The Fed, the Fiction, and the Fight for Control ft. Alan Dunne

[00:00:01] 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 Alan Dunne and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global markets through the lens of a rules-based investor.

Alan, wonderful to be back with you this week. How are things in Dublin?

[00:00:37] Alan

All good here, thanks. Yeah, enjoying the summer, bit of sunshine today. So yeah, all good.

[00:00:43] Niels

Has your summer, just out of curiosity, been as wet as it has on mainland Europe? Because it really has been wet.

[00:00:50] Alan

Not unusually, no. I mean, July has been a bit dreary, but no, not terribly wet, but it hasn’t been a bad summer.

[00:00:57] Niels

Okay, very good. We’ve got some really good topics as usual, dare I say.

And of course, they are going to be related to some of the latest papers but also some articles that’s been featured, including one of your own, by the way, regarding the environment for CTAs and trend, predominantly, today.

I’m sure we’ll weave in some other stuff because we’re also going to do some macro stuff initially. But before we get into that, and I will say I struggled a little bit this week, so, I hope you’ve got something good, and that is what’s been on your radar for the last recent time? Anything exciting that you’ve focused on?

[00:01:43] Alan

Well, the one thing I picked out, it’s not in left field. A lot of people have been talking about it but it is quite dramatic in some sense.

Obviously, Trump fired the head of the BLS last week, in the aftermath of the weak payroll numbers, which it’s funny having done that, I heard a bunch of people on CNBC defending it, saying, well, actually maybe it wasn’t the wrong thing to do.

But it does raise all manner of questions, like how far is the administration going to go in terms of if they don’t get the right answers on the economic data front? But it has obvious market implications too, if the administration really started to tamper with economic data.

Take for example TIPS, inflation protected securities. They are priced on the basis of the actual CPI print. So, I had a look. I didn’t see any meaningful reaction in the TIPS market. I saw it being referenced on Bloomberg that some participants there were concerned.

But you could have investors demanding a higher risk premium in the TIPS market because they fear that the CPI might be manipulated lower than the actual if we start to see higher inflation that Trump felt wasn’t correct. I saw him on the TV, I think it was yesterday, saying, all prices (not oil prices) all prices in the economy are down except stock prices, which are up, which obviously is not correct.

But for somebody who has that belief, then maybe they could start to tamper with data. And obviously lots of things are linked to CPI, contracts are indexed to inflation, etc. But I think the broader narrative here is that it’s just another example of the US kind of becoming more, at least in terms of how it appears externally, more like an emerging market. It is the kind of thing that you hear more and more in emerging markets.

Obviously, for years, China, nobody trusted the growth numbers in China. They felt they were manipulated. Now we’ve got a developed market where they’re firing the set decisions because they’re not coming up with the right answers. And bear in mind, Trump obviously challenged the election results because he didn’t like those as well. So where does it end? I think it is quite interesting and potentially worrying.

[00:03:58] Niels

Yeah, I completely agree. I think it is disturbing when you look at it with that lens, for sure, very disturbing. Here’s my question to you, since you probably know much more about this than I do. I think recently, not entirely sure who I spoke to on the show about this, but there was a… I think I read it in an update from the Odd Lot Skies, and they talked about the percentage of the statistics that were now being guessed. They use guesstimates rather than actual data. And it had gone up quite significantly recently.

And so, I don’t know whether this is part of the Doge thing that we’re getting rid of people, so there’s not enough resources to do this in, in a proper way. I have no idea. But when these numbers come out, and I think the revisions were large. Is it not possible to, actually, precisely say why and where these revisions came from? I mean, so kind of to demystify whether it’s a political number or not a political number. Is that not possible?

[00:05:12] Alan

That precise question… I don’t know. I think it probably is. I know there are more revisions. There are a whole bunch of revisions that come kind of annually, I think, in early September, kind of the annual benchmarking. So, there will be more revisions coming, I suppose it’s important to bear in mind that these are all statistical measures.

It’s not that they’ve counted up to 200,000 jobs or whatever. It’s that they’ve done a survey and they come up with an estimate based on the survey. So, it’s not an actual number. It’s a statistical measure.

You’re right in what you say about the lower response rate. And I mean, that’s in two ways. For example, in the CPI, the percentage that’s imputed now ,as opposed to actual market rates, that’s been going up. But the bigger question is poor response rates, and people are less inclined to respond to these surveys. Whether that’s… It started in Covid. I mean, maybe they’re using outdated ways of contacting people. I think I saw Jeremy Siegel talking about this, and they were sending out faxes. I mean, I don’t know if that’s a thing still. But anyway, they’re sending out faxes.

[00:06:23] Niels

They’re sending out faxes and they’re surprised they’re not getting a response.

[00:06:25] Alan

Exactly, yeah, I mean, that does sound odd. But I mean, should it be mandatory to respond if you get this? You know, should you be fined if you don’t? I mean, I think there is a general growing skepticism of government. So, if somebody calls you up and wants to ask you about your wages or your… Some people generally don’t want to answer.

People don’t want to answer the phone at all, there are so many bots. So, I think there’s a whole range of things there that have made the job of assembling these statistics and data more difficult.

But, you know, I suppose on the other side, maybe in defense of Trump, you might say, well, maybe a new approach is needed, and maybe that’s the point, to get more reliable stats.

[00:07:08] Niels

Yeah, yeah, you’re absolutely right. I hadn’t thought about this, but I know that from personal experience. I mean, every time you get one of these calls from a number you’ve never seen before, and the first thing they start is asking personal questions, you kind of just hang up, and delete, and block the number. That’s actually a very good point. Anyways. Okay, very interesting.

Now, as I said, I kind of struggle a little bit, maybe because I’ve been moving around, so not focusing too much on what’s going on in the news flow, but also because I think, in many respects, so many things are happening in the news flow. But I obviously could not help noticing that Trump, on the birthday of my home country of Switzerland, actually put on a very large tariff rate for that country, maybe I think one of the biggest ones we’ve seen so far of 39%, which will be interesting how they untangle themselves from that.

And I know, from the Swiss news, that people have really been very critical of the current prime minister or head of the government for that negotiation. So, yeah, that’s something I think is very interesting. Although, and I don’t know if this is true or not, I just seem to remember it like this, that a lot of the trade deficit that the US may have with Switzerland is actually due to gold coming from Switzerland into the US. So, I wouldn’t really call that necessarily a real trade deficit. But anyways, it is what it is. So, we’ll see. We’ll see.

Okay, well, we’re going to stay with kind of the macro theme for a while and, and we’re going to get into and maybe spend a little bit more time than we normally do on this section because this is where you have some thoughts on the global macro situation. And I’ll try to chip in with a few things that I’ve noticed. And so, I’ll hand it over to you, Alan, and talk about what you’re seeing.

[00:09:18] Alan

Sure, yeah. Well, I just want to talk about two things in this section. Firstly, just kind of appraising where the US economy and policy is, kind of six month into Trump, and then linked to that is the Fed. But I think a bigger question then is what the Fed is going to look like over the coming years. And we’ll get to that in a minute.

But it is interesting. You know, we’ve obviously got the weaker data lately. Obviously, payrolls was disappointing. We had negative revisions. And I think it’s interesting to look at how the economy is performing versus, maybe, what expectations were at the back end of last year when Trump came in.

Bear in mind, the idea was Trump’s going to run the economy hot. We’re going to have stronger growth, deregulation, possibly fiscal stimulus. It’s going to be a positive backdrop for the markets, possibly inflationary.

And actually, I think what we’ve had is actually a much slower economy, in the first six months of the year, than probably what most people anticipated. And the reason for that is obviously tariffs are a tax increase. So, I mean, we’re seeing that in the data.

Obviously, consumer spending is running at just about an annualized rate of 1% or even less. So, you know, you’d normally expect that to be around 2% or so. The savings rate has increased since last year, about 4.5%. Now, back in the late 2010s it was more like 5.50%, 6%. So, it still could go a little bit higher.

But I think if you think about it, what we’ve seen with Trump’s policy is we’ve seen a reduction on the supply side because of immigrants. So, people are being deported or else immigrants are not coming out and working because they’re afraid of getting deported.

So you’re seeing a smaller labor force, actually, lower labor force participation, and at the same time weakening job growth. So, it kind of creates a little bit of a policy challenge for the Fed because the economy is clearly weakening, demand is slowing, but supply is slowing at the same time. So, in terms of the Fed’s mandate, it’s maximum employment and it’s still more or less nearly there at 4.2%.

But the problem is that, on the demand side, you’re seeing weakening demand and slowing job growth. And I guess the general sense, now, is that trend growth in the US might be more like 1%, whereas previously it was 2% to 2.50%. And bear in mind that I think it was 2023… Yeah, in 2022 there was a lot of pessimism on growth. And in 2023, the economy rebounded very strongly. And that was largely driven by a surge of immigration into the US.

I think from the perspective of what’s different to what we expected, maybe, at the start of the year, the tariffs have had a more negative impact, I think, on growth that was partially uncertainty, partially on demand. But at the same time, the immigration policies have had a meaningful impact on supply.

And then on the other levers, there were hopes of fiscal stimulus and the Big Beautiful Bill, etc. We’re not really seeing that. There might be a little bit of that next year. And then obviously deregulation was the other side of it. I’m not really seeing anything meaningful on that side yet. So, kind of the six month scorecard on Trump has actually been more negative for the economy.

But actually, this impact on the supply side, if the economy was to rebound in 2026, that would mean that the threshold for raising rates would probably be lower in the sense that because you’ve got a smaller labor force. If the economy rebounded, you would expect to see stronger wage growth down the line.

So, I think it’s interesting. The consensus, now, is that the Fed’s going to ease in September. Hard to argue with that. We’ve got two more CPI numbers before then but certainly the Fed is already under a lot of pressure. It had been saying that the labor market is solid. The most recent data doesn’t seem to support that. It would be hard to kind of go against a rate cut of at least 25 basis point in September, it could be more. If the CPI was kind of in line or not rising, that would have the case for a bigger cut. But yeah, I think the Fed is kind of painted into a difficult spot here.

[00:13:31] Niels

So, I’m imagining that when you say growth is slowing, maybe not just in the US, maybe elsewhere, I don’t know. And I imagine, correct me if I’m wrong here, that we look at GDP as the measure of growth to some extent, maybe to a large extent.

My question to you is when you think about this, and I guess it ties into a little bit about kind of the whole Fed discussion, but when we think about growth in GDP, I mean that’s a number that was kind of designed a long time ago. And the world or the economy today has changed a lot. You know, we have a lot more services, intangibles. We have a whole economy that maybe is very hard to measure.

I mean, for example, does an influencer count as someone who’s employed. I’m just asking that question. Or, this morning when I went to buy some groceries, I mean, I do the checkout. I mean, there’s no one checking out.

[00:14:38] Alan

That’s right.

[00:14:39] Niels

My work is not being counted anywhere but I do the checkout.

[00:14:42] Alan

True.

[00:14:43] Niels

So, I’m just thinking sort of out loud here is that it might not be so easy anymore to really, even with the best intentions, to really rely on a lot of the data we’re served up. And I’m not an expert. I know we have an expert coming on the show very soon on Kevin’s series.

But I do think it raises a question, and, of course, as systematic rules-based investors, we don’t care whether the numbers are right or wrong for that matter. But I imagine that most asset managers who don’t do what we do, and investors in general, it’s pretty tricky to figure out how good is the real economy, so to speak.

[00:15:29] Alan

True, and we had Paul Donovan at UBS on before. He was big on this topic, as you say, doing his groceries, and swiping them at Tesco, and obviously not getting paid for that. And it’s true. And, obviously, there’s lots of kind of activities in the economy, TikTok, content generators, etc. who are providing…

[00:15:53] Niels

Podcasters, we’re not employed.

[00:15:55] Alan

Podcasters, yes, exactly, unemployed, Yeah, all of the value add that’s been generated here doesn’t get counted in the GDP numbers. And it’s all true.

And I mean, I guess from policy’s perspective, if you think about the Fed’s mandate, at the end of the day it’s maximum employment and price stability. So, they’re the things to really focus on. Obviously, everything else goes into helping them think about that.

And they acknowledge, obviously, the challenges of changes in the economy over time and how that might be influencing. And I guess, with all the PhDs and economists that they have at the Fed, that they are grappling with how to address these issues.

But I mean, certainly we have seen divergences as well between the GDP numbers, even between GDP and production and income, as well as between those numbers and employment over time. So, it is something that you do see periodically.

As I say, I think the Fed has kind of concluded that for their purposes, although they say they look at a wide array of labor market data, the unemployment rate is probably the most important number that they watch. So, that somewhat simplifies the task for them. But what you say is true, but they’re kind of structural issues, I guess they’ll say. What we’re looking at from a cyclical perspective is the changes kind of month to month, quarter to quarter, which shouldn’t be overly impacted by those kind of structural trends.

[00:17:10] Niels

Yeah, well, of course, of course, I’m sure we’ll come back to this in future episodes. We’re still probably yet to see the real impact of AI. I heard Cem talk about, recently, kind of the changes you see in unemployment among really young people in certain, I think, college graduates, young college graduates, was really increasing a lot at the moment, and so on, and so forth. So anyways, it’s definitely worth watching.

You mentioned Jeremy Siegel. Did you want to talk a little bit about some of his stuff? And I know you also want to talk a little bit about the Fed as well.

[00:17:53] Alan

Well, It’s probably a natural segue into the discussion on the Fed. There was… Jeremy Siegel, he does a number of things. He’s at Wharton, but he was the chief economist when he was at Wisdom Tree. He had an op ed, recently, just talking about the need for reform at the Fed. And his whole point is around, it’s kind of a technical point that basically after a financial crisis, the Fed went through to this kind of ample reserves system whereby, because they’re doing a lot of QE the banks have a lot of reserves. It’s not a reserve constrained system. The Fed pays interest on the reserves and that’s an income to the bank.

But what it does mean is that the Fed funds market, which used to be the traditional kind of indicator of how tight or how loose monetary policy was, the Fed used to do open market operations to kind of target the Fed funds rate. That’s kind of become a little bit defunct in the last while.

And he’s saying they need to change this approach because it’s not kind of serving their purpose as well. But it’s kind of part of a broader narrative, I think, at the moment. The Fed is under threat from a number of different angles; obviously from President Trump, which has kind of been more so than we probably have experienced in any kind of Fed/President relationship. But we knew this would happen, or we had a good sense because it was a case in Trump 1.0. He’s been more vocal this time.

But it’s not just Trump. I mean, there’s kind of an unusual coalition of hard money and easy money people criticizing the Fed. On the one hand, you have the likes of Trump saying policy should be easier, rates should be lower. The likes of Jeremy Siegel said you need reform. And, at the same time, you’ve got Scott Bessent, Treasury Secretary, saying you need root and branch reform of the Fed. And then Kevin Warsh, one of the leading candidates to be Fed governor, also talking about regime shift.

And I mean, partially this comes from the fact that, obviously, they missed the 2021 surge in inflation. They were too late to respond to that. So, they’re still kind of living with the consequences of that. But also, there’s a view that… So that’s kind of the hard money crew saying that we’re too easy all along with policy. But equally, some people are saying you’ve had mandates drift at the Fed as well, because they started talking about climate change, they started talking about, well, it’s inclusive maximum employment, so we want to have low unemployment for minorities as well as kind of for the broader economy.

So, I think it’s interesting that the Trump is about to make his decision on the new Fed chair at a time when the Fed is generally under criticism, not just from the administration, from lots of people. And then when you look at the candidates, they’re quite interesting. So, I do think it could be quite consequential.

I mean, there is a view out there, oh, yeah, it doesn’t matter that much. I mean, the Fed chair, he’s only one vote on the FOMC. There are governors, there are the regional presidents, but I don’t agree with that.

I think it is quite consequent. I mean the Fed Chair is hugely influential in setting the agenda. You can, you know, at the margin guide the direction of policy. So, I think it is very interesting, and we’re getting to the point now where some of the candidates are, you know, we’re really seeing some of the credentials of the candidates.

[00:21:30] Niels

Plus, there’s actually an extra space that’s become available. There’s someone who resigned only a few days ago, a lady, as far as I recall.

[00:21:37] Alan

That’s right, yeah.

[00:21:38] Niels

So, there might be two seats there. Talk to me a little bit about that you sent me a link to a CNBC interview with Kevin Warsh. The thing is, it’s a little bit confusing. There are actually two Kevins who are up for the Fed Chair nomination. This one I think is the least favorite of the two but nonetheless probably important to listen to him. What were your takeaways from him? Because I’ve made a couple of notes myself but I’d love to hear what were your main takeaways from him?

[00:22:15] Alan

He’s an interesting guy because he’s a former Fed governor. He was a governor during the financial crisis, so, he was heavily involved with QE and the bank bailouts. He had worked at Morgan Stanley earlier in his career in M and A and he was quite involved in, at the time, Morgan Stanley was changed into a bank holding company. So, he was kind of involved in those discussions. And he was kind of quite close to Bernanke through the period because of his Wall Street connections and also he had served in George W. Bush’s administration. So, he’s quite connected politically as well. So, he’s very kind of influential in that time. So, he does come with that background as a Fed governor.

Now, he’s not an academic economist and, historically, the Fed Chair has tended to be somebody with strong academic credentials like Volker, or Greenspan, or Bernanke, Yellen, all kind of PhDs in economics, and have published, etc.

Powell wasn’t like that. Powell is, obviously, a Swiss by background and Warsh isn’t a trained economist either. So, he’s probably more of a political mover, I think. He also works with Stanley Druckenmiller. So, if he has Stanley Druckenmiller’s ear, he’s obviously saying something relevant and Interesting. When you listen to him, it’s quite interesting. He’s very much in the kind of more of what you might call the hard money school. I mean, he’s very critical of the use of QE in the last 10 to 15 years.

He was an advocate of it during the times of crisis, but he’s opposed to it in terms of an ongoing policy tool because of the potential distortions it brings to the capital markets. I mean, at the moment, he seems to be in favor of lower rates.

He seems to be embracing the potential productivity boom from AI, and he sees lower prices. So, my impression is he’s aligned with Trump at the moment, at this point in time, because he is in favor of lower rates. And a lot of what he says, I think will resonate with Trump. He’s very much critical of Powell.

So, you’ve had mandate shift at the Fed, which I’ve talked about, which you shouldn’t have had, a crisis of confidence – he pointed to the fact that the Fed cut rates 100 basis points last year and long end yields went up 100 basis points, and he highlighted that as a lack of credibility.

But one of the other things, he did a speech earlier this year called Central Banking at the Crossroads. And in that, he was actually quite critical of the Fed for kind of facilitating US fiscal profligacy. I guess from the QE perspective, if you’re doing a lot of QE, then that allows the government to issue a lot of debt.

So, I mean, I think, as I say, I think it’s quite aligned with what Trump’s mandate is at the moment. But I could see it turning more problematic down the road, particularly if the administration is looking to the Fed to finance the deficits with a lot of bond purchases, then that wouldn’t fit with his worldview.

And I think the other thing that’s a big unknown, he says the Fed should have tightened policy in 2021. There was a lot of money printing from the government. The money supply was growing. But that leaves open. What is his model? Is he going to bring back monetary aggregates? Is he going to look at credit growth? So, he has a very different perspective. He’s been critical of the Fed’s models. He said the models that they have are back from 1978. It’s kind a Keynesian Phillips curve. You get inflation… If you get wage growth, you get inflation. And that’s the only thing you need to look at.

He’s kind of saying, no, you need to look at money growth, you need to look at credit. But that would be a very radical departure from what we’ve seen in major central banks in the last while. So, as I said, I think he would be the more interesting candidate in terms of more uncertain as to how things could go. Things could go radically different.

And I think, actually, from a markets perspective, he could be a lot less favorable in the sense that if he’s less inclined to do asset purchases, less inclined towards bailouts, more inclined for markets finding their own level, there is a certain scenario where that could be quite a bit more challenging for equity markets.

[00:26:43] Niels

So, there are a couple of things I took away from that. Some of it you’ve already mentioned. But a couple of things, he was very good at referring to Paul Volcker and kind of the things that he did, but left out one important point and that is that, actually, Volcker specifically told Congress that they had to cut deficit. And that’s a very important point to leave out, I think if you want to go down that route.

The other thing I noted was he completely denies that the pandemic and the Ukraine war had anything to do with the inflation that came. It was all down to the Fed.

Now, I will agree, because we talked about it at the time on the podcast, that yeah, I mean, the Fed was out of touch and we could all see that inflation was going to come if they kept interest rates at zero, and all of that stuff. But to say that there was no influence from the fact that we had supply issues and all of that stuff, I think that just kind of shows the color.

Now the final thing, and this is something I hear you talk about, and I did pay attention to it when he said it because again, he mentions Druckenmiller as a name. We know Scott Bessent has a connection with Druckenmiller, and so on, and so forth. There seems to, when I hear more and more about what’s going on, there seems to be very strong links back to Druckenmiller, or you could say maybe it’s back to Bessent, I don’t know.

But it kind of feels like there’s now going to be this new small group, elite group of these hedge fund titans who may be extremely influential in terms of Fed and monetary fiscal policy going forward. And given the fact that they’re all billionaires, I’m not so sure that’s actually going to be in the country’s best interest.

But what’s also interesting about that is that, as far as I remember, and so don’t take it for more than, than my recollection here, that that both Druckenmiller and I certainly Paul Tudor Jones, whom I think is part of that kind of group of people, I mean, they really talk about how they expect much higher rates in the future because of the ballooning deficit.

So, that sits a little bit odd with me in the sense that they actually expect things to get much worse, but they’re being put in charge to kind of solve the problem. But if you have your own positions in one way, how likely are you going to go against that? I don’t know.

[00:29:35] Alan

Yeah, you’re right. And I mean, I think the likes, as you say, Druckenmiller and Paul Tudor Jones, they all pointed to the coming wave of challenge with entitlement spending, etc. And that hasn’t gone away, and it’s going to get worse on the back of the Big Beautiful Bill. You’re already at a huge deficit.

So, I think that’s where, as I say, that’s where it could be a challenge point if you had the likes of Warsh in there because he has been critical of the Fed for facilitating this fiscal profligacy. But what’s he going to do if they stop doing that?

I mean, in theory that would push up bond yields and kind of naturally force the administration to do something, but the Trump administration has already had a chance to try and do something on the deficit and they haven’t. So yeah, you could have kind of a stress point there at some point in the future.

So yeah, I mean, I do think they are all in the camp of kind of deregulation as well, and more kind of right wing types of ideas. And Bessent’s philosophy seems to be to try and grow your way out of the deficit. Whether that’s achievable or not, who knows? It seems optimistic.

So yeah, I mean, your point on excessive influence from hedge fund managers? Yeah, interesting. But I mean, nothing really surprises you with this administration, does it?

[00:31:04] Niels

No, no, no, no, no, no. I mean, linking it all back to kind of our world. And, for sure, it seems like the Fed and maybe other central banks as well, it seems like they’ve lost a little bit of their control, which is not unusual. I think you go through cycles of strong central banks and weak politicians. We are in the reverse at the moment, strong politicians and weak central banks. I don’t think that’s anything new. But obviously these cycles are long.

But I mean, systematic strategies, we do try to build models that ignore the noise. But maybe what we could say, and it kind of leads into our later discussion about the challenges we’re seeing, is that maybe at the moment, actually it’s the noise that generates the signal – the noise is the signal.

So, because we’re not really geared for that kind of environment, maybe that explains part of why this narrative driven world is a bit more challenging for us. Like it was, really, under Trump 1.0. Frankly, if you look at the annual returns during that period, it wasn’t the strongest as far as I recall.

But anyways, let’s move on. Let’s do a quick update on…Oh, by the way, interestingly enough, I know you’ll follow it but for those who don’t follow it, later on this month we’re going to have Jackson Hole coming up, which will always be quite fun to hear what central bankers are thinking and all that good stuff.

Anyways, from a trend following point of view, my trend barometer finished at 34 yesterday. That’s a weak number, and I think it ties in very clearly with what happened early this month, namely on August 1st, with the jobs numbers and the big kind of fallout we saw, in our industry, from that, with a reasonably big hit. And it was actually the day after Trump had come out with the copper tariffs which also led to a big drop in performance because of these reversals.

So, I think the weak number we see right now reflects that. But I also want to add that this week, actually, has been much better, much more constructive for trend followers and CTAs. So, we’re kind of digging our way out of that initial slump as far as I can tell.

But it has been a period, so far, where it’s been a story of a few themes. One is that equities recently, again, are doing well for trend followers, well by themselves. But we did have of course a huge correction in response to the Liberation Day. And that screws up the overall annual performance because we had to cut back a lot of exposure during that period of time. So, the recovery we’ve seen in equity markets has not been captured fully in terms of performance. So that’s the struggle. But it is definitely one of few highlights this year.

And the other highlight this year has really been focused on very few markets, as far as I can tell, such as gold. We know that’s been pretty steady, pretty good. A smaller one that most people probably won’t trade, but we do, that’s live cattle. That’s definitely been a really nice trend in that market. And then some of the grains, mostly to the downside (is it soybean meal that actually is going the opposite direction?. I can’t remember.) But soybean meal, actually, has been a pretty good trending market as well. So, it’s been selective to say the least.

And one of the big sectors, bonds, has been very difficult in terms of transitions. I think we’re transitioning right now again to become mostly short in the fixed income space. So, we’ll see where that leads us. But it’s definitely been a challenge.

And currencies, although we’re seeing probably more volatility in that area compared with recent years, it certainly hasn’t been an easy ride. So, I imagine that’s also where we’re seeing some of the losses so far this year.

As of the 5th of August, so, a couple of days ago, Tuesday, we saw the following numbers which were pretty flat actually. BTOP50 up 5 basis points for August, down 3.93% for the year. SocGen CTA index down 33 basis points, down 7.76 for the year. The Trend index up 10 basis points but still down just shy of 10% for the year. And the Short Term-Traders Index (maybe That’s the surprise one) down 72 basis points, but down almost 6% so far this year. So, clearly these narrative quick market moves we’ve seen have not even been able to be captured by shorter-term models and, on a volatility adjusted basis, they’re actually struggling more so, I would say than, than the longer term trend models.

MSCI world up 40 basis points as of last night, up 11.7 for the year. The US Aggregate Bond index S&P, from S&P, up 80 basis points, up 4.50% for the year. And the S&P 500 Total Return up 10 basis points in August, up 8.7% so far this year.

So, before we jump into the articles, Alan, anything you want to add, from your perspective, to performance?

[00:36:38] Alan

No, I mean obviously things were looking much better in July until we hit the last few days of the month.

[00:36:45] Niels

The last day of trading.

[00:36:46] Alan

Yeah, exactly. And then, obviously, with the payroll that impacted in straight markets as well. So, I mean it did feel like some of the managers that maybe had outperformed a little bit, maybe by being a bit slower had lagged a bit, and maybe the managers who had been underperforming were doing better in July. So, it’d be interesting to see if we see that.

I mean it certainly has been the case that kind of faster and more medium term has struggled, particularly this year, whereas it’s paid to be more longer term. So, I mean, I think that’s something to monitor as we go a bit further out there, if that is sustained.

[00:37:30] Niels

Okay, well, let’s dive into some of these gloomy articles we’re seeing. Well, they’re not all gloomy, but certainly the Wall Street Journal had one that was a little bit gloomy in terms of trend following performance, to no surprise. But of course, whenever an article starts out by saying something like, oh, the trend following industry has the worst start since 1998, you obviously think, okay, that is awful, that’s awful news. But let me just put it in context for the people, before you take over,

There are a couple of things. First of all, I did notice, and I’m just curious about this, I did notice that they were using an index called the Pivotal Path Managed Futures Index. I’ve never heard about the Pivotal Path Managed Futures Index. So, I don’t know how reliable that is in terms of an industry benchmark.

But even if it is reliable, I mean this is only like the sixth down year, so far, since 1998. So, you know, that’s pretty decent for an industry to only have had six down years on that.

The other thing that when you start an article by saying, oh, it’s been the worst period since 1998. Now, of course we don’t have the SocGen Trend Index to reference back in the ‘90s, so, I was just looking at our own performance at Dunn, and just looking at the ‘90s. Yeah, okay, well actually 1998 was an up year. Yeah, it was a little bit rocky in the beginning but it was an up year.

Well, we also had an up year, a very strong one, in 1995,1996,1997,1998, as I mentioned, 1999, 2000, 2001, 2002. So, all I’m just saying when you use an article that pinpoints like that, maybe you need to say, well actually this was just a bad six months out of a run for something like six or seven years, that we’re all positive for the industry. So, anyways, just putting a little bit of a caveat out there. But anyways, tell me what you took away from Caitlin McCabe’s article.

[00:39:37] Alan

Yeah, so I mean, I think maybe the most interesting thing is that when trend following performance justifies a big enough article in the Wall Street Journal, I mean, that’s probably the main point. It’s not every week, every month that it is such a big focus. I think that’s the first point that I would make.

I mean, the article I think summarizes well the challenges and some of the debate that has been going on in the industry. And I mean, it’s not just purely focused on the trend following industry. It kind of zeros in on Man AHL and the challenges they’ve been having. And it highlights their recent results where, I think, their AUM has been growing and they’ve had very strong inflows, but their fees have been going down because of not being in performance fees. And obviously, they’ve been challenged on the trend following side.

And the article has some quotes from the CEO and the CFO highlighting that it’s been one of the toughest periods for 25 to 30 years. And there’s the classic line in there that trend following is not broken. So how many times have we had to say that?

It does highlight as well. That it’s not the first time the strategy has faced criticism. All true. And it quotes somebody highlighting the US 10-year yield very much up and down in a range. So, I would agree with all of that. It’s been very rangy for three years now.

It does highlight in the paper that it says it highlights one of the weaknesses of trend following – it doesn’t work when markets are choppy. Well, yeah, you can’t disagree with that.

As I say, it’s probably more interesting to think about, are these articles a country indicator? Is this the dark darkness before the dawn? Possibly.

You know, if you go back, there was an article in August 2018, Laurence Fletcher wrote in the Wall Street Journal, The Big Hedge Fund Strategy That Isn’t Working. So that was definitely when trend following was in the midst of a very serious drawdown, and 2018 was a tough year as well.

And then Laurence Fletcher, I think he must have moved to the FT, in 2019 he wrote an article which, I think this is the article where, basically, David Harding kind of says they were downgrading or they were less optimistic. They weren’t exiting trend following completely, but he was saying that the outlook wasn’t as positive for trend following anymore. So that was September 2019.

But actually, in 2019 the performance was starting to improve, I would say, by kind of the middle of 2019, performance for the industry was starting to improve. So maybe we need a second article like this in the next six months to mark the bottom. I’m not sure. But certainly there is a sense that, in the midst of drawdowns, you will read more of this. I don’t think there’s anything that people in the industry would disagree with. We’ve seen the challenges before.

I think it is hard to argue with the narrative that, as you say, markets in the current environment are choppier. You’ve got these about turns on policy in relation to copper, etc. So, yeah, but equally, back in 2019, I heard plenty of people telling me, oh, trend following is not going to work anymore. Central banks manipulate markets and they dampened the vol. You’re not going to have big trends in markets anymore.

And then we had good performance in the industry, 2021, ‘22 for a three to four year period. So, markets change. We will eventually come out of the cycle. But yeah, I mean, I think it’s interesting that CTAs are back in the headlines on the Wall Street Journal for the wrong reasons, as usual.

[00:43:14] Niels

Yeah, absolutely. There was one quote that I thought summed it up pretty well and that was, “the case for trend following hasn’t changed, but the burden of patient has gone up”. I think that is true, but here’s the thing and maybe they’ll tie into our next topic, which is a LinkedIn article you wrote as well.

But, there are a couple of things that I think about when I read these articles. So, why do people in the first place, or why should they in the first place even consider managed futures trend following? It’s because it’s non correlated. So, you can do all your studies, and it improves the overall portfolio. There’s no discussion. There’s never been any evidence to suggest otherwise.

So, what surprises me is that a lot of people are “unhappy” with their diversifying instrument or strategy in, say, an equity portfolio that it’s not firing on all cylinders during a time where the equity market itself is compounding at twenty plus percent in the US at the moment. I’m thinking this is wonderful news.

This is the best time that your diversifier shouldn’t be, first of all, it shouldn’t be making money necessarily. It could do, but it doesn’t have to. And you’re making all this money in 60%, 70%, 80% of your portfolio.

Why do you even worry too much about your 1% or 2% or 5% allocation to trend following? So, from my point of view, I would flip it completely and look at it differently. But of course, the problem is also, I guess, to a large extent, that you have certain election cycles in boardrooms where people sit for a couple of years and they have to kind of defend something.

And, maybe it becomes a challenge if you just hit that wrong 24 month period, and if you’re a believer in trend following, and every time there’s a board meeting you have to kind of make excuses for it I understand that. But, it’s just, that then we’re talking about, again, kind of decisions based on the wrong basis really. So yeah, those were some of my thoughts.

There was one thing, by the way, one thing that came up in my preparation. I mean, you obviously have been on the side of the allocation world. You still are for that matter. And I was wondering, is there a moment in your career where you have been the closest to cutting trend, maybe because of a period exactly like this? I mean, is there something you can recall?

[00:46:08] Alan

I definitely remembered it like the 2019 period as well. You know, at the end of the day, after a period of tough performance you have to kind of go back to fundamentals and say, it’s kind of like what’s your world view, how do you believe markets operate?

If you don’t believe that markets kind of operate in a way that will eventually produce opportunities for trend following, then it would be hard to stick with it. I mean, you can point to the statistics, but the statistics just tell you that you can’t prove that something is broken. It would reject that hypothesis.

But I think it has to come back to something more fundamental. I’d have that view that, you know, markets are kind of inherently unstable. You know, you go to periods of stability, but then something eventually will cause a trend.

But you know, I mean, even in the last few weeks I have been thinking about this, for sure. It’s performance, it’s three years of meaningfully negative numbers. And I mean, I think the thing that’s really frustrated me, in this period, has been that.

[00:47:25] Niels

Well, can I just stop you there? Can I just stop you there? You say it’s been three years. I mean, a year and a half ago yes most managers were making new all-time highs, so, I disagree with that. I think it’s been a 14, 15 month period that’s been challenging. The drawdown is nothing bigger than what it’s been before, so, I view it a little bit differently.

I view it more specifically as a period of just a number of big reversals happening in a few big sectors at the same time combined with lots of noise, political noise, leading to equity V shaped sell-offs. That’s how I see it. I don’t see it any other than that really.

[00:48:09] Alan

Well, my point is, if you take the three-year period, performance has been poor. And actually, if you take the 10-year period, the 10 years Sharpe in the SocGen Trend is 0.1 which is like…

[00:48:19] Niels

I know you brought that up which, of course, and is in your article, and which Andrew jumped on straight away. But then I looked at the numbers, and actually in that episode, I should correct that episode because, well, I can’t correct the episode but I can correct it now, I mentioned an number saying, well, hang on I see that the SocGen Trend index being up 96% over the last 10 years. But, when I went back to check the numbers, because Andrew was saying to me afterwards are you sure, I actually looked at the 10-year period but as of June last year, not June this year. So, it is true that it’s only been 30% in the last 10 years. But, hey, a year ago it was almost 100%.

[00:49:02] Alan

I made that point in my article that these long-term measures are quite sensitive, that a meaningful drawdown does change the picture and, as you say, if you go back 12 months, I think it was annualized at 7% or something like that – quite respectable. And I mean, I think if you go back to 2022, from memory, I think, say, in October 22nd, if you did the analysis of the S&P versus SocGen Trend, I think SocGen Trend was maybe ahead of S&P as of that point, going back from 2000.

So, these things, long-term measures, do change. But I do think, yeah, I mean I think there are reasons. It’s easy to see why people might be concerned particularly in environment. I think, in my article, I referenced that the 10-year Sharpe and the S&P is something like 0.8 or so. You’re in a period where the realized Sharpe is above the long-term expectations for equities and it’s below indication of trend.

As you say, sitting in the boardroom, sitting in the investment committee, if you decided to allocate to trend following 18 months ago, and you were some research analysts, and you said, hey, I’ve done a bunch of research, this is the greatest strategy ever. Look at this zero correlation crisis alpha performance 2008, look at 2022, let’s invest, and then suddenly you’re down 15%. Well, of course, it’s so easy to exit because people have careers, they have got to look good in the committee, they have got to look good in front of their peers. So, I mean, I think narratives matter. That’s one of the points I said, the narratives stories are more than statistics.

Nothing is outside of statistical expectations. But if the story is that trend following won’t work because of choppy markets and policy u turns, it’s hard to argue with or hard to come up with a counterfactual to that.

[00:51:02] Niels

You know what it reminds me of, that thing you mentioned about the boardroom, it reminds me, and this is public knowledge so even though I don’t really like naming managers, he went on Odd Lots to talk about it. So, I’m going to do it.

And, that is this oil, very successful oil trading firm, hedge fund that suddenly, last year, started taking big bets on cocoa. And at the time he was saying oh, yeah, but one of my analysts had come by a few weeks ago saying, look at this, and here are all the reasons why cocoa is going to go to 20,000 and all of that. So, they start buying into cocoa at the same time the CTA’s were selling cocoa because of vol constraints.

So, they were buying into this. And, of course, this came out in a news story, this week or last week, that particular fund is down 57% or something like that this year. A lot of that is due to mistaken bets on cocoa. So yeah, I mean, you can have bad timing, let’s put it that way, for sure.

Now, is there anything else you want to highlight from your article? People should go and read it of course on LinkedIn. But is there anything else you wanted to highlight on that or do you want to jump into to the last paper that you brought along with you, which is from our friends over at AQR?

[00:52:24] Alan

Yeah, I mean from my own article it’s kind of in line with what you’ve said. I mean a lot of it is around the downside of zero correlation.

[00:52:30] Niels

Right, exactly.

[00:52:31] Alan

People like zero correlation, but what comes with zero correlation? It means that there will be periods when equities are going up and you’re making money. There will be periods when equities are going up and you’ll be losing money. But it comes back to the behavior aspect. But yeah, so it’s called The Highs And Lows of Allocating to Trend Following, and it’s on my LinkedIn newsletter.

But the final piece then is an AQR paper called Diversifiers Forever, which is an interesting topic. It’s back to this idea of, if you’re a really long-term investor, do you really need diversifiers? And very often I get this, speaking to family offices, long-term investors that say, oh, we’re not interested in hedge funds. Hedge funds, they’re vol dampeners in a portfolio. They’re fine if you want a less smooth ride. But for us long term investors, we don’t need that.

But this paper takes the perspective of endowments who are long-term investors. They’ve got their ultra long-term because you might have an endowment or foundation to support a university. So, the portfolio is forever. Basically, the idea is to maintain the real value of the portfolio and try and generate a return or an income that they can draw down annually, say something like 5% or the like.

So, what AQR do in this paper, they look at the kind of the typical asset allocation of UK foundations based on surveys from Mercer and Cambridge which show kind of, as you would expect, kind of a growth heavy portfolio, 45% public equities, 20% private equity, 10% real estate, hedge funds, bonds, a little bit of cash.

And then they look at, well, you know, is there a case for these types of portfolios? Would they be better off if they added some strategies like trend following, liquid diversifiers, I guess, long short equity. But basically, in their analysis they use trend following to represent liquid diversifiers.

Now it’s a little bit contentious what they do because the analysis goes back to 1972. They’re basically looking at how this portfolio would have done back to ‘7, and how would adding liquid diversifiers have done so.

I mean, to solve the question which you alluded to, the lack of industry data in the ‘90s for trend following, it’s represented by the SocGen Trend index, adjusted to 10% vol, actually. And then they used the HFRI Systematic Macro Index. They used that between 1990 and 1999, but they discounted by 60% to reflect, I guess, that there’s a survivorship bias because it wouldn’t have been live back then.

And then prior to 1990 they use a hypothetical kind of in-house trend following system and they also discount that by 60%. But in some markets they wouldn’t have actual futures markets. So, it’s a bit hypothetical.

Were you going to say something?

[00:55:34] Niels

Well, I was just going to say why don’t they just look at managers who have been around since the ‘70s? Because there’s still a handful of those.

[00:55:40] Alan

But they are the survivors. So, you know, sure, they live through it.

[00:55:45] Niels

Right.

[00:55:45] Alan

You could use John Henry or somebody as well. And then you know, they would have obviously hit a big drawdown along the way and then gone out of business.

But anyway, what is interesting, I mean, I think the big point of this analysis that they bring out is the importance of more stable returns. So, if you think about it, if you’re an endowment and if you have an equity centric portfolio, if you go into an environment like 2008 or 2000, 2002 or 1973, 1974 bear market and that whole period of really challenged real returns, the value of your portfolio goes down and you’re still drawing down your 5% every year. So, a smoother ride means a higher average payout for whatever it is you’re funding, whether it’s a university or whatever. So, that actually has implications, if you think about it.

Like, in Ireland, if you have a pension, once you go into retirement you move it into like a post-retirement vehicle and you have to draw down like 4% every year from that, 4% or 5%. So again, the same logic applies, even if you might be kind of long-term, having that stability is important.

So, what it shows is that even, obviously, reallocating 10% of the portfolio into liquid diversifiers did improve the statistics, the return, the Sharpe, etc. And also, they look at more of a portable alpha approach of leveraging up by 10% or allocating to liquid divers on an unfunded basis. And that also improved the numbers as well.

I mean, it’s interesting when we talked about Sharpe ratios, etc. I think it had the Sharpe for the liquid diversifiers historically at 0.44, which, is that high or low? Who knows? They also do a forward-looking analysis based on some assumptions and it was lower in that, but still the results were the same.

So, I mean, I think it’s an interesting analysis. You might debate some of the return assumptions. They are quite pessimistic on equities as well.

I mean, one point in there that was quite interesting, actually, I mean, AQR have written plenty about private equity and the downside of private equity. So, no surprise that they’re making some comments negatively on that. But they did kind of highlight how the cost of debt, the real cost of debt has gone up from, say, 2.2% to 4.5%.

And they reckon that the return impact of that on private equity, it goes from a boost, the leveraged boost goes from 4 percentage points down to 40 basis points. So about 3.5% reduction in the expected returns in private equity, because, obviously, in the last 10, 15 years we had close to zero funding costs. Obviously, for riskier transactions, you would pay a risk premium.

So, I guess their point is, in an environment of more challenged equity returns, it makes sense. I mean, again, you might say, well, this is very sensitive because they’ve added in the 1970s, which was obviously a very tough period for traditional assets in real terms. Bonds and equities were negative in real terms.

So, what to do is to run another analysis where one takes out the 1970s and takes out the last 15-year bull market to kind of say, okay, let’s take a really good period and a really bad period for traditional assets. So that was, whatever that was, 1980 to 2009. And they say the results still stack up from that perspective.

But, I mean, again, I think it’s one of these ones where people might be a bit skeptical of the results because it seems pessimistic, under return assumptions, for equities and a bit more optimistic, maybe under return assumptions, for liquid diversifiers. So, it comes back to your beliefs again.

But I think their point about stability of returns and how that reduces the volatility of the payouts and ultimately can lead to a higher average payout, I think that’s a very valid point. It’s another way, I guess, of presenting the argument for diversifiers even for long-term investors.

[00:59:52] Niels

Yeah, absolutely. And it really does help on the compounding of returns if you don’t have these huge drawdowns. Speaking of which, I just looked up some statistics while you were talking. If you take the period of January 2000 to June 2025, again, we’re talking about diversifiers, but a lot of people tend to go back into things like long/short equity. Well, the Barclay Long/Short Equity Index actually has an annual correlation to a 60/40 portfolio of more than 60%, 0.6. If you take some of the other ones, even Global Macro is 0.34 correlation, positive correlation. But they’re all positive, maybe with the exception of market neutral – it’s been pretty flat.

But then comes the SocGen Trend index. In that period, it’s negative 0.38 correlation. So, you know, these things are really important.

If you look at those four crises that we know of: the tech bubble, the debt crisis, the Covid the inflation period; I mean, again, most of these indices that you have, in terms of traditional hedge fund strategies, they’re all down. Maybe with the exception of the tech bubble, there are definitely a few positive numbers, but for the most part they’re down during those crises.

And of course, you know, the SocGen Trend index was positive, strong, with exception of Covid where it was just a little bit positive, but it was very strong. And, of course, what it all comes down to, which you’ve alluded to already, is what is the impact of these diversifiers on a traditional portfolio? That’s what we really should be concerned about.

And there just isn’t any real competition when it comes to adding 20% of one of these strategies compared to adding 20% of, say, a SocGen Trend index.

The improvement that you see in your overall portfolio Sharpe is just, you know, unbeatable. It comes out with the highest Sharpe, if you do that, compared to any of the other sort of Barkley hedge strategies. So, yeah, I mean, the evidence is there.

It doesn’t mean that people will embrace it, we know that. I mean, after a good run they’ll probably say, oh yeah, of course, we should have some of that. But it’s the brave ones, it’s the people with real conviction that keeps it in there.

But also, maybe, actually, as you say, maybe the articles we’re seeing at the moment coming out are still some kind of contrary indicator that we may have seen the worst and that things get better. It doesn’t mean the world gets better, it just means that things get better from a trend perspective. I would not be surprised personally, but only time will tell.

[01:02:59] Alan

For sure, yeah, I mean, in 2022 I heard a lot of people kind of saying, oh, allocate trend following. I’m not hearing so many people say it now, but you know, the long-term characteristics of the asset class haven’t changed, have they?

[01:03:12] Niels

No, no, absolutely not. Anyways, this was fun and very educational as usual. Thank you for preparing all of this, Alan.

If you want to leave a nice message review for this episode, and in appreciation of Alan’s hard work, you can go to your favorite podcast platform is a good place to start and leave a rating and review. It certainly helps more people find the podcast. As usual, if you have questions for any of the upcoming guests, you can email them to me at info@toptradersunplugged.com.

Usually I would say who’s coming on next week. I completely forgot to look it up, so I have no idea who I’m speaking to next week. I know it will be a fun and good conversation of course, but I just can’t remember exactly who’s on.

Anyways, from Alan and me, thanks so much for listening. We look forward to being back with you next week. And in the meantime, as usual, take care of yourself and take care of each other.

[01:04:13] 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.