The Paradox of High-Volatility Alternatives ft. Alan Dunne

[00:00:00] Intro

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

[00:00:23] Niels

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

[00:00:36] Alan

Very well, Niels. Thanks a lot. Great to be back.

[00:00:37] Niels

Yes, it doesn’t feel like it’s long ago. That’s because we recorded some other stuff earlier this week. We’ve got a good, solid lineup of topics. I say that each week and I mean it every week. But this week it’s actually quite varied, which I like. We will get to.

There are no questions, so we’re definitely going to be focusing on all the topics that you brought along. But as usual, as we always do, I’m curious about what’s been on your radar lately, things that you find interesting.

[00:01:08] Alan

Yes, I have a couple of things. Obviously, it’s been a couple of months since I was last on, so a lot has been going on. We had the volatility at the end of the summer, mid-summer, I guess, and we’ll talk about that later.

And then as we went into August, we had Jackson Hole. I think Jackson Hole is always interesting because it revolves around a particular theme, which is always interesting. What is the dominant theme that policymakers are talking about?

If you go back to last year, there was a big focus on debt and debt sustainability. And if you go back to 2022, it was all about the challenges for monetary policy with supply-side constraints and all of that. There was even 2021 with monetary policy in an uneven economy.

And this year, it was all about the transmission mechanism of monetary policy, which is interesting. The thing that the policymakers are grappling with is the rates raise from 0% to 5%, over 5% in the US and haven’t had much of a reaction. We’re obviously starting to see a slowdown now.

But that was one thing that’s a big focus from an academic economist perspective. And the second thing that’s also interesting is sometimes the chair, Powell, will talk about a big issue from a more of an academic point or a research perspective. Like going back a few years, it was around neutral rates and stuff like that.

And then sometimes it’s kind of a short, snappy speech about something policy-related. And it was the latter this time around. So again, in 2022, he had a very short speech saying, we need to do more in terms of tightening.

This time around, it was very much short and focused saying, we’re cutting rates. So, I mean, in a sense, those two aspects of Jackson Hole were very interesting. So that’s one thing.

A second thing just out this week, which I think is very interesting as well. In Europe, we had Mario Draghi coming out with his plan or his recommendations to Europe about the need for a new industrial strategy.

The numbers here are really noteworthy. He’s saying that Europe needs to invest 800 billion euros a year for the next number of years, which is about 4.5% of GDP. This is written in the EFT’s analysis. And they’re saying that’s double the size of the Marshall Plan in terms of GDP, which the Marshall Plan was obviously the big investment that came after World War II, which kind of propelled European economic growth.

So, it’s all around the need for Europe to invest heavily, to boost its productivity. And this is coming from the fact that one, economic growth in Europe has been very sluggish. Obviously, Europe has an aging population, which doesn’t help from a GDP perspective. But productivity has been sluggish. So, it’s justified on that basis.

But also, I guess from the global dimension, we’ve seen the shift in policy in the US towards much more active industrial policy, putting policies in place with the infrastructure bills and the Inflation Reduction Act to attract investment and to boost their capability, things like chips.

At the same time, China has targeted certain industries like solar and EVs. And now this is Europe’s response saying, hey, we’re falling behind. And if we don’t do something, we’re going to be left with slow growth going forward, declining living standards.

So, it’s definitely like a call to action to European policymakers. Also, he references the need for common funding. So basically, bringing back this topic of a common debt instrument, a safe asset, which is always contentious in Europe.

So, I mean, as ever in Europe, what will actually happen may actually be quite different from what’s being proposed. But I do think it’s certainly a story to monitor, potentially hugely significant. But as ever, will European policymakers be able to come together to move forward on that?

So, I think that’s a very interesting macro development that could be quite far reaching and important over the coming months and years. But it’s definitely one will have to watch.

[00:05:06] Niels

Yeah, let me just ask you one thing on that. I don’t follow European economy that closely, to be frank. But I seem to have the impression that Europe has always been kind of slow, low growth.

I mean, you can’t really compare our economy to the US. And we don’t have as much, necessarily, volatility in growth either. That’s kind of how I seem to remember it. I also seem to remember that politicians always talk about, you know, how Europe is going to grow and blah, blah, blah.

And I don’t know where, because I do feel, and this is of course more from maybe you could say a Danish point of view, because I do follow that a little bit more closely. I mean, it’s not like the government isn’t investing in many things.

I know the Danish economy is perhaps a lot stronger and different than many other European countries. But they do invest a lot in new things and certainly also in the energy transition as well. So, I kind of wonder whether this is also a result, even though Draghi would never admit this, as when we try to put all these countries together, there’s a huge amount of, you know, bureaucracy. And I kind of feel a lot of the energy, but probably also a lot of the money just disappears in some kind of black hole in Brussels when we take these initiatives.

So, I’m not surprised that he comes out with such an idea. I just don’t know if it’s ever going to work.

[00:06:40] Alan

No, I agree. I mean, it kind of feels like that with respect to Europe, but I’m sure if you look to the data that we have gone through periods, like obviously the Marshall Plan post-World War II, there was a big surge in economic activity. Before the EU, of course.

Yeah. I mean, when we talk about Europe, I mean, the core drivers of European growth are always going to be Germany and France, and then I suppose Spain and Italy, the next two. But even like in Germany, growth was stronger.

If you go back to the kind of the Gerhard Schroder reforms, you know, going back whenever that was, 2000s. So, it did have a period where, you know, there was productivity gains, a lot of outsourcing to Eastern Europe. You know, you couldn’t take a skeptical view and say, well, yeah, and cheap oil coming in from Russia, which now is part of the problem for Europe.

But I think certainly a part of the Draghi focus is on trying to encourage more pan-European initiatives. So, they’re particularly talking about the need for pan-European spending for kind of cross-border energy infrastructure. So, things where it can’t be just done within one country that is pan-Europe.

And also, then around defense spending, where it makes sense to kind of, there’s efficiencies with respect to procurement, et cetera, if it’s going to be kind of a common defense initiative. So, I think you’re right. That’s the challenge.

It’s always been a challenge with Europe, lots of different countries, different national agendas versus the European agenda. So that’s why I say it is potentially hugely significant, but we’ll wait and see.

[00:08:10] Niels

Indeed, we will. Indeed, we will. In the meantime, while we wait, you also highlighted an interview by Kenneth Rogoff, actually, which is kind of on an interesting topic. We’ve debated this over the years and I have a feeling that a lot of us (and when I mean us, I mean the host and co-host on the podcast), we kind of have the same underlying expectation that maybe inflation is not going to be as well behaved, let’s put it that way, as a lot of people hope and think. So, tell us a little bit about what he had to say about this.

[00:08:47] Alan

Yeah, exactly. I mean, I think you’re right. A lot of us would probably be of the same view that we’re into a changed global macro environment and a paradigm shift, etc. But obviously, you know, inflation has been coming down. CPI this week, again, was consistent with the disinflation narrative and PPI even better contained. So, you know, people who are of the view that maybe we’re heading back to this, you know, to where we were four years ago would have ammunition to support that case.

So, I just thought it was noteworthy to see this interview with Kenneth Rogoff, who’s obviously a very well-known economist at Harvard, wrote the book about debt markets. And this time it’s different going back a few years. So, he’s saying, yeah, we’re entering a period where volatility is going to be higher, which, again, this was a big theme of the Jackson Hole in 2022 about, you know, we’re going to have more supply challenges. So there will be periodic supply shifts, which will lead to higher and more volatile inflation.

His core view, I would say, is he just thinks we’re going to find more situations where they take a chance on inflation rising rather than having high unemployment. He’s talking about central banks.

He’s kind of saying kind of the political support for, yes, I know they want to be hard on inflation, but if it comes down to higher inflation or higher unemployment, they might just take a chance on the high inflation. And equally, he says his view, or his forecast is that we’ll have one more episode like the inflation surge that we’ve had. We’ll have another one like that in the next seven or eight years.

So that’s quite a forecast. I mean, most people are assuming COVID was a one-off. He’s saying that the conditions are there. If you get a supply side shift, the policymakers might err on the side of letting it take effect. And so, I think that’s interesting that, you know, I suppose mainstream academic concurring with that view. When we’re in the midst of the disinflation, it would be easy to kind of say, look, inflation, the problem is solved.

[00:10:55] Niels

Yeah. And actually, he also highlighted one thing in the conversation that I find personally kind of interesting because I think it might be a risk that we underestimate to some extent and that it actually ties in a little bit to something about the carry trade, which we’ll talk about. Also, we can highlight the fact that we spoke and interviewed one of our colleagues on the podcast, Kevin Coldiron, who is one of the authors of the book, The Rise of Carry. Obviously, it’s become a really hot topic this summer, but it’s actually a really important topic in general. And the point I’m talking about here, Alan, that Kenneth Rogoff mentioned, is this central bank independence that is under pressure, because I think the whole carry regime is reliant on trust in central banks.

I’m just sort of trying to connect things where I say, well, if really it was to happen that Trump wins and he kind of takes control of the central bank, as he’s threatened to do, then at some point maybe the market, i.e. the bond vigilantes, come out and say, well, hang on, we don’t want that. And this can then have this effect on the whole carry regime, which is kind of the financial “regime we’ve seen for a few decades” and that most investors know. They don’t know anything else.

And on the inflation point (just not to go on too much on this, since we really want to dive into some of the main topics), but I was chatting to one of my friends and we were talking about when it comes to inflation. The thing I find interesting, at the moment, is the fact that there is this shift in dynamic where we previously had, back in the 70s and maybe the 80s, unions were strong, workers were strong, employers not so. And then it shifted.

For two or three decades, for sure, employers had the upper hand and wage growth was kept at a minimum, probably to a loss in real wages and so on and so forth. But that’s changing. If you speak to people who run companies today and who have to hire people, they all say it’s very difficult to get the young people to do a little bit extra without something in return.

They want to be paid, or they actually just say, no, I don’t want to do that because on Saturday I have already made commitments with some friends. In the old days, when you and I grew up, we would always say, yeah, okay, we can do that. We can do that without asking for anything in return. So, there is a shift. It’s an interesting one. And it actually goes back to inflation as well.

[00:13:46] Alan

Yeah, for sure. Obviously that’s part of the challenges of declining labor force. So fewer workers would actually point to a greater bargaining bar as well as the structural behavioral shifts that we might see as well.

[00:14:04] Niels

Indeed. All right.

Before we turn to our usual trend following update and the global macro views from you, you had another one, an interesting little topic. Just an article you had found from, I think you saw it in Financial Times. It’s based on the Goldman Sachs report where they are seeing, now, client redrawing money from these very popular multi-strat funds. So, what’s that all about?

[00:14:33] Alan

Yeah, it was interesting. The FT reporting, they had seen the Goldman Sachs report on the large multi-manager hedge funds that they’d suffered their first outflow of assets in seven years, a decline of AUM of $30 billion. That came from some of the funds that were actually giving money back to investors. That accounted for about $10 billion of it.

But the balance, $20 billion, was from client redemptions. And they talk about a few reasons why this has been the case. The performance last year, for a number of funds, was not great. Performance seems to be better this year. So that’s one thing.

The second thing is that investors have already allocated a lot. There’s been an enormous growth in this sector, you know, and really over the last five years.

I was talking to one allocator this week who was making the point that a lot of this might have come from, you know, after strong allocations to private markets, VC, PE, a lot of big institutions looked at portfolios and said, okay, we’re way overweight in the private suite to allocate to hedge funds. And getting the multi-manager kind of diversified exposure was a quick and easy way of getting kind of a diversified hedge fund portfolio all in one allocation. So, they were the kind of natural destination for that allocation. But that kind of was maybe more of a one-off shift.

Now, obviously they’ve made that allocation. Performance is okay, you know, not great last year, better this year. But the other factor is obviously the fees. And then these multi-manager funds are based on a pass-through model where all of the expenses flow through to the investor.

And in aggregate, that can account to up to 10% in terms of your allocation. So, you know, that’s fine. Well, you can debate whether it’s fine if performance is good, but as soon as things slow down a bit, investors might balk at that.

And that’s something that was definitely, you know, we spoke to John Jackson, the head of hedge fund research at Mercer recently, and he was making that point. Also, these are large complex portfolios which can be a little bit more difficult to get your arms around in terms of understanding what’s in the portfolio. And coupled with that, around the pass-through fees, can be a challenge.

So, it’s just interesting that there is that little bit of a shift in sentiment. It remains to be seen if it’s anything more noteworthy or is this starting something more permanent or not, but definitely something of interest.

[00:17:06] Niels

Yeah, I think your point about this being a quick and dirty solution, kind of the lazy man’s approach for institutions to get a large amount of money from private to more public, makes a lot of sense. I’ve not actually thought about that.

I personally, of course, struggle significantly with this fee model. I mean, how can you just, whatever cost you have, pass it on to investors. It makes for no accountability for managing your own business well. And so, I understand that.

But what I don’t understand about this, Alan, is that it just strikes me that institutional investors, who are clearly behind these massive allocations for sure, they seem to be gravitating towards perhaps the most expensive strategy of all with the least transparency. And that’s everything that goes against what they’re telling us about how we should lower our fees and how we should be transparent almost to the point where they want to know what’s in our algorithms.

I mean, it’s kind of weird to me and I see some similarities, of course, as well as the money they have put into private equity. It’s not cheap. It’s not very transparent. And there’s a big debate about who actually prices the underlying investments and so on and so forth. So, yeah, I can’t figure it out.

Then there was one thing I thought of also, which may not actually have any impact at all. A lot of these multi-strategy strategies, they’re neutral. They’re market neutral, a lot of them. And so, in a sense, it goes back to our conversation with Kevin on the carry regime and if things are stable, they can probably eke out small inefficiencies with a lot of leverage and deliver the returns that they have delivered.

But I just wonder also if what Kevin was writing about, five years ago in the book, and what we now saw over the summer, that perhaps this stable carry regime and some of the big carry trades are coming to an end. And, of course, this would probably fit into at least the views that you and I have about the future and as we talked about instability and inflation, etc. But maybe it’s just becoming harder for these multi-strat firms to deliver those returns for the reason that there is a change in the underlying market structure or regime, however we define it. So, that was just something I thought about.

[00:19:41] Alan

It remains to be seen, particularly as you add more and more assets. The whole model is predicated on finding diversified sources of return and levering it up. But are there only so many different return streams you can access? So, yeah, that’s a valid point, I think.

[00:20:00] Niels

Well, from one big story to a big macro picture from you, I’m always curious to hear a little bit about how you see the world and what may come, in your mind.

[00:20:14] Alan

I think, obviously, the big thing, we’re back on Fed watching again and I referenced Jackson Hole. We had the Powell speech on that day, which was interesting, not just signaling a September rate cut, but also signaling an easing cycle. So, I think that’s an important point. And then we had speeches from Waller and Williams, following on in short order saying the same thing.

So, the market at the moment is very much debating, is it 25 or 50? And that’s an important and interesting debate. But I think the more important thing is, where’s the destination? So, where is the Fed heading now over the course of a number of months?

I think you can make arguments for 25 or 50. Historically, I would have said it would have been more typical, you do 25 and then, you know, actually what we’ve seen from the Fed in the past, in the 2000 easing cycle, 2007 there’s a 25 and if things get bad, then suddenly you’re doing intermeeting cuts or you’re doing more aggressive cuts.

So, that would be the typical I guess, playbook. I mean, you’ve had the fact that they’ve been doing 75, you know, on the way up, 25 might feel a bit tame. There might be an argument for getting towards neutral more quickly. But I think on balance, if I was to call it, I’d probably go for 25.

But as I say, you know, there are arguments on both sides. As I say, the more important, I think more interesting question is the destination. Like, where is policy now heading?

As I say, Powell has signaled the start of the easing cycle and both Waller and Williams made the point that now they can start removing the degree of restrictiveness and moving towards neutral. So, this is all, you know, the whole point and debate about where is R-star? You know, R-star is this hypothetical level of interest rates that provides an equilibrium for the economy.

It’s that perfect short-term interest rate that means that monetary policy is not stimulative, or not restrictive. So, obviously, with inflation coming down towards target, their view is they don’t have to be restrictive anymore so they can bring rates down. But the question is how far and at what point is policy neutral?

It’s interesting, if you look at their projections; so obviously every quarter they issue their statement of projections for where they see the dot plot, you know, where they see rates going over time. And one of the numbers that they’re referencing there is what’s the long-term Fed funds rate. And that’s really our estimate of what the Fed thinks neutral rates are, or R-star.

Now, for a long time, that was 2.5%. If you go back to 2019, if you go even 2021-‘22, even up to last year, it was always 2.5% on the view that real neutral rates is a half percent and inflation over the long term should be 2%, so 2.5%.

Interestingly, in the last few months, that’s been edged up a bit. So now it was 2.5% to 2.6%, now it’s 2.8%. And, you know, we’ve spoken to plenty of people on the podcast who are saying, you know, there are reasons to suggest that equilibrium rates could be higher, productivity is picking up, we’re having more fiscal expansion, so it could be 3%. And actually, if you go back to Jackson Hole in 2018, I think it was Powell gave a speech all around R-star saying it’s very hard to observe or estimate R-star in real time.

So, it could be anywhere from probably, I would guess, 2.5% to 3.5%, you know. But that still leaves a lot of easing. You know, we’re at 5.25% at the moment, so we could certainly see the markets pricing in, you know, 100 basis points of costs by the end of this year, and then is pricing in rates, you know, getting down to 3% by about the middle of next year.

So, my interpretation of what the market is saying is, yeah, we’re moving towards neutral, but it’s also pricing in a bit of recession risk as well, and some probability that rates will actually have to go below neutral, which would be, you know, we had Peter Berezin on, he’s calling for 2% Fed funds in this cycle. So, he’s pricing in neutral with some risk of going below there.

I think what’s likely? I think the likely scenario is the Fed’s moved to being much more reactive. Now they’re saying they’re data dependent, but not dependent on one data point. Which is, okay, fine, but I think what we’re going to see is, you know, the problem with that is if you get a minus 100, they’ll almost certainly have to cut 50 basis points at the next meeting because that’s what the data is saying.

So, I think what this means is, you know, we’ve already seen this transition away from kind of having a forecast of where things are at 2% or 2 years forward and calibrating policy from that to this more data dependent approach. So, I think it means that as soon as you get any kind of significant weak data, you’ll immediately get a reaction. That points me to there being much more volatility in rates going ahead.

I mean, it feels like there’s a lot priced in. I mean, based on where neutral is, you know, you can say, okay, it’s fair enough. I think there are risks around it.

The election’s certainly a risk. You know, you mentioned, if we were to see Trump, I think all bets would be off because, you know, he would certainly want to extend the tax cuts and if not do more. Now obviously it looks a little less likely after the debate, but, you know, it’s still close to 50/50.

So, I think there’s a lot priced in. It looks like a lot. It’s not unreasonable given where the estimates around neutral are and the Fed is stating it’s on the way back to neutral. But you know, there’s a lot to come in the next few months in terms of political risk and I think we’re going to see a lot more rates volatility because of this heavily data-dependent approach. So, I think that’s going to be the feature for the next few months.

[00:26:23] Niels

Like myself, Alan, you’ve been around for quite a while in the financial markets. I wanted to ask you something. Do you remember when the Fed started to give this guidance, this idea that they’re going to tell the markets kind of what their plan was for the next one or two years?

Do you remember when that was, because I don’t remember it back in the 80s. That’s not how I remember the 80s.

[00:26:50] Alan

Not even in the 90s. Forward guidance came in as one of the suite of tools kind of after the financial crisis. The idea was that if you give forward guidance that rates are going to stay low, then that can anchor long-term rates. But that’s kind of transitioned into now, Powell at Jackson Hole announcing what was going to be decided.

[00:27:14] Niels

The reason I ask is that there’s a very high correlation then with that coming into play, that being the new way of doing things, and the extreme carry regime we saw exactly after that. And of course, that’s part of what people are now accusing central banks for, is being the facilitator of the extreme carry regime. So, I find it interesting.

Interestingly enough, again, just to show you how things are, the former Federal Reserve of New York President, Bill Dudley, who as far as I remember has been a bit of a hawk, he’s now out saying this morning that he thinks there’s a strong case for 50 basis points to be cut. I truly hope that they don’t. I hope they stay with 25 and I applaud them for not doing anything during the August volatility.

I hope they just stay the course, but we’ll see. And by the way, I’m not smart enough to figure this out, but I’m pretty sure I’ve heard many people talk about that, yeah, we talk about policy being restrictive, but there are so many other programs happening that in fact monetary policy is still loose.

[00:28:24] Alan

That’s the point. I mean, you can have rates at 3%, so short-term rates at 3%, but long-term rates could be at 3% or 6%, and the equity market could be up or down, and credit spreads could be tighter or not. So, this idea that there’s one rate that is guiding the whole economy and you can encapsulate everything in one rate. I talked to Adam Posen about this and he was much more in the camp that financial conditions are more important than one rate, and he was also critical of this excessive communication from central banks as well.

So, I think it’s all right in theory, but as I said I think what it means is more volatility in rates and yeah, more jitters for the markets I guess.

[00:29:12] Niels

Yeah, absolutely. Well, we are halfway through our episode-ish and we only now get to the trend following update. I think that must be a record, Alan, so well done for keeping the suspension going here.

August so far, we’re kind of about at the halfway point, I guess. It’s been fairly quiet compared to what we saw over the summer. A little bit of a better tone, I would say as well, from a trend following perspective, but interestingly enough, this is all down to fixed income and the sector, as far as I can tell, from the data that I see. We saw, and what makes it kind of interesting is, we saw this transition from having short exposure from a trend following perspective to fixed income for more than two years, and then slowly in the early summer and over the summer exposure was cut and we started seeing some long exposure being built just in time, really, for taking some of the brunt, I would say, in August. So, this is obviously depending a little bit on the speed of your models but that’s been quite interesting.

Now, there are a few things that have, you know… So, I also think, by the way, that fixed income is now generally a positive sector return for the whole year, not just for the month of August, actually I think for the whole year. That would be joined by, say, Japanese equities, which have been pretty good despite recent setbacks, and of course the soft commodities with cocoa and some other stuff. So, that’s kind of how I see it.

We have enjoyed, in August, a few other markets individually that have done okay. Gold and silver I think are doing okay for managers, and also we see some continuation of the downtrend, specifically in things like soybean oil and canola, but not necessarily the whole grain complex, because we have had some headwinds in some of the other grain markets, as we have at least until recently in equities and currencies, but we still have another half of a month to go. Feel free to comment if you’ve seen anything interesting from an August perspective.

[00:31:26] Alan

Well, no, but I think on the fixed income, it has been an interesting year, and the August, July period again is, you know, in terms of the dispersion across managers, we saw this at the back end of last year, kind of in December and January, that bonds rallied from November and some managers were faster to get on that. We saw those managers doing well in December, and slower managers not, and then the slower managers did better in January, and the faster ones didn’t, and we’re seeing the same now.

Some managers have transitioned, obviously, into long bonds in the last number of weeks. There’s still, I think certainly you can see positions in the ETF space, and those products have been slower. So, it’s been interesting. Obviously, equity risk has been a big driver this year, but equally fixed income risk has been a big driver, and has been quite different across managers, I would say. So, from a dispersion perspective, I think that’s been an important driver.

[00:32:23] Niels

Yeah, as well as the role that fixed income is playing now from a risk perspective, it was quite muted, actually, during many months, and now we’re back to it being maybe the largest exposure, generally speaking.

My own trend barometer also has picked up a little bit. It finished yesterday at 50, so that is generally in line with what we’re seeing from a performance point of view.

These numbers, of course, are as of Wednesday evening, although Thursday was very, very quiet, so I think Thursday would have been flat overall for most CTAs. Anyways, BTOP50, up 67 basis points in September, up 3.4% so far this year. SocGen CTA, up 81 basis points in September, up 2.15% for the year. SocGen Trend, up about 1%, up 2.34% for the year. And the Short-Term Traders index having a little bit more success, up about 1% and change, but up not a lot, I think half a percent or so for the year.

Equities, although there’s been a little bit of a comeback, they’re still down. MSCI World, as of last night, down 1.36% in September, but up almost 14% for the year. S&P 500 Total Return, down about 1% as of yesterday, but up 18.5% so far this year. And the S&P Global Developed Sovereign Bond Index is up about 1.1% so far this month, up 2.62% so far this year. And, of course, bonds in the last three or four months, for a change, I should add, have seen some positive performance coming in, but still, I think over the last 10 years, have still not produced any returns.

So, with all of that, we’re getting close to the main attraction, Alan. But, before we get to that there’s one more paper we wanted to address, and in particular you wanted to address. And we’ve already touched on the topic, but BIS wrote a paper about the carry unwind, so that is important, given their…

[00:34:34] Alan

Yeah, I just wanted to chat a little bit about the whole period. Obviously, in July, August, we had this carry unwind volatility coming back to markets. It impacted portfolios more broadly, it impacted CTAs, so kind of a few observations around this.

And the BIS had a paper out talking about the market turbulence in carry unwinds, so I think I’d certainly recommend to people to have a look at that. It’s an interesting review on what happened. They do actually reference, it was pointed out, they do reference how CTAs may have contributed, but they said, well, CTAs might have gotten long yen in early July, which seems incorrect, because obviously CTAs were heavily short yen, and they were just unwinding their short yen.

All of that aside, I mean, they have an estimate of the carry trade at $250 billion, and they are actually probably on the low side, because within the paper they do look at all the different components to yen funding. You have hedge funds, interbank yen flows, yen denominated loans to non-bank overseas, and then also there’s a huge market in yen denominated secured notes to fund things like US CLOs.

So, thinking in terms of if you were to just look at the CFTC data, that’s a very small fraction of the dollar/yen long position, whether it’s a carry trade or not. Also, you have to bear in mind, with all of this stuff, you’ve got the hedging activity. You might have Japanese with US assets, they might put it in an unhedged basis and tactically say, okay, we’ll ride up the dollar/yen trend as long as it’s in place, but if we see signs of it turning down, we’ll put our hedge on.

So, it’s very hard to estimate how much, I mean, they acknowledge that, saying the $250 billion is probably on the low side. I think what’s more interesting and not unusual, is to hear the BIS say this. They’re kind of making the points that this market turbulence we’re seeing, you know, reflects structural features of the system, and that’s nothing that we haven’t talked about before.

Basically, periods of low volatility encourage greater leverage, and that’s kind of the nature of the system as well. Obviously, if volatility is low, margin requirements are low, and as soon as vol spikes, there are a number of mechanisms which cause deleveraging and degrossing, obviously exchanges. Put up margin requirements, that’s one thing. There are margin calls on levered positions, and then there are obviously market participants who will vol adjust their positions.

So, for all of that, these are kind of structural features of the market. I do say that this is kind of ominously to say, although an outright market dysfunction was averted this time, the structural features of the system underpinning such episodes deserve continued attention by policy makers. So, they’re kind of saying, okay, we had a lot of turbulence here, but a big accident was avoided, but that’s not to say we couldn’t have something more serious in the future. So, I think certainly that was interesting.

I think from our kind of perspective, you know, there are a couple of things. I was engaging with one investor around this, and he was saying, oh, I think we’re going to see more of these flash crashes, and more of these extreme moves. It got me thinking about it.

The S&P didn’t have that big a move on the day, you know, it was, what, 2%-3%. Now obviously, the Nikkei had a huge move, and the VIX had obviously had an outsized move, but most of the focus was on the S&P. As you say, there was a huge clamor, you know, for the Fed to cut rates.

I saw Jeremy Siegel on CNBC, on the Monday, saying the Fed needs to cut rates by 75 basis points immediately, and to signal another 75, in a state of panic, as if it felt like the markets had tanked. The S&P was down 10%.

So, it kind of reminded me, you know, of a period earlier in my career when I was trading in London. I look back at the data, I remember an episode it was October 1997, you know, the S&P was down 6%-7%, end of October in one day. It was a big move, twice the size of the move we saw this time, but I don’t remember the clamor, the hysteria that we felt in this episode.

It kind of relates, I think, to something we’ll talk a little bit about, with Cliff Asness who has a paper on how the markets maybe are becoming less efficient and he’s pointing to social media. But I think the intensity of the focus now around some of these moves is of a much greater order of magnitude, whereby a move of a certain amount is getting such a reaction because markets are so intensely followed all the time.

Whereas, back in the 90s, you might have had a ticker that you brought home, told you where dollar/mark was, or dollar/yen, and how much the S&P was moving, but you weren’t monitoring it in real time. A 6% move was a big move, but it wasn’t the end of the world. So, I just think there’s something different going on with this increased focus that, arithmetically, we’re not seeing bigger moves but they feel like we are.

[00:39:59] Niels

I love that point, because actually, and I can’t remember who I was talking with this about on the show, but around the same time is when the less than 2% daily drop S&P streak finished at 350 days, something like that. And you’re absolutely right, but I think it goes back to this thing about us being conditioned, and it really does relate back to this whole carry regime.

I love how the BIS points fingers at all sorts of participants for being involved in this, but maybe they should mention monetary policy in Japan as being another reason for why there is a carry trade in the first place. So, this will never go away, but I do feel that, certainly in my career, the first 20 years or so was one environment, and then we’ve had 20 years now of an environment where we’ve all become conditioned on the Fed put, of course, but generally speaking, nobody wants downside volatility, not even the central banks.

What’s even more incredible is hearing people, like Jeremy Siegel, calling for 75 basis points. Even if the market was down 10%, it’s down 10% from an all-time high. It’s not like people have lost a lot of money, right? And it’s still up for the year. So, this is kind of complete craziness, in my opinion.

[00:41:22] Alan

The second thing I want to talk about briefly, obviously, it was another period from a trend following asset allocation perspective where trend following, obviously, trend followers were long equities coming into the period. Obviously, you had the dollar/yen trade on, so it was a tough period, obviously, I would say, for most trend followers. If you were very fast, maybe you got on it, or if you were trading big…

[00:41:48] Niels

But even the fast one’s, Alan (sorry to interrupt), but even the fast strategies struggled, right? Because it was almost too fast – the rebound. I talked about this with a company member who we discussed this with, that we can have V-shaped recoveries that are really painful for a trend follower, maybe like COVID where it took like a month, so we had turned positions and were caught on both sides.

But with this one, actually, I think trend following did pretty okay. I mean, we’re down, but it was too short to really have a major impact. What impacted position size probably was more the volatility spike than the change in direction, first down, then up.

[00:42:29] Alan

But it was interesting. I saw a LinkedIn post from somebody on this talking about CTA’s poor performance in this period and how they are not reliable diversifiers, which got me thinking. People have such short memories.

I also saw an article on the FT talking about how other allocators were happy they had long bonds and obviously this was an episode where bonds did well. So, if you look at TLT ETF, it’s about 10% since the start of July. So, it was a capital markets event, deleveraging and degrossing, the type of event where bonds do well. That’s not to say we can’t have more episodes like 2022 where bonds might do badly, and we get more prolonged down moves in markets.

But it kind of made me think, this LinkedIn post talking about that CTA’s weren’t reliable, he said, oh yeah, they’re supposed to zig when equity’s zag. And this is an expression you do hear a lot. I used to spend a lot of time going and talking to financial advisors in the US around it and they would often use that, oh, I like CTA’s to zig when equity’s zag.

And it made me think of it, there’s this expression from Einstein that everything should be made as simple as possible but not simpler and that’s the problem with an expression like that. Zig when you zag it implies negative correlation but obviously it’s not, it’s zero correlation and there will be times when equities are zigging and so are CTA’s unfortunately and that’s just the nature of it. But it’s a communication thing that you try and simplify something, the risk is you oversimplify it into something that sounds nice but actually that’s not the case.

So, it wasn’t unusual, we have seen these episodes for CTA’s before, it doesn’t by any means mean that they’re not reliable diversifiers. I mean what is a reliable diversifier? Is that a hedge? So, I don’t know, I thought it was an unusual comment but certainly…

[00:44:29] Niels

But not surprising Alan, I mean this is what people normally say, as soon as CTA’s lose money, if equities go down, people, not all people but some people will come out straight at the gate and criticize. I just think it shows their ignorance really about the strategy, that’s all I can say at the risk of offending someone who wrote that article that I may know, who knows.

[00:44:53] Alan

Exactly.

[00:44:54] Niels

Anyways, that kind of leads us to the main attraction which is great. There’s 15 minutes left to give some focus on one of the more, how should I say, vocal people in our industry, Cliff Asness, who writes some wonderful, funny, insightful papers and you’ve been studying two of them, although I think it’s the latter one that will be the main feature today.

But the first one I think you wanted to, which you’ve already done, eluded a little bit to this, which I think is actually an interesting point, that with all this information and so on and so forth that we get today people would think that markets are becoming more efficient, but he takes a different view.

[00:45:40] Alan

Yeah, so Cliff Asness, as you say, there are two papers. One’s on his view that markets are actually becoming less efficient, and a second paper on, it’s called, In Praise of High Volatility Alternatives, which is probably the main thing we want to talk about.

But just on the market efficiency, and actually Eugene Fama was interviewed in the FT recently, so he had some comments. It’s an interesting one, I’ve got this comment from investors before as well, saying trend following isn’t going to work, the markets have gotten more efficient, data is readily available, information flows are faster. Cliff Asness makes the point, it doesn’t mean that markets are more accurately priced, just because data comes more quickly.

A lot of his paper is around value metrics in stocks, and basically shows, if you look at the multiples paid for some of the most expensive stocks versus the cheapest stocks, investors paid way more in 1999, 2000, that period, and then again in 2019. But even on that metric it’s still high relative to history so you’re not seeing this normalization in valuation metrics.

Now, I thought initially, when I saw it, oh well that’s just the MAG 7, or it’s just the influence of technology. He says no, they’ve adjusted for that, and even allowing for that. You do see these prolonged periods of these valuation divergences. I mean, he makes an interesting point about the whole point of the efficient markets is related to the wisdom of the crowds; the fact that if you get a lot of participants, by virtue of a lot of views, you’ll end up with the right answer, because you get a lot of people.

The original thing about this was you had to guess the size of, I think the weight of a cow or something. There was this famous example. You ask a thousand people and you actually get the right answer by virtue of the wisdom of the crowd. He makes the point that that works as long as the crowd is independent, which is an interesting point. Because information flows so quickly, is everybody looking at the same thing, social media all being influenced by the same influencers, the same whole process, so is the crowd as independent as it was in the past?

His paper is very much a qualitative assessment, there’s no kind of data to support a view. I thought it was interesting, particularly from what we’re talking about in relation to the recent episode as well. There’s another episode of obviously herding and people overreacting to the same points.

Maybe moving on to the other paper, which is around in praise of high volatility alternatives, which is something that we’ve talked about before and something that’s very relevant. When I work with investors, trying to guide, explaining the benefit of volatility and why a lot of times investors are conditioned to look for high Sharpe, low vol.

In Cliff Asness’ paper, he makes the distinction between thinking about these things when you’re talking about your overall portfolio, and the components of your portfolio. That’s an important point, because it’s true, you probably don’t want excessive volatility for your overall portfolio. If you think about the mathematics, if you lose 50%, then the portfolio has to make 100%, so those types of numbers.

So, volatility is kind of a drag on compound returns. He talks about the difference between compound and arithmetic returns, but that distinction between the overall portfolio and components of your portfolio. High vol can be beneficial for a component of your portfolio, particularly if it’s uncorrelated with the rest of the portfolio.

He gives the example of if you had an investment that had a 66% chance of being up 100%, or a 33% chance of being down 100%, obviously that’s a high positive expected return. Now you couldn’t put all your money in that strategy, because eventually you’re going to hit the minus 100% and you lose all your money. But if that strategy is uncorrelated with the rest of your portfolio, that can be quite valuable, even if you have the periodic down 100%, just then rebalance to the other parts of your portfolio and do it again.

So, what he does then is, he talks about different kinds of stock, bond, alts, mixes. He shows some model portfolios or simulations and shows that if you had a portfolio, and you had 3 assets stocks: bonds, and alts; and you were solving to a 10 vol portfolio, based on his expected returns for the different asset classes for various assumptions, what would you get in terms of different allocations?

Interestingly, if you purely wanted to do no alts, it’s kind of very close to 60/40. If the alts are available at 10 vol, what he showed is that based on the assumptions that he used, what the optimizer would do is that it would tend to actually allocate to the alts and not the bonds. Now that’s partially because he assumed alts were zero correlated to equities whereas bonds were 0.3. So, you could debate that. Anyway, that was one of the things.

Then what he shows is that, actually, if you raise the volatility, if you could allocate to the alts at 25%, what you can do then is you allocate a smaller amount (you would then allocate some to bonds as well), and it raises the return for the level of volatility. So, it’s more efficient. So rather than allocating to the alts at 10%, allocating at 25% you can get a more diversified portfolio and a better Sharpe ratio and a better return.

I won’t go into all of the examples that he runs, but I suppose to highlight a few things that I thought were relevant from this. He does well to explain the benefit, arithmetically, of higher volatility. An important point is how do you get that volatility? For a lot of investors, if you’re an institution, you can do managed accounts. But a lot of investors, private individuals or family offices, maybe they don’t have the infrastructure to do managed accounts. So, there are tax implications. You have to treat all of the individual components individually for your tax returns.

So, that’s one of the reasons for why high vol funds can be more interesting when you’re constructing a portfolio of alts. Rather than looking at strategies that are 8% or 10% vol, actually 20% vol, it sounds risky, scary, but it can be actually much more capital efficient.

The irony with this, that I wanted to mention, is that very often when you see people say we’ve developed an institutional product that’s 8%-10% volatility, you would have thought, surely the institutions would have figured out that high vol is beneficial. Actually, institutions seem to prefer the low vol. I don’t know why that is. I was kind of thinking about this. Is it because maybe institutions have to explain it to non-sophisticated [people]?

Maybe a pension fund has to explain it to their board, or private wealth has to explain it to their client. It’s curious that it’s often, in my experience, the family offices who are willing to look at the high vol, whereas often the institutional share class or the institutional product is aimed at 8%-10% volatility for the institution.

The second thing I wanted to talk about, what are you getting with high volatility? You’re getting leverage basically and you’re getting cheap leverage. So, you’re getting access to leverage that you might not get.

If you think about it, if you had a portfolio, like a 60/40 portfolio, and you said, well that’s 10 vol, but I’d like to be that balanced in the allocation, but I want something with more volatility, you could go to your bank and say, I’ve got the 60/40 portfolio, can you lend me 50% of the value of that out and I will allocate to that. A lot of banks will say, no, not sure about that that’s not really our business line.

Okay, if you convince them to do it, they’d probably have a margin of, I don’t know, 2%, 3%, 4% over the actual risk-free rate. Whereas actually, if you’re allocating to a high vol fund, you’re getting the leverage (if it’s a CTA, a futures trading fund), you’re getting the leverage because they’re basically trading larger positions and they’re getting the market price of leverage. So, you’re basically getting leverage priced at the US overnight rate, as opposed to the spread that your bank is going to charge you.

So, I think this is an important point that people kind of gloss over and don’t anticipate, that the efficiencies of futures, when applied in this context, one, it’s giving you access to leverage that you might not be able to get source elsewhere and it’s also giving you cheap leverage. It’s the most efficiently costed leverage. So, I think that’s very important and that’s the benefit you get when you add an element of that to your portfolio alongside traditional assets.

Part of his paper is around some of the behavioral challenge of high vol strategies, and we have to mention that. He does mention that when they started AQR, their first offering was a high vol strategy and immediately it went into a drawdown. He was going out to investors saying, oh if you don’t like the high vol, why don’t you just give me half the amount and it’s the same thing.

I’m sure, Niels, you’ve had that experience, most people in managed futures have. But it doesn’t seem to resonate with investors, that there is this challenge, behaviorally, of holding the high volatility. Particularly, there’s that transition risk as soon as you decide, okay we’re going to make the allocation, what are the first three months, what are the first six months? If you hit the minus 10%, or the minus 20% in those first few months, yes, it’s difficult.

So, I think it’s a good paper in terms of showing the efficiency you get with high volatility funds. It could have gone into the leverage benefits a bit more. He touches on the behavioral challenges, which I think are valid. You could talk about those all day. I mean it is tough, but it’s kind of trying to divorce the longer-term perspective of when you add this, this is the benefit you get over the long term to the short-term potential volatility.

[00:56:54] Niels

Yeah, I mean lots of good points to talk about. Firstly, I would say I think the one thing that’s so important to always remind ourselves of, and that is the tool that people love to focus on is Sharpe, but Sharpe was invented for portfolios, not for single strategies. So that is, in itself, a huge problem.

The other thing, maybe just to address some of the more recent comments you made, and that is of course that people focus on, as you rightly say, they love the low vol type product, maybe even low vol that provides a decent return. What people maybe do not focus enough on, and that is, what is the max drawdown of that strategy in relation to that vol?

Once you start looking at that you’ll find that some CTAs that look potentially volatile actually have much lower drawdowns in relation to the volatility which, in my view, is of course a very strong selling point actually. When I started in the industry, in 1990, the strategies around us in the CTA world, volatilities of 20%-25% annualized was perfectly normal. That was kind of what we did.

Remember, this is when the industry was, in total, less than $10 billion. Then it started to grow, and then around 2000, this is where the first institutions started to invest. With the institutionalization of the industry, clearly there was a move, there was probably a wish for them, as you rightly say, to have lower vol products. I imagine that this is because when they go through their portfolio at an IC meeting investment committee meeting, having to explain a strategy that was down 15% is not as fun as something that was down 5%. So, I think that’s purely what it’s based on. As you say, they should be smart enough to work this out. They know this for sure.

CTAs and, I’m sure, other strategies responded in kind by starting to lower their leverage. Now, then you could be a little bit facetious and say, well hang on, maybe they also lowered it because then they could manage more money because with lower leverage, your position size improves, so to speak. Of course, with the money that was suddenly thrown at the industry, remember, $10 billion in total and now we’re at $400 billion, that is a big change because the managers are more or less the same, frankly, in our industry.

There are not a lot of newcomers that have taken big size. Now, I know that in that $400 billion that is quoted, they include Bridgewater for whatever reason, and I don’t know, but that’s about $150 billion we need to take out and adjust for. The $10 billion in 1990 was not including Bridgewater because they weren’t really known for risk parity at the time. So, there are certain caveats we have to take into account, but it definitely has driven down volatility for whatever reason.

I meet this argument, because at DUNN we kept the original version, which is a 20 plus annualized volatility, but then we also, about 10 years ago or a little bit more, introduced a half leverage version. Certainly, in the USITS space, once it becomes really institutionalized, at the time with interest rates being close to zero, they didn’t really want something that was particularly volatile. If you can give them 5%, 6%, because back then there was no interest, they were thrilled.

As interest rates went up, I think the wish for higher returns, of course, has come up as well. As you rightly pointed out, CTAs have the benefit that actually the alpha is the alpha. So, if there’s another 4% interest income, it really just falls back to the investor. Therefore, the returns of these vehicles will increase with interest income, of course.

So, I mean, it’s an interesting discussion. I’m as surprised as you are that not more people would choose a high vol solution because of its capital efficiency. So, we still have some ways, Alan, to go when it comes to education.

[01:01:34] Alan

Yeah, I think you’re right, I mean, I’ve definitely noticed a little bit of a shift in the USITS space, as well, around this point. It’s probably linked to the rates environment, as you say, but also maybe people are getting a bit more into that mindset around capital efficiency. I don’t know, there’s certainly a little bit of a move that way. It is curious. so I still find out this is it, we’re designing this to be an institutional product, which means low vol.

[01:02:04] Niels

Yeah, and I will say with USITS, of course, you have regulation on top. Regulation does prevent you from running full leverage in my world. Full leverage, you can’t really get there. So, what I’ve seen is that maybe USITS product at the lower end of vol, but there are some people who came into the space a bit later and they’ve gone for like 15, 16 annualized volatility which still keeps them just below the vol limit that USITS product has, and so on and so forth.

Yeah, I mean if you can get high vol with a reputable manager and put it into the portfolio, because you’re absolutely right. The benefit inside the portfolio, by having a high vol manager that provides you that non-correlation, is extraordinary. As I, maybe not for a while, but as I have quoted many times, I don’t think there has ever been a white paper written that doesn’t confirm the fact that combining traditional assets with non-correlated return streams, such as trend following, that that doesn’t produce a safer and higher returning portfolio. That’s just how the evidence is, but we’ll see, we’ll see.

I appreciate all the stuff you did in terms of preparing for that. There were lots of papers that had to be read, and so thank you so much, Alan, for doing that.

If you appreciate Alan’s work as much as I do, why don’t you go to your favorite podcast app, leave a rating and review, and maybe while you’re doing that send a link to the podcast to your friends and colleagues so that we can have more people join the ongoing conversation about trend following as well as all the other topics we cover

Next week I’m joined by Mark, he’s back, so make sure you send the questions in that you may have for him. Email them, as usual, to info@toptradersunplugged.com and I’ll do my best to bring them up with him.

From Alan 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.

[01:04:25] 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.