Should You Just Buy a CTA Index? ft. Rob Carver

[00:00:00] Intro]

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

[00:00:25] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor Series with Rob Carver and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor. Rob, great to be back with you this week. How are you doing? How was your summer?

[00:00:40] Rob

Yeah, it was really good. I took one of these long European holidays that Americans are so jealous of. So, I’ve been kind of off, mostly off since mid-July, but with, you know, doing odd days since.

I’ve done some traveling, had some sunshine, had some rain, a bit of everything really. So yeah, a very pleasant break. And I think you know when you’ve had a good break, when you’re really struggling to motivate yourself to do anything when you get back. So that’s where I am in the moment.

[00:01:05] Niels

Although I will say, I think most Europeans would also be envious of your long holidays, because I’m not sure we all get that kind of holiday.

[00:01:14] Rob

My location is European plus.

[00:01:16] Niels

You combine it. Yeah, fine. Okay, good.

Well, you know, we’ve got quite a few questions that came in while you were away. We’ve got kind of a variety of topics we want to discuss today, which are maybe not the usual ones. And then also, as we always like to do, is to talk a little bit about what’s kind of been on your radar, what’s caught your attention outside what we’re talking about today. Yeah, and I normally say since we last spoke, but it’s been so long, so I’m sure it’s more recent than since we last spoke.

[00:01:50] Rob

Yeah, I mean, I guess most people in the industry have had a pretty torrid few months in terms of performance. So, I kind of had a high watermark in late May or April, I think it was. And yeah, the last few months have not been very good.

So, I’m kind of flat for the year in terms of my own performance and in terms of my current risk, which I think is probably more meaningful than looking at what’s gone on in the past in case people are interested. So, I’m currently long equities, long bonds and short some sort of gas and agricultural markets. So perhaps I’ve kind of got almost like a risk parity portfolio, I suppose, if I’m long equities and bonds. That’s a portfolio that’s kind of positioned for a particular kind of macroeconomic outlook. So, we’ll see how it goes.

[00:02:40] Niels

We’ll see how that goes.

[00:02:41] Rob

As I say, also running quite low risk at the moment, which is what you’d expect in the middle of a drawdown that models struggling to find strong forecasts in a lot of markets. So, running at quite low risk.

[00:02:50] Niels

Yeah. Now you could have chosen any topic that might have been on your radar. You chose to talk about your own performance.

And my follow up question to that is, I know when you go away, you let your systems run. And to me and many, maybe to other people, that sounds like a scary endeavor just to let it run and do the trades and all of that. I’m sure you get reports along the way.

But July and August were interesting months, generally speaking. I mean, there were some pretty huge moves. Did you feel differently this year leaving the systems on or have you now built so much confidence having done it for many summers, so to speak, that actually this was no different to any other summer?

[00:03:39] Rob

Yeah. I mean, you know, I’ve gone away in the summer and had really good months and come back. And although I do get reports sent to me by email to me, to be honest, I don’t really look at them.

The fact that I’m getting the reports means my system’s working. So, I kind of relax, really. And also, because there’s not really anything I could do if something was going wrong apart from, I guess, manually log on to my futures account and close all my positions because my server’s not a cloud server. So, it’s running on a home machine. And although I probably could think of a way to do some kind of remote access, I’ve never really got around to it.

And so yeah, I guess I’m kind of, I have enough trust in it. I mean, it helps that it’s my code. I’ve written it. It’s my trading strategy. I understand everything that’s going into it, I think, and it’s my money. It’s my choice what I do with my money, right? So, it’s not like I’ve got other people’s money and I’d have a fiduciary duty to kind of look after it properly.

And I guess most people would be quite upset if they gave me some money and then went on holiday for a couple of weeks and just left the system running. So, so yeah, I mean, I’ll be honest with you. I don’t like losing money. I don’t think people do. I don’t like being in a drawdown. I don’t think most people do.

This drawdown is probably about as equal as the worst drawdown I’ve had before since trading the last 10 years. So, it’s like, you know, it’s not ideal, but it’s probably easier, in some ways, to kind of leave your system alone if you’re not there, right? So, the big temptation, when you’re losing money, is to change your system and change your strategy and fiddle with things and think, oh, have I missed something?

That’s obviously quite a lot harder to do when you’re sending yourself to the South of France as I was. So yeah, it’s one of those things. I do find that the longer I’m doing this, the less and less attention I pay to kind of day-to-day market noise, to be honest, unless it kind of reaches the main headline news.

So, when I was on holiday and somebody said to me, “Have you heard about Bayesian?” I’m like, well, yes, it’s one of my favorite methods of statistical methodology. I sort of started talking and they kind of looked at me like I was mad. They’re like, “No, no, the yacht Bayesian,” which of course, as everyone knows is this super yacht that belonged to Mike Lynch, who’s a founder of Autonomy, that sank in this freak storm in Italy.

So that was like the only time I even had any conversation that was even tangentially related to what I do for a living, and that was about the Bayesian. So, I’ve actually had to explain to quite a lot of people what Bayesian actually is now, because quite a few people are curious as to what actually is Bayesian, what does it involve?

Weirdly, actually and coincidentally, yesterday I was actually walking past the graveyard of George Bayes. He’s buried in, in the city of London, in a graveyard, and I was actually walking through it.

I thought, ah, there he is the man himself. So, if any listeners want to hear more about Bayesian statistics rather than Bayesian yachts, obviously I’m an expert on both because I’m a sailor. So, the sinking of the Bayesian kind of ties into two of my key interests.

So, yeah, that’s the only kind of sort of significant news that filtered through to me. I mean, this may sound crazy, but we had a bit of political instability in this country and there were actually riots in the street across the whole country.

And I didn’t know there were actually riots in my hometown where I lived until someone told me. I didn’t know it was going on. So that’s how detached and disengaged I can get from the news that’s going on when I’m on holiday.

But even when I’m not on holiday, I kind of glance at the headlines in the FT and read bits of pieces, but I couldn’t tell you, you know, I only know, for example, that the US yield curve has just disinverted.

So, 10 year yields, now, are above two year yields, which is the kind of “the correct way around” because somebody sent me a message about it. Otherwise, I would have had no idea that happened.

I like to think of myself as a very kind of purist sort of purely systematic person, and I’m trying to achieve that goal and I’m not quite there cause I do still worry and think about losing money and about maybe I should change my system and so on and so forth. But I’ve got quite good at detaching myself completely from what’s going on and just letting it run.

[00:07:56] Niels

I think a really important point in what you just said, for our listeners, is actually the level of dispassionate view on systematic trading you’ve achieved, and I think that only comes with experience. I actually also think that a lot of people, when they hear the fact that you can really kind of log off, so to speak, for a while, I think that’s in definitely short supply and a lot more people should do it, probably myself included. It would be much better for our mental state if we could take these true breaks. So yeah, I appreciate you sharing that.

[00:08:39] Rob

Yeah. And one thing to say, actually, is that I think it is experience, with me, because I don’t think I’m one of these people who naturally could do that. So, I think that some of the best discretionary traders are those who are able to look at markets very dispassionately without any emotion, and really detached themselves. I have kind of analyze what’s going on and I can’t do that.

I do, certainly, when I was trading more discretionary way, used to get very emotionally involved with what was going on. I think that’s why systematic trading suits me, and probably most people out there, better than discretionary. I think the natural ability to kind of withdraw yourself from the market, especially if you’re not trading in an automated way, it’s extremely hard to achieve.

[00:09:19] Niels

Yeah, absolutely. My thought of what’s been on my radar is not nearly as interesting as yours because I was thinking about the US and unemployment data that’s coming out in about an hour or so from when we are recording. The reason I was thinking about that, and why it came up to my attention, is really that I think today’s number might really be the one that will set kind of the trajectory for the rest of the year for the Fed. So, in that sense it’s important.

Interesting to note that a lot of the economic data that we had, leading into April of this year, was giving them reasons to keep rates where they were.

And then, since April, unemployment numbers have been a bit soft and now everybody’s speculating in terms of how much they will do. And that number seems to change a lot. I think it might change again today. We’ll see.

I wouldn’t be surprised if they just do 25 basis points at each of the next three meetings or whatever they have left. That would be not surprising in the market. So, we’ll see, we’ll see how it all pans out.

Oh yeah, and by the way, the other thing I thought of is that I think that maybe next week we have the first debate between Harris and Trump. That might also be quite interesting.

[00:10:37] Rob

I thought you and I agreed there was no politics in this. No, I just said it’s a debate coming.

[00:10:41] Niels

No, I just said it’s a debate coming. I didn’t say one way or the other.

[00:10:43] Rob

You’re not expressing your preference. Okay, fine.

[00:10:46] Niels

Okay. Good stuff. All right.

Before we dive into the questions and the topics, just the latest update from trend following. We know how you fared. You can expand on it in terms of what you think is going on.

From my point of view, the first week of September was obviously a lot more quiet than the first week of August for sure. So far, I think the major themes has been that equities are down in price, but they’re also hurting trend followers whilst heading south. Bonds are up and most likely that’s going to be helping trend followers at the moment. And then maybe one of the sectors that is becoming kind of meaningful, in terms of exposure for many trend followers, would be the grains. They’ve corrected upwards for the last few days. And that’s probably not to the liking of trend followers who on sort of a downtrend at the moment, position wise.

The other thing I thought of, and maybe you’ve seen the same in your system (and I don’t recall exactly how you do it), but I do think August may have been a month that tricked a lot of risk reduction, overall, in CTA portfolios, not least because some markets and some of the bigger sectors flipped direction and that leads to changes in correlations, and went from a risk management point of view. So, I think that could also have been an interesting outcome from the month itself. Does that kind of sound reasonable, in your mind, looking at how you’re doing?

[00:12:16] Rob

Yeah. I mean, as I said, you basically reduce risk for two reasons. One reason being that you’ve got the trends that turn against you. Actually, three reasons, apologies. One reason is the trends that are turning against you. And that might be because you’ve got a continuous forecast, like me, or a stop loss system – a more traditional system. The second reason why is that you’d reduce risk if volatility increases. Again, this only applies to people trading in the way that I trade. But if volatility spikes, you’d reduce your positions. And the third reason is hell, you’re just losing money.

So, all the things being equal, you know, if you lose 10% of your equity, and some people do close trade equity, some people do open trade equity, but if you lose 10% of your account value, then you should reduce your positions by 10%, even if nothing else has changed.

So, I guess in August we’d have seen all three of those things coming together. So yeah, I would have expected to see risk reduction and certainly that’s what I’ve seen on my system.

[00:13:11] Niels

Okay, cool. All right. Well, from my point of view, my trend barometer, which by the way, is back online on the website, for those who’ve missed it. It finished at 50 yesterday. So that’s actually a pretty good number. So maybe, Rob, it’s time to consider buying the dip of your drawdown. You never know, but it is actually a good number. I think yesterday was a little of an up day for CTAs.

As of Wednesday, BTOP50, for the month of September now, down a quarter percent, up two and a half-ish for the year. SocGen Trend index down 35 basis points in September, up just shy of 1% for the year. SocGen Trend down 34 basis points (very similar) and also up about 1% for the year. And the Short-Term Traders index, obviously enjoying maybe a little bit better conditions, up 64 basis points and up 10 basis points for the year.

In contrast, the traditional markets, MSCI world down 2.56% for the month of September, as of yesterday, up 12.57% for the year. The S&P Global Development Sovereign Bond index (it’s such a long title) is up 78 basis points down 2.2% for the year. And the S&P 500 Total Return down 2.57% and up 15.38% so far this year.

All right, before we get into the topics, we have a few questions. Some of them are quite long, so I hope I don’t butcher them up too much.

The first one is from Luis. Luis says, “Thank you for sharing your knowledge, experience, and developments for the community. You are a great inspiration to all of us.” That must be you he’s talking about here, Rob. “I have a question regarding the paper series, A Half Century Of Macro Momentum From AQR. I attempted to implement the various macro momentum signals, described in the paper, using Rob’s methodology. This involved creating different forecasts for macro factors like growth, inflation, monetary policy, risk sentiment, and international trade.

I applied these forecasts to all the futures markets I trade, about a hundred markets, and obtained results comparable to those published in the paper. However, I was very disappointed when I ran the backtest of the price trend, plus carry, plus macro momentum strategy and found that the total Sharpe ratio was worse than the original system with just price trend plus carry. The system is much more complex and depends on data that is difficult for a retailer to obtain, yet it has a lower Sharpe ratio, although it’s probably a more robust system (he writes). I was wondering if you had tried to implement something similar in your system. What are your thoughts on macro momentum for retail traders? What would you do in my position?”

So, of course, I’ll pass it on to you, Rob, but just want to add that, of course, Luis, it’s not going to be investment advice Rob is going to talk about, but he’s going to try and answer your question, nevertheless.

[00:16:10] Rob

Rob never gives investment advice because Rob is not qualified or certified or regulated to do this. So, it’s best to always be very clear.

So macro momentum is a very interesting idea, and I have a lot of sympathy with the sort of underlying theory behind it, which essentially is that there are a bunch of latent factors in the world that you can’t see. And when we do momentum, what we’re doing really is doing momentum on individual markets that are, sort of effectively what we can see of those latent factors.

The factors are invisible. We can’t see them directly. We can’t observe them directly, but they form trends and by trend following individual markets we can kind of get that to work. One thing that supports that theory is that if you do a momentum, just at an asset class level (so you, you kind of put all the bonds together, all the equities together, and you form a kind of synthetic index), you find that actually captures about 80% to 85% of the PNL of trading the individual markets. The rest is, effectively, like a relative momentum across markets. So that kind of supports that idea.

So, the AQR theory is that the macro factors are a more to a true version of these underlying factors, or maybe just an alternative set. We could trend follow those instead.

So, it’s a nice idea, but obviously it’s a lot more work. I’ve not implemented this specific system, but in my olden days at AHL I did implement a global microsystem. So, I have experience of collecting macro data and analyzing it. And it’s obviously more expensive and time consuming, and there are issues with it, which we won’t go into today.

But I think the best way of addressing this question is in a very abstract sense, which is to say the following. I’ve implemented system A, which has got a good Sharpe ratio in backtest, but when I add it to another system B, the Sharpe ratio drops from 1.3 to 1.2. Should I add system A? That’s basically how we can summarize this question without getting into, you know, macro momentum or the details behind it.

Now, the answer is that, well, it depends on a few different things. So, why would a Sharpe ratio fall when I add something onto in the system? Well, it’s probably because it’s got a lower Sharpe ratio than the thing you’re starting with, but the diversification benefits of adding it are not sufficiently high to overcome that.

Okay. So, you can boost Sharpe ratio in two different ways: by adding something that has a higher Sharpe ratio than the original portfolio or something that has a lower Sharpe ratio but has got a lot of very low correlation or even negative correlation. And that will bump up the Sharpe ratio.

My suspicion is that macro momentum is quite correlated with price trend – sort of what we do. As I said, I think they’re based on the same underlying idea, which is these latent factors. I don’t know what the correlation is off the top of my head, but I’m guessing it’s not like zero or, probably, adding this strategy and would have improved the Sharpe ratio. That would be my guess.

Sort of in general terms, a Sharpe ratio fall from 1.3 to 1.2 isn’t necessarily a deal breaker because that’s not a big amount. So, in general terms, when I’m adding stuff to my system, I don’t look too closely at the Sharpe ratio. I look more at the correlation. I look more at whether it’s adding something different to my system.

So, my prior would be that macro momentum is probably a bit different from normal momentum and worth putting into my system a bit – not 80% or something, but a bit. I wouldn’t necessarily look just at the Sharpe ratio to sort of determine that because (getting into statistics for a second) Sharpe ratios are a lot more variable and harder to forecast. And I’ve got a lot more dispersion in backtests than, say, correlations, which are more stable.

So, look at the correlation. The correlation between these two things was, was like 0.4, then yeah, I’d probably add a bit. I’d probably think that’s worth adding 5%, 10% to this, even if it does reduce the backtest Sharpe ratio, because I’ve kind of got more faith in the correlation and the diversification power than necessarily the Sharpe ratio being a bit higher or lower.

If, on the other hand, the correlation is like 0.8, 0.9 between say macro momentum and price momentum, I’d be kind of thinking, well, you know, I’m happy personally to add things to the correlation of 0.8, 0.9 to my system, but not if it’s going to involve a huge investment in all of this extra work, I’ll be asking myself whether it was really adding value.

So, what I would basically do is go back and look at the correlation between macro momentum and price momentum. If that seems quite high, I probably put the whole thing on a back burner and say, this is a lot of work. It probably will add a bit of value with a small allocation, but it’s not worth the extra work for an individual investor. For a big fund, sure, yeah, because they can throw people at the problem and it’s worth the extra value. If, on the other hand, you see a low correlation, then it may well be worth doing. Who knows.

[00:20:54] Niels

And it may also actually improve drawdown profiles, et cetera, et cetera.

[00:20:58] Rob

Yeah, it’s not just about Sharpe ratio.

[00:20:58] Niels

Yeah. Yeah. Okay. Cool. Now the next question is from Roman, also related to something that you’ve done. He uses some short, well, I don’t know what it’s called, but you will be able to translate this, I’m sure, for us. He writes, “In the AFTS book, Robert introduces the IDM and the FDM multipliers to target portfolio volatility. By applying his concepts to 30 different instruments divided into six S classes, I’ve introduced two additional multipliers to account for the existing diversification among the strategy classes and different strategies within each class. Is this an appropriate approach? Are there any other methods to efficiently target volatility?

[00:21:46] Rob

So, very briefly, the IDM and the FDM, the idea is that when you combine a bunch of return streams with a certain target standard deviation, that’s the way I build trading strategies. So, you might say I’m going to target 25% standard deviation. Say I’m doing it across markets, I throw in 150, 200 markets, I’ll find that my volatility drops from 25% to about 8% because that’s how much diversification I get with 300 markets.

Even with just two markets, unless they were very highly correlated, I’d find my standard deviation dropping from 25% to 20%, 15%. So, to account for that, I include these multipliers. What they basically do is effectively multiply everything up again.

So, I hit my standard deviation target again, and I do that in two different places. I do it when I combine different forecasts or trading rules, if you like, for an individual instrument. So, I might have six momentum predictors, three carry predictors, and so on and so forth.

I combine those together and I look at what the effect of diversification is, and then I account for that by applying this multiplier so that that sort of individual little system that’s just trading one market has got the right volatility target. And then I do the same thing across my instruments. So, I could throw in the S&P 500 trading strategy, the US 10-year, and so on and so forth. And I see what multiplier I need to apply there. So that’s what those abbreviations mean. That’s what they are.

What he’s suggesting is doing that in a couple of other levels. So basically, what he’s suggesting, I think, is to say, okay, well, I’m going to have, say, six different ways of doing momentum at different speeds. I’m going to combine those, and then I’m going to apply a multiplier. And then I’m going to have some carry systems. I’m going to combine those and apply a multiplier. And then I’m going to put momentum and carry together and apply a multiplier.

So, he’s sort of doing the same thing, but at more granular levels. I actually do a similar thing myself for my portfolio construction, but I don’t call it that, if you like. So, I do my portfolio construction in a hierarchical way. I do put together my momentum signals. And what I then do is rather than applying this multiplier.

Let’s say I’ve got more diverse, internal diversification and more momentum signals than I have carry signals, what I do is give a bigger weight, a bigger risk weighting to those momentum signals. That’s basically exactly the same as the approach that Roman’s using. It’s just that I call it a different name and it happens in a different part of my system.

So, to 80% of the people listening to this podcast, they’ll be like, what was that? What was that? But that will answer Roman’s question. And also anyone who’s listening, who’s familiar with the way I construct portfolios, will answer the question for them as well.

[00:24:26] Niels

Good stuff.

All right. The last question is from Joshua. He writes, “I’m a new listener to the podcast, about two months in, and have devoured hours of content. Thank you for the wonderful show and all the great teaching moments.

I had a question for you and your guest. I have a small account under $10,000, have 29 future instruments that I follow for diversification and two trend-following systems I’ve tested – a medium and long-term. Due to my account size, I only trade one contract and they are most mini and micro instruments. My problem is with risk management. Initially, I only wanted to risk less than 2% of capital on each individual trade. And when I tested using a volatility-based stop: two, two and a half, or three ATRs, I would be risking 5% to 7% of capital.

I began trading with a 2% risk, but I often bounced out of positions after a couple of days of it going my way and then a slight pullback. This has led to multiple small losses that have added up, when in reality, the instruments haven’t really gone anywhere. And with an ATR stop, I would still be in the initial trade and not to exit and just render as I have.

My question, for a small account like mine, should I base my risk management on ATRs versus actual percentage of capital? Meaning, I focus on using two or three ATR stops, though it would be a 6% of my capital. I’ve heard many of your guests talk about doing the right thing, even though it’s uncomfortable. I’m just not sure what the right thing is in this situation. Losing money prematurely and taking a bit larger risk on a percentage capital basis. Any advice would be greatly appreciated.”

Joshua, again, obviously no investment advice from here, but some thoughts at least on this particular issue.

[00:26:15] Rob

Yeah, yeah. So, I don’t actually use stop losses or ATR stop losses in my own system, but I have written about them. So, I have sort of understanding of the problem that he’s sort of driving at.

Basically, I think that the problem with stop loss in the way that most people think about it is that it’s effectively doing two jobs for you. First of all, it’s determining the sort of amount of risk you have on per trade, which is sort of determining your overall risk, if you like. But it’s also going to tell you how long you’re going to be in your positions for.

And it’s this confounding of the two things that leads to this problem. Because it does seem like you’ve got a binary choice between either having huge risk and letting positions run for longer, or having tight risk and risk them being prematurely closed. And the solution is to completely get yourself out of this mindset.

And I’ve written a series of blog posts on it, so I won’t get into massive detail here, Joshua, you can Google my blog and see for yourself. But basically, what you want to do is completely separate out these two decisions. So, one decision is, how big should my positions be? And the second decision is, how long should I hold my positions for?

The other thing about doing it this way is that it’s completely abstract for what kind of trader you are. And it completely depends on which market you’re trading, as to what speed you want to trade, and so on and so forth. So, you can completely abstract all that away.

So, in one of my books, I actually kind of put together a system that does use an ATR stop. And from memory, I think it’s something like an 8 ATR stop. And that’s quite a slow system. That’s a system that’s going to be holding positions for about three months.

And the reason I do that is because the books aimed at retail traders were often trading instruments that are quite expensive to trade. So maybe futures, probably, you can trade a bit quicker. So, he could probably use a slightly looser stop.

So, he talks about two and a half, three ATRs. Yeah, I mean, four ATRs, something like that’s probably about right. I don’t have the numbers in my head, but I think four ATRs would give you a holding period of about a month, which is kind of hand-waving, sort of typical average CTA futures holding period. So, it wouldn’t be too far wrong.

Go much tighter than that, then you’re no longer sort of in the medium speed momentum trading world. You’ll become a short-term trend trader, which is a whole different ball game and a different set of expertise.

So, the ATR is then set at, say, four ATR. And then what you want to do is actually size your positions according to how much risk you should be taking. And that’s, again, it’s not just a pure percentage of capital. There are a lot of factors that go into that. Go and look at my blog post to see that.

What happens as you increase the ATR stop is you do take more risk per trade. But because you’re taking fewer trades, your actual overall risk stays the same. So, these two factors counterbalance each other. So, you shouldn’t be concerned about the fact that it looks like you’re taking more risk. Actually, you’re taking less risk than somebody who was putting, say, 2% of their capital in, but only using a one or a two ATR stop, because they’re going to be doing lots and lots of these 2% trades. And their risk will be much bigger, which means if their trades go wrong, their drawdowns will be much larger. Their annualized standard deviation returns will be much bigger.

So that’s the problem with this kind of mindset that people have that it’s, oh yeah, it’s an ATR stop, and it’s this percentage of capital, and therefore I’m risking this much. You need to separate these two things out in your mind. And yeah, just go and look on my blog, and there’s a series of posts there that explain it, or even better, buy my third book, Leveraged Trading, which also explains it.

[00:29:46] Niels

I think definitely, Joshua, you should buy Rob’s book. I will add one thing, and it’s going to be maybe a little bit surprising for people listening to the show today, because I would maybe consider, Joshua, given the fact of your account size at the moment, is actually maybe to say, okay, until I have more capital, I’m going to buy, say, an ETF that tracks a CTA index or one of the single manager CTA products out there, and then just save up a bit of more cash to get you to a point where actually some of these issues may be dealt with in a better way as well. It’s very hard to get that level of diversification on an account size of $10,000.

So, I’m just going to throw it out there and say there are third ways, so to speak. But by all means, I’m impressed with the level of detail you’ve gone into for your trading system, and just keep developing it, keep learning about it, keep running it, and get more comfortable with it. And from there, you could probably also work out what would be a good account size to start off with, and in the meantime, let someone else do the heavy lifting for you.

[00:30:56] Rob

Yeah. Just to reinforce that, I think I say you probably should be looking at least $100,000 to trade a diversified portfolio futures, because even if you’re just on the micros and the minis, those are unavailable in a lot of asset classes. So, it’s most likely that your portfolio will be dominated by equity indices and agriculturals, where there are a lot of micro contracts, and there are much less liquid contracts in the other asset classes. So, it’s really hard to get diversification without at least, I’d personally say, at least six figures.

[00:31:24] Niels

Yeah. Okay, Cool

All right. Well, now we’re going to jump onto some completely different things, because these are the topics that Rob brought along, and they’re very interesting. I don’t know much about some of them, but I’m always in safe hands when I’m guided by you, Rob.

The first one is, it’s about Bitcoin. It’s about this idea, as far as I understand, that Trump has talked about. He wants to create a US strategic reserve of Bitcoin.

Some people might think that’s a good idea. Some people might think that’s a terrible idea. Tell me why you wanted to talk about this particular topic.

[00:32:02] Rob

Well, I think it’s fair to say that the people who think it’s a great idea are probably people who are long Bitcoin. That would be my starting point. Because obviously, if the US goes and buys an absolute ton of Bitcoin, then the price is going to go up.

And even the expectation that potentially, even Trump floating this idea, has kind of probably bumped up the price of Bitcoin. And now I think Bitcoin’s going to be quite highly correlated to Trump’s chances of winning, right? We’re probably going to see the price go up. So that’s a nice proxy, if you want to bet on Trump winning, maybe just buy Bitcoin.

It’s kind of interesting to me, because it does go back to this debate about why should Bitcoin exist, what the point of it is. And I want to rewind it back, because the first initial idea as to why Bitcoin should exist, which is effectively as a form of money, right?

That seems to have fallen by the wayside. I think most people agree now, it’s just a purely speculative asset. But if you’re going to have a US central bank holding Bitcoin in its vault, so to speak, in a metaphorical sense, as a reserve, in the same way that all central banks hold other currencies in their vaults for various reasons, for example, to try and control their exchange rate a bit, potentially, or to help with cross-border payments and just to diversify their balance sheets.

There are various reasons why central banks might want to hold assets. And of course, central banks also hold gold as well. So, you could say, well, maybe Bitcoin’s a bit more like gold.

So maybe it’s just a way of diversifying the Fed’s balance sheet. I mean, I don’t know what percentage of the Fed’s balance sheet is gold. I think it’s probably quite a small amount, to be honest. I don’t have the figures at the top of my head, but I expect it’s not a significant percentage anymore, compared to, say, 50 years ago.

So maybe if they just kind of add a little bit of Bitcoin to their balance sheet, the same as they have gold, it’s not going to change the Fed’s balance sheet very much, but it may potentially change Bitcoin’s price quite a lot, because it would be quite a big flow of money into the Bitcoin space.

If it’s there as money, if ultimately the idea is that it’s money, then it seems like a pretty… I mean, I know we aren’t going to get into politics, and I’m not going to kind of say what my opinion is of either of the candidates, but it seems like a pretty dumb idea, I’ll be honest with you. Because the US dollar has, well, all currencies, but still the US dollar, has this amazing characteristic for the government.

The first is that the government can make as many US dollars as it likes.
The second is that the government can make people pay their taxes in US dollars. They don’t accept anything else. Sometimes they’ll accept in kind, but basically, you have to give the government back its money.

Not everyone agrees with the MMT people, but one thing I think they’re right in saying is that when people moan about paying taxes, well, actually, you’re just giving back the government the money that it created. Okay, so it’s not your money, the money belongs to the government, the government created it, the government controls it. What the government’s actually doing, of course, when it charges you a tax, essentially is saying that all of the sort of productive work you put into the economy this year, which as it happens is denominated in this currency, we want to take 10%, 20%, 25% of that to provide you with services and also to redistribute income. That’s what taxes do.

It just so happens that it’s denominated in this currency, and we use this currency to do it. But you can imagine a barter system where we still have governments, but where this happened hundreds of years ago where you’d have had to have brought two of your cows and given them to the high sheriff as your tax payment.

Now, I guess you could think of a system where you let the government just have a percentage of your hedge funds there as their tax. So, it doesn’t have to be cash transfer. It could be barter in principle. The money is just a way of keeping score and keeping count.

The reason I mentioned this is that when I first started looking at Bitcoin and being very critical of it, frankly, is one of the reasons why I said, well, this will never work is because there’s no way any government would be crazy enough to say, oh yeah, well, you can pay your taxes in this other thing that we don’t control. We think that’s a great idea.

So, it strikes me as one of the… I mean, the US dollar is a fantastic thing for the US as a country. The dollar hegemony is weaker than it was, but the fact that it’s the world’s global reserve asset, the fact that everyone has to kind of use it for trade and transfer and so on and so forth, the fact that it’s controlled by them is a huge advantage of the country.

To me, it seems completely bonkers that you even get close to frittering that away by saying, actually, we’re going to bring this other asset into the monetary system, and we’re going to kind of give it an official stamp of approval, and we’re going to buy in our reserve account and perhaps say, yeah, you can pay your taxes in Bitcoin, which is this thing we don’t control.

So, there we go. It’s a bit of a rant, but it’s kind of an interesting one because it relates to the idea of what money is and the purposes of money.

[00:37:12] Niels

Yeah. Interesting. A few thoughts.

First of all, by the way, I mean, I guess the US could buy up all the Bitcoins because the market capitalization is only about 1.1 trillion. So, you know, they can just add a trillion to the balance sheet, which is down from like nine to seven. So, they can take it back to eight and buy all those. So that’s one way, one solution, of course.

But the other thing, more seriously, I agree with your idea that if people think that Trump might win, it would be bullish for Bitcoin. But actually, what’s also interesting is crypto and Bitcoin and Ether haven’t done very well in the last period of time. They made highs in March, I think. I think Ether was down 22% in August and Bitcoin is down as well. So, I don’t necessarily see that anticipation and demand, even though the chances of a Trump victory is obviously real. That’s one thing.

Offsetting that a bit is that I read an article just this morning where it talked about how hedge funds institutions are embracing Bitcoin ETFs. And it mentions that most, and I’m quoting now, most institutional investors who allocate in Q1 either held or bought more shares this spring. Among Q1 filers, 54% increased their position in Bitcoin ETFs in Q2, 22% held steady, 21% decreased their position and 13% exited from this. So, there are clearly some people who still think it’s a good idea to hold it as a part of their portfolio, but it’s not really reflected in the prices at the moment.

On the other hand, gold is making new all-time highs.

[00:39:02] Rob

Indeed. Yeah. So maybe they should just buy a bunch of gold instead.

[00:39:06] Niels

You never know. But the good thing is we’re going to be talking about ETFs now. So where do you want to go with the next topic, which is about kind of actively traded ETFs, I think?

[00:39:18] Rob

Yeah. So, I mean, there’s a lot. ETFs obviously are a big thing. And I think in most people’s minds, ETFs are the kind of core passive part of your portfolio. I think most people still use ETFs to get exposure to, say, the S&P 500 or the MSCI world or whatever the very long name of the bond index is that you choose to mention.

Why are there so many global bond indices and why are there such long names? It’s funny how there’s no MSCI world equivalent in bonds, that’s what everyone uses anyway.

So that’s kind of, I guess what, in people’s minds, an ETF is and what an ETF should be for. Even though, for example, Vanguard, who are the big people who are in the vanguard of passive investing (see what I did there) were actually quite slow to come to the ETF party. So, it’s not necessarily like a one-to-one correlation with passive investing.

And of course, there are ETFs now that do other things, some of which are very, very, very far away from the idea of a passive long- only holding. So, here are a few stories kind of in the ether in the mix at the moment.

So one is that the actively managed ETFs have now hit, apparently, a trillion dollars. Trillion dollars always sounds like a big number, right? It sounds like an awful lot of number until you then convert that into a percentage of actively managed asset, or of the ETF universe. It’s not a big number then. It’s, you know, off the top of my head, it’s probably about 10%, 15% of the entire ETF universe. So, the ETF universe is still very much more of a passive thing.

That sort of makes people… I think people need to kind of wake up and understand what ETFs are. Because I think part of the problem is that ETF has almost become like a brand and people think, oh, this thing, but it’s an ETF. So, it’s a bit like buying an S&P 500 tracker.

So, I’m not, I’m not going to look too closely at the label. It’s an ETF, so it’s probably fine. It’s probably safe. You know, all ETFs are by definition sort of regulated. That’s why people like crypto ETFs, right?

There are a huge number of institutions that cannot legally buy crypto outright or do not want to buy crypto outright because they don’t want the hassle of when they’re warehousing it and worrying about so forth. And they don’t want to trade crypto futures for whatever reason.

But they can buy any ETF that they like. It’s listed on a major exchange. It’s almost like a kind of shrimp wrap around it, with a stamp on it saying, you know, well, amongst other people, the SEC is fine with you buying this. You can buy it. It doesn’t matter what’s inside, you know?

So, it’s a branding thing. It’s also a regulatory thing that whatever you put inside an ETF automatically feels safe and nice and kind of good. I think people need to be a lot more aware and careful.

Actually, all an ETF is, it’s a legal entity, it’s an investment vehicle that works in a particular way. So, let’s rewind to before ETFs. (And I apologize to people who are aware of this history, but I think it’s important.) There are basically two types of funds, open-ended and closed-ended. And they have different names in different countries.

So, for example, in the UK, we call our open-ended funds unit trusts. And in the US, they call them mutual funds. We call our closed-ended funds investment trusts in the UK. In the US, I think they call them closed-ended funds. So, the name’s quite accurate. Open and close is the important distinction here, regardless of what kind of American or British name you put on top of it.

So, the idea about an open-ended fund is, I’m a manager and I’ve got a whole bunch of, say, stocks that I own. Neils, you come to me and say, well, Rob, there’s another, there’s $500. I want you to add this to the account. And basically, what I do is I take your $500 and I essentially say, right, well, this entitles you to this many units of my fund at this price.

And the pricing’s normally done on a daily basis. So, you know, once a day, I’d say, this is how much my fund is worth. And this is what you’re buying in at.

I take your $500 and I then use that to buy, you know, basically a tiny bit more of each stock that I want to own. And if I’m a passive investor, that’s quite straightforward. I’d obviously just buy a little bit of each stock, you know.

And if I’m a, you know, an active investor, then I put it into whichever stock I felt like buying that day. And then you come back to me in a few months’ time, say, Rob, I’m really sorry. I need to buy a new T-shirt because the one I’m wearing, I can’t help noticing, Neil’s is looking a bit tatty. Viewers at home can’t see this. I need to buy a new T-shirt. There’s a really nice designer T-shirt. I want some of my money back. I then say, well, this is the price. This is the mark for today.

And I then have to sell a little bit of each stock to get the cash. In practice, it doesn’t work exactly like that. For example, you know, most of these funds keep a bit of a cash reserve so they can pay out to investors coming in without having to, you know, redeem the underlying investment. So that’s an open-ended fund.

Closed-end fund works completely differently. Closed-end fund works like this. I launch on the stock market an IPO for, say, $100 million. And I take the $100 million I’ve been given by outside investors. And maybe I kick in some of my own money. Maybe I use leverage as well. I can do that. And I go and buy $100 million worth of stocks that I like. And, you know, every day I come into the office. And if I’m a passive fund manager, I might have to do some quarterly rebalancing. If I’m an active fund manager, I’ll have to, you know, do whatever.

But that pool of $100 million, that original pool of money, stays static, OK? Without going to the market, I can’t get any more. And I can’t get, you know, also redeemed.

So, you may ask how you, as an investor, can get into that unless you were in the original IPO, which is unlikely because it was probably only open to big institutional investors. Well, what you do is you take your $500, and you go to the market, and you buy shares in my closed-ended fund, just like buying any other fund.

And so, you’re buying those shares not off me; not off me, the fund manager. You’re buying them off somebody else who already owns the shares already. And the price you’re buying at, well, that’s easy. That’s a market price. You know, these things trade in the secondary markets. The price isn’t determined by me making my daily NAV marks like it is with an open-ended fund. It’s determined by a market price.

And then, you know, if you want to sell, you just sell again in the market. So, this is sort of closed form, hence the name, closed pool of money that remains the same. Obviously, its value can go up and down. But if you want to kind of buy or sell, you do it in the secondary market with people who already own or want to get rid of those shares.

So where does the ETF come into this? Well, the ETF is kind of an interesting hybrid of these two things.

So, most of the time, and to most people, an ETF works exactly like a closed-end fund. It’s launched with a certain amount of money. And if you or I want to buy an ETF in the market, we go to the market, we get a market price, and we buy it if somebody wants to sell it.

However, it is possible for an ETF to behave more like an open-ended fund, if you are a big enough player in the market, and these people are called authorized participants. And what an authorized participant can do is treat the fund a bit like an open-ended fund, because they can come to the fund manager and say, okay, I want to put some money into your ETF, but, you know, we’re not talking $500, we’re talking $10 million. I don’t want to do that in the open market because it’s going to be messy.

Your ETF is not that liquid. Instead, what I’ve done is I looked at the basket of shares that you own. I have bought $10 million worth of those shares.

I’m going to give them to you, not as a present, not for free, but in exchange for an equivalent amount of ETF shares. So those $10 million of shares go into the ETF fund vehicle. The value of the ETF fund vehicle, the kind of market value, the market cap will increase accordingly. The price, of course, will remain exactly the same because it’s price divided by number of shares, number of shares increases, blah, blah, simple maths.

And it’s possible to do that operation in reverse as well. It’s possible to take money, a big amount of money out of the ETF by basically saying, we’ll just give you the shares back, please. And then I’ll give you the ETF stock in return.

So, it’s a very nice vehicle because it has the immediacy and the ease of trading a closed-ended fund for a small investor. But you have a no arbitrage situation because if the NAV gets out of line with the price, then big players will come in and take advantage of that with creation redemption. And that keeps the price honest.

Whereas with a closed-ended fund, it’s perfectly possible. And indeed, in the UK at the moment, it’s a big problem for the shares to trade either at a big discount to the NAV or sometimes at a big premium.

So that’s all an ETF is. It’s not actually a kind of special shrink-wrapped SEC approved, this thing is definitely safe because you can literally put anything into this thing – anything.

So, you can put an active, actively managed ETF. That’s fine. There are issues around the fact that the constituents of an ETF need to be known to do this authorized participant thing. And there’s a way of getting around that a bit. If you’re an active investor, it doesn’t want to disclose your positions constantly. We’re not going to get into the details of that, but there’s all kinds of other stuff in there, right?

I mean, there’s some stuff in there that, you know, so let’s take an example of probably one of the worst possible things that you can put into an ETF, and no, Niels, it’s not Bitcoin this time. Okay. So, with an ETF, you can buy a single share. So, you’re not, it’s just, it’s not a basket of shares. It’s just one share. Okay.

So, you’re thinking, well, surely you should just buy the actual share. Why would you need to buy the ETF? Oh no, this is triple leveraged. It’s a triple leveraged share. So, this thing is basically like owning three times the amount of money you put into the individual share. And there’s quite a few of them.

One of the more crazy ones is MicroStrategy. MicroStrategy is this weird business that claims to be a real company, but actually is just a huge pile of Bitcoin. Okay. The guy that founded this business thought, you know, his business model over the last few years has been buying Bitcoin and kind of storing on his balance sheet. I think net/net, I think that’s been profitable and is a very strange business. I mean, again, would it be probably cheaper and easier just to buy Bitcoin?

If you want to leverage bet on Bitcoin, there are options. You can buy options, or you can buy futures. So why does this ETF need to exist? Why does this crazy gambling thing need to exist?

Well, exactly as with people who buy Bitcoin ETFs, there are people out there who want to make this absolute crazy leverage bid on Bitcoin, but do not have the access or the capability to do it with options or futures or whatever. Frankly, they’re going to be retail rather than institutional investors.

The chances are, I hate to say it, but it’s quite a high correlation between people who really don’t understand markets and people who like Bitcoin. I hate to say it, putting it out there. So, they’re likely to be less informed retail investors.

I just really worry that they’d be lulled into a false sense of security because this thing has the ETF prematures and the SEC says you can buy that.

The SEC would never let these people trade, you know, huge leveraged options on underlying Bitcoin in a million years, but you can do it via this thing. And of course, you know, it’s a very profitable business for the people that produce this thing, because obviously MicroStrategy itself operates as a business. That’s kind of an extra cost. And also, the ETF itself has quite high charges for an ETF. So, yeah, just because it’s an ETF doesn’t mean it’s safe.

[00:51:32] Niels

I completely agree. And I also, I discussed this last week, with Andrew, where I also mentioned to him that with ETFs people, I think, don’t do much due diligence and, and so they don’t really know how substantial the companies are behind these ETFs running the money. This is very different from the hedge fund industry where we really go through a lot of due diligence before people would allocate money to any of our own funds.

I think for good order sake, Rob, I should refer people to, if they want to read more about this strategy or this ETF, they should read an article on Bloomberg, from Matt Levine. What he writes about is this Europe listed 11 million Granite shares, three X long MicroStrategy, daily ETP ticker, LMI3. And what he basically writes is that while MicroStrategy itself is higher by more than a hundred percent this year, LMI3 has dropped nearly 82%. And I don’t need to say any more. People should go and read it because that clearly shows how bad you can get burned.

[00:52:48] Rob

This is specific property of leveraged ETFs that people really need to understand. Now, the fact that this is European listed as well, again, this is for people who, you know, want to buy a US stock, but can’t because they’re in Europe. So, the whole thing is just a way of, frankly, allowing people to gamble in an arena that they wouldn’t otherwise be allowed to gamble in.

[00:53:15] Niels

Let’s move on to our last big topic for today, which is something that came out just after I spoke last week with Andrew. Maybe it’s inspired by my conversation with Andrew because in last week’s conversation Andrew could reveal that, hey, there’s a new CTA index; a new SG, SocGen CTA index. Even though my understanding now, a few days later, is tha,t actually, it is two different parts of SocGen.

And it’s not the part that normally publishes these SocGen indices that I refer to. This is, anyways, referred to as an investable CTA index. It is engined by Andrew’s DBMF replication model.

Now, again, I don’t know exactly if the good people over at Transtrend had heard that and said, well, let’s put a paper together on this. Nevertheless, they published an interesting paper that you’re going to talk a little bit about today. They titled it, Can’t We Just Buy the Index, which is very clever I thought. Tell us a little bit about the paper. What are the key takeaways from your side?

[00:54:32] Rob

Yeah, it’s a very interesting paper. It has been written by Harold de Boer. He’s a smart guy. He knows what he’s talking about, it’s very well written.

He talks a bit about some bits and background about the CTA indices themselves, which is kind of interesting, but I think the thing that’s kind of in there that I find quite interesting (and this sort of goes back to this discussion we had about macro momentum and this idea that there are sort of these latent factors that you can’t see, and by sort of trend following, you’re sort of picking up on those), he’s got a similar argument in his, which is that basically a stock index is like owning a bunch of companies. But those companies in turn are (I don’t think he used this exact phrase) exposed economically to various factors.

So, for example, he says, Oh, well, if you buy, say, I don’t know, Toyota, then you’re exposed to things like the yen – yen/dollar, because it’s a Japanese company. You’re exposed to things like the price of metal potentially. Therefore, by buying a stock index, what you’re actually buying is effectively one step removed; a whole exposure to a whole bunch of factors. And he said, well, basically CTA indexes is like that as well.

Cause by being a CTA index, you’re buying essentially a bunch of CTAs, and they are themselves then exposed to, you know, we both trade yen/dollar, we both trade various metals and so on and so forth. So, you could potentially do some kind of quant exercise where you sort of try and work out what the exposures of a stock index are in underlying kind of futures space. And then you could actually build an MSCI World Alternative index where you used things like the yen/dollar futures price and things like that to kind of back it out.

So, really, it’s a very interesting argument. And I guess that the sort of conclusion that he comes to is that the difference between buying a, say, small or a large number of individual CTAs and the difference in buying an index is kind of analogous to the sort of situation with stock indices. And it’s not clear to me, actually, from reading it, whether he’s pro or anti buying the index as well.

I think what he does a quite good job of saying is the sort of pros and cons of buying an index of CTAs versus buying individual CTAs. So, in very broad terms, if you think you’re good at picking winners, if you think you can pick good CTAs, either based on their past performance or based on due diligence, then you should probably do that rather than buy an index because you’ll outperform.

And if you have sufficient money that you can diversify between enough of those managers, because CTA managers are quite correlated, you don’t need that many of them to give you a kind of a reasonable diverse, theoretical diversification benefit. So, if you’ve got, say, $30, $40, $50 million in the bank, and you think you can pick the best 10 CTA managers, well, you should probably go and do that rather than just buying the index either through replication or some other methodology.

So, he does quite a good job of outlining the pros and cons of that, which is the reason to read the article. So, what I want to come back to this is this idea of the fact that stock indices and CTA indices are basically the same because I’m afraid I see quite a few holes in that argument, although I kind of like it conceptually.

One is that companies, big companies, make a lot of effort to actually hedge out their risks. So, you know, if you go to Tokyo’s head office, you’ll find a whole bunch of guys working in the treasury department trading yen/dollar, FX contracts amongst other things.

One of the reasons they’re doing that is because, in their opinion, people who buy Toyota as a stock aren’t buying it just as a proxy to bet on the yen/dollar rate, they want a lot of that risk to potentially be hedged out. Whether that’s true or not, I don’t know, but most companies do hedge out their exposure to the principal risk.

So, oil companies hedge out their exposure to the oil price as much as, you know, to a degree, and companies with operations in different currencies or with particular inputs also try and hedge out their exposure. So that takes away from it slightly.

the other thing is that the difference between, say, Toyota and the CTA is that obviously the kind of exposure that Toyota has to, say, yen/dollar or to metal prices is kind of systematic. It’s always going to be in one direction, pretty much abstracting any hedging activity.

The CTA has changed their exposure dynamically. Sometimes they’re long, sometimes they’re short. So, although I do kind of buy the argument that potentially these latent factors and that any asset you buy, whether it be a stock or a CTA manager, are sort of a bet on those, I don’t think it’s as simple as saying that this is the same underlying set of factors. It’s very linear and it’s very kind of systematic and in one direction.

[00:59:31] Niels

If I can just interject here, I’m not sure, from memory when I read it, I’m not sure he’s saying that they are the same. And I think one of the reasons why is they also go on and say that they don’t believe that you can just replicate the index because you can’t replicate the diversification that sits within the index. You may get returns that are highly correlated, but people shouldn’t be fooled that they’re buying the index. If you know what I mean. I think that’s one of their conclusions.

I can’t remember if, actually, he believes that also because of the distinction between a stock index and a CTA index. They are not the same things. I mean, if you’re buying a stock index, you’re just taking the price of the stock. And that makes up the index every day. But in our case, as you say, we have different strategies, different exposures, and we change our exposure dynamically as well. So, it won’t be the same.

[01:00:28] Rob

Yeah. Yeah. Yeah.

So actually, this is interesting because it ties into a couple of things. One, it ties into the debate we have, actually you were having last week, and you and I have as well. And I don’t see the evidence that having, say, 250 rather than 50 markets is better.

That’s one of your things. I’m in the much in the ‘more is better’ camp. That’s one of the reasons why I think replicating with a relatively small number of futures markets is not ideal. But we’ll talk about that in a second.

But it’s a similar argument in a sense. Just because all the CTA managers in an index might be highly correlated, that doesn’t mean that correlations are a linear measure. And that doesn’t mean that you’re not going to get these outlier situations where you might happen to hold a CTA, like a certain one based in London that begins with an M, that just has an explosive year and makes a ton of money. If you look at that correlation with everybody else, it may still be quite high but doesn’t stop these outliers happening. And these outliers can happen with individual stocks within an index. But that can similarly happen with managers and the correlation support is a poor judge of anything that isn’t linear. This stuff definitely is not linear.

It also means that the kind of idiosyncratic risk, if you happen to pick your own CTAs, and you miss out on the one that does really well, the same way that if you pick your own stocks and you’ve got some that are 95% correlated to the index, well, you might miss out on the NVIDIA, which does incredibly well, because you missed it from your portfolio.

What doesn’t help is that the SGCTA index, in particular, is quite a small index. It’s not big, I don’t know about the new one because I haven’t looked at it, but the existing one is not. I think, is it 10 managers?

[01:02:16] Niels

Well, the SGCTA index is 20 managers, but remember the new one is not an index of managers. It’s a replication model.

[01:02:23] Rob

Replication of the, yes, it’s slightly backward. Yeah. But even 20 is not a big number for an index. Most stock indices are much bigger than that. So, if you’re 20 misses out on one of the other CTA managers that’s potentially going to do very well, then your index itself will be, in effect, undiversified.

The conversation you had last week really got me thinking about what the point of all this is (not in a kind of, what we’re wasting our time discussing). It’s a more existential point because I don’t think we can really discuss this whole issue around indexing and replication without actually taking a step back and asking ourselves why we’re doing it. Last week Andrew did actually say, well, here are some of the reasons why you might create an index, traditionally, for things like benchmarking.

Also, I think the other reason he gave was effectively to give you a proxy to, in some kind of asset allocation model, say, well, you know, I’m thinking about adding CTAs. This CTA has only got five years of history. I’m going to use this index with 20 years of history as a proxy for the CTA universe so I can get an idea of what the kind of correlation performance characteristics are. And once I’ve decided how much I should put into CTAs, then I’ll worry about selection later. That’s another reason to have an index, potentially.

What strikes me about that is that is a very institutional way of thinking about the world. And the whole point about ETFs, as we’ve been discussing, is they are this fantastic vehicle that can open up the opportunity to invest in something for a retail trader that otherwise would not exist without the ETF. And for all of the fact that there’s a lot of scary, dodgy ETFs out there, don’t get me wrong, I think that’s a fantastic thing.

Going back to our earlier question with his $10,000, which we both agreed was probably insufficient to trade futures with, If he has access to an ETF that has a sort of trend following style within it and the fees aren’t too bad, that’s probably a better use of his money, frankly. But without the ETF, that option would not be available.

So, this whole sort of source of alternative risk premium or alternative beta, whatever you want to call it, would not be accessible without ETFs. So, ETFs are a good thing for retail investors.

Rather than thinking about a very institutional way of thinking about benchmarking… So, institutions love indices, they love benchmarking, they love this kind of stuff. I don’t think that’s necessarily the right way of thinking about it. If you’re not an institution, if you’re just someone who’s wants to buy an ETF to get access to the managed future CTA universe, does the concept of an index even matter?

I’m more of a fan of, if you are going to replicate CTAs, I’m more of a fan of doing bottom-up replication then top-down for statistical reasons. You’ve got it. So, you know, replication is not a bad thing. I’ve got no problem with replication. In fact, technically speaking, the way I trade my portfolio is effectively replication because what I do is generate positions in 250 futures markets, about 60 of which I can’t trade legally, or because they’re not liquid, or because they cost too much money.

Out of what’s left, I haven’t got a big portfolio and it’s gotten smaller in the last few months. I haven’t got a big portfolio. So, if I had a hundred million dollars, I could buy positions on my futures. I can’t. So, every day I try and replicate that big portfolio with my smaller portfolio. So, I’ve nothing against the idea of replication. Replication is a good thing to do.

I’ve actually no problem with somebody saying to fit this particular legal vehicle, this ETF, within this usage regulation and whatever, that can only hold these assets, I’m going to, with that small investment universe, with these restrictions, I’m just going to do the best job I can. I actually have no problem with that at all.

I don’t think that dogmatically matching an index, just because that’s what the kind of institutional industry is obsessed with, is necessarily for most people who are just buying and want to get exposure to trend following, is necessarily that important.

[0(1:06:53] Niels

So just to do justice to Harold’s writing, I want to read just five lines from the paper itself, because I think it ties into what you just said. And then I want to add one more thing. And that is, so Harold writes, “This leads us to the question, how can an ETF that trades in fewer than 20 markets deliver CTA index returns? The answer is simple. It cannot. It may produce returns that are highly correlated with the index returns. And in that respect, it is no different from any other trend following CTA program with the comparable amount of single manager risk (a point that I’ve made to Andrew many times actually), but it does not deliver the index returns. For that, it simply lacks the diversification that underpins these returns.”

Okay. So, we kind of dealt with that. I want to throw in one more thing and hear your comments before we end. The other thing that I think we need to pay attention to at least, and that is when something like this happens (and maybe I’m projecting something that may not happen, but it could happen), “we now know that the index is based on a long-term backtest of a specific engine to replicate.”

Okay, fine. Sure. However, now that it’s labeled an index and people think, okay, well, I can now go and buy that index, a backtest becomes, “a public track record”. And for all of us on the manager side, it’s a big no-no to use backtests as a way to sell our products.

And I’m pretty sure that Andrew would agree with that. I know he had a discussion with Tim, from Ausbiz, about this point, about can you just create an index and then that’s your track record, and then you say, yeah, here you go. So, I think that opens a slightly different discussion to me that also has some risks in it.

Because as you say, as soon as these things become an ETF product or something sold by a bank, whatever, it becomes more difficult to assess what’s really behind it, how was this index created, etc., etc. So, I do think it’s worth paying attention to these things.

[01:09:13] Rob

Definitely. And this isn’t a new problem. I mean, I would say, I think that probably in terms of like legal regulatory marketing, I would be astonished if they were allowed to put the backtest on the material. Because I think, generally speaking, any product that’s offered to a retail investor, you will never see a backtest on it.

[01:09:31] Niels

No, but if you publish the index, I don’t know that they do. I mean, it’s available on Bloomberg.

I think that’s public, right?

[01:09:12] Rob

Yeah, it is. Yeah.

But it’s a tricky one, isn’t it? I think it’d be a weird one, right? So, you can imagine your standard disclosure documents for an ETF if they said, well, here’s the live track record, oh, and here’s the index that we’re basing it on. I’d need to look at other ETFs that have a similar setup. Of course, there are what I call smart beta indices that do things like, for example, simple FX carry strategies. I think Deutsche Bank has got one.
It’s been around for a while. And that’s an index, of course, which is potentially backtested, blah, blah, blah. And then of course, you’ve got a live track record.

I don’t know whether the kind of public disclosure documents, the prospectus has that backtest of the index in it or not. I don’t know. I’m not a legal expert on stuff like that, but I agree with you, potentially it’s very misleading, even if they’re on two different pages, like, you know, and you glance down, well, here’s the index. This is amazing. And it’s an index that’s a backtest of a strategy.

So yeah, it’s not a new problem because there are already plenty of people that have systematic, actively managed ETF products based on an index. That is not a new thing. And yeah, I think in principle, it’s a good thing, right?

I mean, if I wasn’t trading my money with my future strategy, and in the future, I’ll probably go down this route, I potentially would want to buy, you know, some ETFs that give me exposure to different kinds of risk premia that I can’t easily access via just being long stocks and long bonds, which is the other thing that I do.

So, yeah, it’s an interesting development and innovation. And I think the bottom line for me is, you know, as with any ETF product, don’t just buy it and think it’s safe because it says ETF on the outside. You’ve really got to understand what’s inside this. And that’s true of this new investable CTN index, as it is of a three times micro strategy ETP. Although, of the two, I probably have more faith in the CTA index, frankly, than the triple leveraged Bitcoin bet.

[01:11:43] Niels

Yeah. And in fairness, by the way, I should say that this new index is not going to be officially offered as an ETF. They are looking at it as two distinct products, the Andrew product, and this index. However, of course, the index is based on Andrew’s engine. So, there is some overlap. Let’s put it that way.

Anyways, it’s a super interesting development for our industry – evolution for our industry. And whether we are for or against doesn’t really matter. It’s here. So, we need to think about it. And I think this is what these conversations are all about. Good stuff.

This was great. Rob, good to have you back from your holiday. And thanks for sharing all the insights. Thanks for answering all the questions that came in this week. And of course, if you like these conversations and all the efforts that the co-host put into this, I suggest you go and show that by going to your favorite podcast app and leave a rating and review, because it really does show appreciation for the work that goes into producing these weekly conversations.

Next week, I’m joined by Alan. So that will be another fun and insightful conversation, no doubt. I know already roughly what we’re going to talk about, and that’s going to be interesting, I think, for sure. So, make sure if you have questions for Alan, you send them in to info@toptradersunplugged.com and I’ll do my best to bring them up.

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

[01:13:17] Ending

Thanks for listening to the Systematic Investor podcast series. If you enjoy this series, go on over to iTunes and leave an honest rating and review. And be sure to listen to all the other episodes from Top Traders Unplugged.

If you have questions about systematic investing, send us an email with the word question in the subject line to info@toptradersunplugged.com and we’ll try to get it on the show. And remember, all the discussion that we have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies. And you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Thanks for spending some of your valuable time with us and we’ll see you on the next episode of the Systematic Investor.