’ve been watching them. They’ve been hard to trade. They’ve been very bumpy.

[00:]55:31 Niels

Well, they’ve been hard to trade some of them, and then a few others, like the grains, have actually been reasonably well behaved to the short side. But of course, surprisingly, to the short side maybe for some. But yeah, time will tell.

It’s interesting, but it’s also what makes it so valuable to have the opportunity set to go wherever the trends occur, meaning we’re not stuck in a small sandbox where we can only play in financial markets, so to speak.

[00:56:00] Katy

I think time is going to tell. That’s why January is exciting because anything can happen. It’s a new year, new king for Denmark.

[00:56:10] Niels

New king for sure, absolutely.

Okay, good stuff. I think this is a good place to wrap it up. I will, just before I leave again, just give a shout-out to the conversation I just published today, literally, because it is also related to what Katy and I have been talking about today, namely, the year 2024.

Both Cem and Dave had some interesting observations and actually quite relevant also for the topic of whether or not you should have trend following in a portfolio when you think about some of the things they were talking about.

If you liked this conversation, as I always ask people for, please go and support the podcast by leaving a rating and review on Apple, Spotify, wherever you go and listen to your podcast, of course. We certainly appreciate that. And of course, also sharing it with your own followers, colleagues, family, whoever you think might enjoy and benefit from this content.

Next week, I’ll be joined by Alan. It’s your chance to ask him some questions maybe about allocations overall. Obviously, that’s really what he’s been doing for a big chunk of his career. If you have a question, you can email them to info@toptradersunplugged.com.

As mentioned, maybe Katy and I will see some of you in Miami in a couple of weeks at the MFA conference. We’ll certainly try and hook up with Alan because he’s also going to be there, and that could be fun.

So 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.

[00:57:52] 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.

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