The Trend Following ETF Revolution ft. Katy Kaminski

[00:00:02] 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.

[00:00:24] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Katy Kaminski and I, Niels Kaastrup Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor. Katy, it is so great to have you back this week. How are you doing? What’s going on where you are?

[00:00:41] Katy

I’m good. The weather’s turning. It’s soon June, so things are good. Summer is on the way. So things are good.

[00:00:51] Niels

Even though I’m a few hours ahead of you, it is June 1st tomorrow and the weather doesn’t feel like June whatsoever over here in Switzerland. It feels like February, to be frank. I hope there is a change in the weather as we move into the summer months for sure. But we’re not here to talk about the weather, Katy.

What I do want to know before we dive into all our good topics, and they’re going to be a little bit juicy today I think, it’s always interesting to hear what’s been on your radar, things that you just find interesting or come across that’s not really related to what we’re going to speak about later on. So I’m curious whether you’ve come across anything interesting at the moment.

[00:01:34] Katy

I think one of the things that shocked me this week is I don’t know if you saw the headline about Nvidia surpassing the value of the German Stock Exchange. I was like, wow, that’s pretty phenomenal. So I think that’s going to be the trade of this year, people talking about just how much Nvidia has gone up. It’s the buzzword for 2024. So that’s definitely been on my radar, and I thought that was interesting.

[00:02:02] Niels

There’s definitely some crazy stuff going on. Of course, we had a few years ago when Tesla was worth more than, I don’t remember how many other car companies, or it was all other car companies together. But speaking about Tesla, one I came across a podcast this week talking about this upcoming vote on Elon Musk’s pay package, which I think used to be at its height when the share price was at its highest.

A pay package worth more than $100 billion. Now it’s quote-unquote down to just about $50 billion. But it’s still completely crazy, in my mind, what’s going on and the way it’s being conducted according to the people that I heard talk about it and the lack of oversight of any credible board, so to speak, that hasn’t been “paid off”.

Anyways, let’s move on to our usual playground, which is trend following. As I mentioned, we are speaking on the last trading day of May. May has been an interesting month. There have been quite a few big movements I would say intra-month. It might be settling a little bit more closer to what would, from the outside, look as a quiet month. But intra-month, I seem to have seen cocoa being off by like 25% from its high. I think I’ve seen natural gas being up by 40% from its end of last month, so to speak.

So I’m pretty sure there’s going to be somewhat of dispersion in performance, even though when I look at the benchmarks, which we’ll come to, it does look pretty calm in many respects. So I’m curious how you have experienced maybe May, maybe April, or maybe the year as a whole from a trend following perspective as it is a few weeks since we last spoke.

[00:03:58] Katy

This year has been very interesting. I think, looking at the positions of trend following, you’ve seen very much this polarized view. You’ve seen long equities signals being paired with short fixed income signals as well as long dollar, and then the commodity sector has been one we’ve been following quite a bit because you were seeing that pivot starting in February with energies tending towards long, the precious and base metals being really interesting, copper, silver, gold.

The biggest change in May for me has been this disinflation trend in agriculturals has been pivoting. So you saw some pretty large gains in some of the Ag contracts. So let’s take soy or coffee are some of the examples there. You really saw this bifurcation where you saw short signals in Ags but long signals really coming up since Feb. So I think the commodity moves are something that tells us that there’s still a lot of things going on in volatility related to inflation and pricing that, consistent with this inflation, is still kind of a big theme.

Short fixed income, that’s higher for longer and that’s been a noisy trade, but it has kind of worked. It definitely was a good position against the equity drawdown we saw in April, for example. So to me, it feels very much bifurcated, equities look good for now versus higher for longer and potential resurgence of inflation. So those themes are exciting. There’s definitely vol. So trends have been positive this year in lots of interesting trends like cocoa, for example, or gold.

[00:05:50] Niels

Yeah. I think overall, the year looks pretty strong for the industry. The last couple of months, it’s been a little bit more quiet, so to speak. It feels to me like it’s almost like rolling reversals. We’re seeing different sectors, different markets, getting into a little bit of trouble from a trend following perspective, but they don’t happen all at the same time. So overall, when you look at the performance, it doesn’t look too bad.

But of course, depending on how you allocate risk to the sector’s performance can still be somewhat different between managers. My own trend barometer finished yesterday at 45. That’s pretty neutral. I don’t know if I expect overall indices to be flatlined. I have a feeling they might be a little bit down for the month.

But anyways, as of Wednesday at least, BTOP 50 was down 1.14% for the month of May, still up 10.25% for the year. SocGen CTA down 62 basis points, still up 11.18% for the year. SocGen Trend down 79 basis points, still up 13.41% for the year. The Short- Term Traders Index flat for the month and up 3.6% for the year. I do think yesterday was a bad day or negative day, however we put it, so the numbers might be a little bit lower than that as of last night.

In the traditional world, after a bit of a soft April, MSCI World has a good month so far, 3.5% up in May, up almost 8% for the year. World Government Bonds are up 0.25% as of last night, still down 2.15% for the year. The S&P 500 up 4.11% as of yesterday, up 10.4% so far this year.

Okay, Katy. We are going to jump into some topics, and maybe a little bit different to the conversations you and I have. We’re going to be talking about the ETF space in relation to what’s going on with CTA offerings in that. There has been a lot of new ETFs in the managed futures space. I’d love to hear kind of your thoughts about this and some of the stuff you’ve been writing about.

[00:08:15] Katy

It’s great timing because this week we just published a new paper, Niels, on the ETF space. It’s entitled “The Managed Futures Ecosystem: The Rise of the Managed Futures ETFs” The reason we wrote this paper is that just like many CTAs, we’ve been on a journey, learning about ETFs, watching ETFs, thinking about how this space fits into our ecosystem, hence the name of the paper.

I think it’s an exciting time and there’s just a lot of things to think about in terms of accessing these and what are some of the things to think about. So I would say that, for me, it’s just an exciting new area to talk about in some sense.

[00:09:04] Niels

Well, I’m all ears. Let me just throw out one question and then you can go into to the paper perhaps. But one of our listeners, Philippe, he asks, when you think about the journey you’ve been on at AlphaSimplex, to move into the ETF space, I think he’s interested in finding out whether that was an easy journey, so to speak.

Everybody was kind of, oh, yeah, this is a great idea, or whether there was kind of a process of compelling some people to say, yeah, this might actually be a good idea. So maybe you can just talk about the journey you’ve been on in order to get to where you are today.

[00:09:47] Katy

I think what’s really happened in the ETF space and why we wrote this paper is that I think initially a lot of CTAs were a little bit reticent about ETFs thinking it’s a little bit more of a simplified wrapper, it’s access to beta exposure. To be honest with you, until 2020, the regulatory framework in the United States was very opaque and it wasn’t as clear.

If you look at the initial offerings in ETFs, there were a few of them, but they did not experience the same growth that you saw in mutual funds. So I think there was a little reticence towards the space. But in recent regulatory changes, those called the ETF rule and the derivatives rule, that really provided the transparency and clarity to the industry to allow for the use of derivatives in a very clear way in ETFs.

That, in some sense, has opened the doors for what is now a booming industry. just to give you a couple of numbers on this, if you look at the size of the ETF industry since 2020, for systematic trend, it’s gone from about $220 million to $1.45 billion and assets, just systematic trend. But if you take a closer look at these non-traditional ETFs since 2020, they have grown as well from $20 billion to $150 billion, according to Morningstar.

What this means is there is now a, not green light, but a possibility to implement strategies in a very clear way in the ETF space which is basically a new avenue to a different set of investors. I think the thing that shocked me the most was I met institutions that said to me, we use the ETF. Whenever I talked to other CTAs, they’d go, “Really?” I said yes, and I would say, “Tell me more. What are you using this for?”

That’s where I realized that they liked the liquidity profile of an ETF. They thought of it as a liquidity buffer, something that they could use as a buffer to their existing CTA exposures, and then they didn’t have to deal with a lot of the red tape of asking for redemptions or changing things around. That was much more easily a liquid vehicle as a liquidity buffer even from an institution.

So to me, it just started to become clear that this is an avenue to a different group of investors that haven’t been in the space. To be honest, like a lot of investors, especially today when bonds haven’t been working as well in a post-COVID, post-inflationary world, having access to alternatives I think is something that can really benefit a wider range of investors out there outside of just institutional investors.

Let me give you one data point that I find fascinating, and this is the fact that if you look at all of the assets in managed futures, it’s about 350 through 45 billion, only 5% of that allocation is actually in the retail space, which tells you that, traditionally, CTAs and managed futures is something that’s accessed by institutions only.

That means that if you believe in that crisis alpha and diversification and having multi-asset class exposures, there is a wide range of investors who utilize ETFs and model portfolios that need some access to more diversifying return streams. Hence, the ETF is a way for them to do that.

[00:13:42] Niels

You mentioned liquidity, and I do agree. Obviously, this is an area that I’ve talked about with Andrew for quite a while. I have to say, although I don’t agree with everything that he stands for, I do agree that opening up the access point to trend following and CTA products for a wider audience is definitely something I think is a positive.

But you mentioned this thing about we’re now giving much more liquidity to institutional investors, but certainly also to retail investors, and then this idea that this will be great if they have crisis alpha. One of the things that I found, I’d just love to hear your thoughts on this, is of course that with crisis alpha, you never know when you need it. You just have to put your own opinions aside and just let the product play out, whatever it’s going to do.

I’m just curious, regardless of your own involvement in the ETF space, whether you think it’s a good idea or a less good idea to give people even more, how should I say, liquidity in a strategy where maybe sometimes it would be better for them to be almost like private equity- not to be able to get out, just stick with it? Do you know what I mean?

[00:15:04] Katy

I totally agree with you. My view on managed futures is you should have a strategic allocation. If you’re going to rebalance, it should be based on things that have done well. Equities have underperformed, so that’s sort of a rebalancing. You shouldn’t have a timing strategy. Actually, if you’re going to allocate, allocate when we’re in a drawdown because on average, we tend to recover.

That’s the only advice that I give people about when should they allocate because I feel like, as you noted, it’s very hard to know when you’re going to have a crisis event or difficult dislocation event in terms of timing. So I think what helps me think about that has to do with access points. A lot of model portfolios in the United States use ETFs. So if you’re accessing managed futures in an ETF as part of a model solution, then it’s already ingraining this portfolio construction holding strategic allocation view.

If you put an investment like an ETF in one of those, then you’re less likely to do the line item picking and choosing over time, which is what anybody suffers from in the industry. So I think for me it’s exciting to see how model businesses have grown so much. Let me just give you some stats of this. According to Morningstar, roughly 286 billion in assets in 2021 were in model portfolios in the United States. In June 2023, it’s 424.

So this is a business that’s really growing and it’s a way for retail investors or through your retirement to actually invest in a solution and actually access things like alternatives. So I think this is an area of continual growth for the retail sector. I think as a tool for that, A managed futures ETF makes a lot of sense or something that gives you access to trend following or non-equity stock long-only exposure.

So from that perspective, I think there are avenues where we can avoid some of this tendency to want to time trend following or trend following squared, as I like to say.

[00:17:34] Niels

I agree with that. I’ve heard Andrew also talk about it, and I’d love to hear your thoughts about this, that I think he very specifically wants to target the model portfolio managers out there to see if they can include some trend. We were having a fun chat about what should the allocation be. I think this was based on a Mann paper where they said 40% and he said I’m only going for 3% or 5%, whatever it was.

That’s not the point of my question. But it comes down to the fact that whoever moves into the ETF space with managed futures products will then have to go and convince or compel these model portfolio managers to include them. What are your thoughts about that? Because it hasn’t been easy for our industry to make a lot of headway.

You quote the number of 350 billion in managed futures. that number hasn’t really changed for a very, very long time. About half of that number is Bridgewater, which I don’t really myself consider a CTA or a managed futures product. So I don’t think we’ve been very good, as an industry, to penetrate a lot of these institutional portfolios, or let me put it this way, portfolios that are institutional to us but of course they may have retail investors in them.

So does the ETF product open up different… I know, practically, they open up some avenues. But why would people start to include them in portfolios when they’ve known about the benefits for a while?

[00:19:15] Katy

I think some of it has to do with where we are right now in the cycle. And you know, one of the interesting things that I have been talking to a lot of investors about is, if you look at the last 40 years, you could just buy a 60/40 and bonds had a lot of diversifying effects. Look for the last three years. In fact, in a higher-rate environment with some inflation, bond volatility is higher, bond-stock correlation is positive.

So if you’re counting on diversification just in a 60/40, you’re not going to get as much of it. So, we’re seeing more and more investors realize that with changing markets we have to change and we have to have strategies and approaches that are also amenable to what could be a very different regime for financial markets going forward. It’s very unlikely, I think, that we’re going to go back to this ZIRP world where interest rates are really low and then all you have to do is buy bonds and stocks and you’re done.

I think that’s where, right no is really a critical point for many investors to start thinking about how much divergence, how much change, how much inflation is going to impact their portfolios. Thus, alternatives are a natural choice, and there’s just not a lot of them that are accessible in the retail space. I think that is going to change, especially with the change of the proliferation and innovation in the ETF space which is going to provide products that are accessible to a broader audience who finally may have an appetite, given the new macro environment that we’re in right now.

So I do agree with you. The education, and this is why I love education and managed futures as a fun space, it’s going to be an education process, which is some of the same education process that we’ve done with institutions since the great financial crisis. I think that was a success. I definitely think that a lot of institutions have learned a lot about these strategies post that event. I think the COVID event and the inflation challenges that we’ve seen, it provides an impetus for thinking about other things. That may be the case that right now is a good time to start thinking about alternative ETFs and alternatives in general for investors.

[00:21:46] Niels

You talked about the model portfolio case, so to speak. That makes complete sense, and I would love to see model portfolios have a strategic allocation to these products. But are there any other use cases that you see that the ETFs will facilitate?

[00:22:05] Katy

We highlight three in our paper, and one is direct investment. So for any investor who previously maybe was interested in ETFs or lower fees instead of mutual funds, it provides just another access point for those that actually prefer to use ETFs. The second is model portfolio and model delivery. The third is the institutional access point is adding an additional set of managed futures exposure with a very liquid profile.

The reason that was interesting and surprising as a use case to me is that if you think about a large institution, and we talk about this in our paper. We go through all the different access points for managed futures, as well as some of the things that are different about them. So that’s SMAs, funds of one, all of these things, once you have invested with a manager, for an institution, there’s a lot of things that have to be done to onboard a manager, to approve a manager, and they have all this liquidity.

They theoretically could change anything in one day, but institutions don’t do that. You know that. Because they need to request a redemption. There’s a lot more paperwork related to that I’m thinking. Whereas if you have an ETF, you can use that as a liquidity buffer. If you have cash management issues or you want to come in or out of it, you can just use that to get to your target without issuing redemptions and subscriptions to your individual managers, because then you’re also asking something of your managers as well; change my account, do this.

So that was actually an interesting argument that I hadn’t thought about that I heard from some institutions, which led me to realize that this is just another tool that’s in the toolkit of investors that gives you CTA-like exposure to allow you to just have more tools in your toolkit.

[00:24:13] Niels

I’d like to dive a little bit deeper on this because I remember when I spoke a while back with Jerry when he was moving into the ETF space, one of the things he mentioned (I’m pretty sure, I hope I’m not misquoting) was that he, maybe he heard it from people as well, maybe he just liked the idea that people didn’t have to call him to make a redemption. They could just press sell and it was all fine, because essentially, investors are anonymous, of course.

To some extent, maybe this is also true in the mutual fund space. I don’t know the investment process that well for these markets since they’re US mainly markets. But I can see a little bit of it in the UCITS space. If they use a nominee, you don’t really know who’s behind it. So I have two questions for you. One is, and you brought it up in a sense when you say yeah, due diligence, I’m thinking with these products, do you think the whole due diligence process from investors will change? Meaning, that maybe they won’t be scrutinizing managers to the same degree because now they can just buy the ticker and maybe they’re just more focused on the return stream they see from the ticker than all the other stuff that we normally have to answer for when it comes to due diligence.

The second follow-up I would say is, from a manager’s point of view, what’s the importance in your view of knowing your client? Funnily enough, we are forced to do these “know your client” when people invest. At least if they invest in an offshore/onshore structure, we are required to know where the money comes from. But then through that process, we get to know the investors.

In this new world, we won’t know the investors. That also means that we’re not able to handhold people when they need it. We’re not able to necessarily educate people because we don’t know who they are. So I’m curious to hear your thoughts on this new way of interacting with investors. But let’s start with the first one.

[00:26:36] Katy

Sorry, that was long. The first is about due diligence and manager…

[00:26:41] Niels

Yeah. From the investor’s point of view and then the other one is more from the manager’s point of view.

[00:26:49] Katy

Let me take a parallel to what we saw happen in the mutual fund space to kind of think about that. This was highlighted in our paper. I found it very interesting. When you look at the proliferation of products that came out initially in the mutual fund space, there were many, many funds launched. Over time, those funds became less. But you also saw that the correlation of the funds that existed started to move much closer to the actual index of institutional funds.

So what we say is that you have this maturation where the products that really are delivering what they’re supposed to, the ones that people remain invested in are the ones that are more similar to institutional quality products. So you’re right in that you don’t have this direct investment due diligence that you have in the institutional space where you’re thinking about onboarding an account. But the market has sort of moved in an equilibrium towards institutional quality products that are actually roughly 95% correlated to the institutional products.

So that to me was interesting to see, looking at that simple chart is that you saw even in the managed futures space, in the mutual fund space, we saw a consolidation towards higher, we don’t say quality, but we can say higher correlation to the institutions. So from that perspective, the market will have to ascertain which of these products and people’s own due diligence are going to have to be arrogated.

I know it seems new to us in the CTA space, but this is the case for so many active strategies out there that already exist in ETFs. It’s just something that given that we’re 95% institutional, (take out Bridgewater, then you may be 80%) institutional as a space, we’re just not as used to this space. So I think there’s a natural mechanism that will occur.

[00:29:02] Niels

I’m going to interrupt you there before we go to the second question I have because something you said there strikes a thought with me, and that is, ever since I think you and I have joined this wonderful industry, I’ve always thought of it as an absolute return strategy, we’re here to deliver the best possible returns. But hearing you talk, and I don’t necessarily disagree with you, it’s almost like, is our industry now becoming a relative return industry where all we need to do is just to be close to a benchmark?

[00:29:39] Katy

It depends on what your goal is. I would say, maybe if I digress for a second, that we oftentimes in finance focus so much about going from good to great, and like we’re going to be good, we’re going to be greater than somebody else. The truth is, if we actually think about the best interest of the investors, a lot of it, that’s why we talk about education, is trying to get people to go from bad to okay.

What that means is that even if you have some allocation to manage futures, you’ll still have a lot more diversification than you did without it. I think where the ETF tools is exciting to me is that at least they’re providing a beta-like exposure to our industry to investors that may never have had it. So I’m comparing a person that has never had managed futures to a person, whether or not they choose A, B, or C, I still feel like they’re better off.

So for me, it’s really about providing an ecosystem of tools for investors. I do agree with you, when we think about building our systematic strategies, we’re always searching for how can we provide the best possible return? Investment excellence is always number one. But we also have to recognize that there are different access points and different ways to do this that can benefit a wider audience of investors. So I’d say that it’s neither/nor instead of either/or. So that’s my view.

I believe it’s always about providing the best. If it’s an ETF strategy, it’s really about providing a robust exposure to trend following and managed futures type exposures over time, which allows you to provide some of that diversification. Now, granted, in the ETF wrapper, it’s more efficient to use highly liquid markets, and maybe a smaller set of markets.

So you may not get the cocoa trade in your book, but you’ll still have access to things like copper, you can have access to bond exposures long and short, and you still have a toolkit of things that are very different from long bonds and stocks.

[00:32:04] Niels

Yeah, we’ll get to that in a second in another way. I just want, before I forget, the second part of my question, and that is, as a manager, do you think it makes any difference whatsoever that the investor base becomes more invisible or less visible for when they come through these vehicles relative to if we were looking at say traditional onshore/offshore funds where every single investor would be known by the manager and you can have these direct conversations and so on and so forth?

Do you think it makes a difference or is it just the way the world is moving? Maybe even the younger generation, for good and for bad, they don’t worry about these things so much. For them, it’s just a click on an iPhone or whatever phone they have.

[00:32:57] Katy

This is a good point. I really appreciate this point, Niels. Because for me, somebody who really cares about investor education, it does make it harder to connect with the clients and help them give them the tools to think about not timing the market. There are certain avenues, like we mentioned, the model portfolio business where some of those avoiding mistakes helps by that construction.

It is definitely just a trend of the industry, especially given the numbers I explained on the alternative ETF space. You’re definitely seeing a trend towards these types of vehicles for ease of use. I don’t think it’s going to change anything on the institutional side and that institutions are still going to do all of their due diligence, they’re still going to want to know all these things and be very closely connected with their managers.

But I do think that that’s a trend that has its pros and cons, cons being that you can’t educate directly the investors, the pros are that you can access more investors and that you’re going to rely more on networks of advisors to educate their clients as your conduits. So therefore, we need to work with them to help spread good education on the space.

[00:34:24] Niels

Absolutely. The good news is, of course, Katy, that whether you are an institutional or retail investor, you can listen to this conversation on a podcast and then you get the education either way.

All right. Let’s shift gears a little bit. As part of this education process, both my own and hopefully those who listen to us, my understanding is those managers who consider or have moved into the ETF space, there are three ways they can do that.

They can try and recreate their full strategy within an ETF like Jerry has. They can do, and I think (quotation), “a watered-down version of the strategy.” What I mean by that predominantly, as you alluded to, it’s a product that trades fewer more liquid markets. So they don’t have the cocoa and so on and so forth. Then of course, as Andrew started doing a number of years ago, they can just go the replicator route where it’s not about a specific trend model.

It’s just about looking and analyzing historical data and trying to “guess” what managers are having in terms of exposure, put on exposure in some very highly liquid markets that will give something that replicates that as best as possible. So, can you talk a little bit about some of the pros and cons or the challenges that each of these paths entail?

[00:35:58] Katy

Yes. If you think about an ETF type of solution, clearly, it’s desirable to be highly liquid. So in general, you might choose a smaller set of assets that you would actually utilize. Also, they’re trading and needing it to be hedged, or at least they need to have market makers to make that happen. So when you think about that type of solution, there’s a couple of avenues that you can follow that. You kind of mentioned them already.

One avenue is a replication beta type approach, where you say, all right, we’re going to follow the general footprint of the industry and maintain consistency with where the industry is moving and what the typical positioning would be for that industry. The other is that you can take, we call this mechanical replication. There’s index replication and mechanical replication.

Mechanical replication in a simple form is just implementing your own strategy, so direct strategy implementation. There’s really pros and cons to both of these approaches. The replication approach uses inference and infers positioning using many, many different types of statistical techniques to try and infer the general posture of the industry. Whereas direct implementation uses actual signals and can incorporate risk management, it reacts to market moves directly with signals.

So if you think about that, you can also do some of both as well. There are also techniques to combine both of those approaches to have something that does a little bit of following indices but also CTA insights and approaches. So let me just go through the pros and cons of each of these approaches. On the index replication approach, some of the arguments are that you have less manager-specific risk because you’re following the industry and you’re not running to the tune of one individual manager’s implementation.

As a result, you’re going to have something that looks a lot more like the industry on average over time, so it’s going to look more like a beta exposure. The cons of this approach is that replication is backward-looking, it can be slower to react, and it’s not necessarily directly implementing risk management because it’s inheriting the risk management approaches of the manager returns itself.

On the other hand, direct strategy implementation depends on the specific decisions of one manager. So are you going to use 252 days or use that combined with 32 days? So it has a specific flavor of one individual manager’s approach, which, at very certain periods of time just based on specific parameters, can also deviate a lot from the industry. We see that all the time. You have one manager, maybe they seem to have a very different bond position for some reason or another, which causes sporadic and not all the time predictable deviation from the index.

So you can look at both of those approaches and they both have merits. I think a combination of the two makes sense. So you have some CTA insights, but also, if you want to follow the beta of the industry that is providing much more similar to what people would expect if they’re adding something like an ETF as a beta exposure to our industry.

Because if you think about how people use ETFs, think about the SPY as an example, it’s your beta exposure to US equity markets. You go and you buy another technology ETF, that’s your beta exposure to that particular view. so I think that’s where the ETF implementation, you can see different ways you would do it. Either you have your own unique flavor or you’re trying to give that industry exposure, or maybe some of both.

[00:40:24] Niels

That makes total sense. So if I was going to summarize it a little bit, yes, you can either choose to have a “single manager risk”. But I guess you could also argue, at least I’m going to argue, that you could have a single replicator risk, because of course, there is no guarantee that the model that’s being used to replicate couldn’t have a less desired correlation than what you think it might have. But I think that’s fair enough. Nothing is perfect. As you say, you could also choose to combine them. That also makes sense.

You mentioned the topic to me, and maybe we’ve already talked about this, or maybe not, and that is, how would they compare to classic managed futures product? I don’t know if you feel you’ve talked about that or not. I know it’s one of the things we put down as a point.

[00:41:19] Katy

If you look at a classic managed futures product, they’re often trading a larger set of markets. So they might be trading 100 or more markets, which means that they have access to cocoa, for example, or they may have access to more esoteric markets like some of the Ags. They also have access to just a wider range of assets, number one.

In the space of managed futures, there’s often a wider range of different model types and approaches, machine learning techniques, a ton of different machinery that can be used to design a managed futures strategy. So I think that when you think about a classic managed futures product, it’s a best ideas product. It’s really sort of putting all these different ideas together and providing the best managed futures exposure.

Now, in the ETF, you just have some constraints. So you can’t trade as many markets and perhaps might not want to use really, really fast signals because they create a redemption process and things like that. But you’re going to still get an aggregate exposure to the industry over time, and that’s where you see deviations and performance. If you take a look this year, you can see that some of the ETFs have done very well.

If you look at their market set, it’s not surprising because things that have worked really well are things like gold, which is a very big market; things like the Japanese yen, which is also a very big market; equities, which are also big markets. So you’re going to see that deviation and performance in that depending on where the trends are over time. So if you have big trends in idiosyncratic markets, you’ll see the opposite.

So you’re going to see differences depending on where trends are. In general, you’d want to have more markets because you get more diversification and more potential trends. But you still can get a pretty broad set of trend exposure which covers general macro themes within a smaller set of markets.

[00:43:32] Niels

Yeah, absolutely. Katy, before we move to a completely different topic that I wanted just to touch on, I think my last question about this new wave of the ETF world in our space. Historically, hedge funds and CTAs have been known for having incentives for doing well, i.e. the fee structure. Now, of course it changed somewhat with the rise of mutual funds.

In the US, more of those became “flat fee” funds, meaning management fee only. So that in itself is not so new. But now that the CTA structure is there, who knows? It may grow significantly. So my question is more to you as a researcher, not so much about the fee itself. But as a researcher, because you’ve seen both in your career so to speak.

If you have a strategy where you have incentive fees versus a strategy where there’s no incentive fee, you have different objectives as a firm. When you have no incentive fee, the only way you can do well is to grow that AUM as much as possible. So I guess my question is, do you think, as a researcher, that you need to take that into consideration when building say the model, meaning, and I think you’ve alluded to it a little bit already, but maybe also speed up models, meaning you have to be able to scale it a lot more? Therefore, even markets to trade becomes more important, I guess.

Maybe there are some other risk management techniques that you have to consider when you go for scale versus when you go for the highest possible return, if I can put it that way. Is that something that you’ve had to think about as well?

[00:45:40] Katy

I think that’s been the trend of the industry for the last 10 years. As soon as the mutual fund space arrive, this became a huge debate. Where should you allocate your resources for research? What’s positive is that a lot of the resources for research are going to be in areas where there are extended markets and other things because if you’re going to charge performance fees, you need to have performance in excess of what people can get normally.

That is going to keep people humble in the sense that you need to allocate the resources of your research to areas where you can justifiably give people access to either new markets or techniques or methodologies that will provide better performance. We often talk about how the performance fees drive research, but the truth is that research needs to drive performance. Thus, you need to be putting research into areas where you can actually provide an edge.

So things like extended markets or technique techniques that are differentiated and that can provide maybe more crisis alpha during a period of uncertain times. So it’s really about finding ways to find improvement and performance for clients. I think people often start with the motivation of those fees. My view is, you need to be putting research into areas where you can actually garner better performance hence deserve the performance fees.

I think that the mutual fund industry basically brought to light, and pushed towards the field, that that research needs to be focused on improving above something that’s actually been a pretty stable strategy that has worked for decades.

[00:47:35] Niels

As we’ve been talking, there’s another question that popped into my head. I thought this would be the last one about ETFs but I actually have one more. I don’t know how well I can formulate it because it literally is on the fly here. But in the equity world, my impression is that you have lots of choices of products that essentially replicate or track the same benchmarks. Meaning, if you want an S&P 500 tracker, there’s more than one. There’s probably 50, I don’t know, 20.

The main difference is I guess how well do they track and are they five basis points, are they seven basis points? Now, in our world, we don’t have that many benchmarks. There are like three or four. I’m wondering if we’re now going to see a massive wave of new replicator products that essentially are replicating the same indices. Suddenly, we’re going to have 10 replicating the SocGen Trend Index, for example, or whatever it might be, but they’re not that many.

So I’m curious about how should investors, how should they choose which replicator to go for if they’re all trying to replicate the same index? Does it come down to price? Are we then almost entering just a war of who can deliver this at the lowest possible price?

[00:49:05] Katy

I would see it the same way we saw the mutual fund industry. That’s why we talked about this in our papers. Right now it’s exciting and everybody’s talking about it. Probably, there will be a lot of people that come into the space, and over time, the industry will probably converge like we see in mutual funds. So that’s why for me it was so exciting to write this paper because it was a thought process about where’s the industry going.

Yes, there could be many different products that come out there. But what did we see in the mutual funds? Well, we saw that products that were more similar to the index that people liked and that have worked had been the persistent products and the industry has converged to a higher correlation to the index itself.

Hence, the typical mutual fund investor is getting something that’s very similar to that index as good as you can get in our space, because like you pointed out, it is an active index. There’s not a simple S&P 500 as your benchmark. It’s something that’s time-varying.

So there is more noise, but it does give me hope that this is going to be a fun journey and that we’re going to see innovation and we’re going to see the funds that really do good at doing this coming out as products that people will use. So I think it’s good to parallel to that as a potential what’s coming next.

[00:50:31] Niels

Absolutely. One final thought on that, and that is, I wonder what happens if these replicator products become so successful? I know one of them of course. Andrew’s product is already included in, is it the BTOP 50 Index. It’s one of the CTA indexes. It’s one of them. I just wonder, what would happen if these products became so successful that they become the benchmark, so they’re replicating themselves? It could happen I guess.

[00:50:59] Katy

I think that’s a long way away. I’m not that far ahead of myself yet on that.

[00:51:06] Niels

It probably is.

Anyways, speaking of something a little bit scary, and in a completely different area, AI. You mentioned just to me in passing that you’ve been spending a bit of time thinking about AI. You’ve also been on a panel about AI. I think because we are quantitative in our approach, a lot of people have opinions about how it might affect our industry. So I’d love to hear what all these thoughts have been about and what you think about AI.

[00:51:45] Katy

It’s so exciting this year. We talked about Nvidia at the beginning. There are so many things that are exciting going on in deep learning and all these things. It’s exciting for us, because as geeks, there’s more tools. I think what I’m hoping the most, and the reason I’ve been thinking about it, we mentioned it earlier in this talk, I really hope that the industry can find ways to go from bad to okay with AI as opposed to everybody’s so excited like we’re going to use AI to get the new best signal to trade cocoa or something like that.

There’s a lot of focus on that and I think that is one area of application, but that’s not going to make the marginal investor that much better off. What I’m excited is more how AI can help investors access better portfolios and also just help us make better decisions. So that’s what I’m excited about with AI, not just like it can help you maybe write some emails. But it is exciting and I think that we’re going to see a lot of really cool…

For the manager side, it’s exciting because there are more tools that you can think about. There’s more data, there’s ways to innovate in your research process like we talked about before. It does add barriers to entry like you said as well. It’s not always cheap to do that type of research. But I’m excited just about how it’s going to change some of the ways that we invest and the way that we think about processing data. If it can help us make better decisions but at some point give us better information, I would be happy with that.

[00:53:30] Niels

You know what makes me really excited about this is actually how classic trend following, if I can use that word, meaning just analyzing historic price data, not making it too sophisticated, using techniques that have been around for more than 50 years. Because we’ve been met with this “challenge” before. I remember when the internet came, everybody was saying clearly, something like trend following, that’s a bit old-fashioned now. Everyone has the same data at the same time, how can it possibly continue to work?

Now we’re moving into a completely new stratosphere when it comes to technology and I still have a sneaky feeling that a normal classical way of doing trend following will do well because it’s based on human behavior. I don’t think that’s going to be completely overtaken by AI. So I will definitely follow this with a lot of interest but not necessarily expecting that our industry will change a lot because of AI. Maybe certain parts of what we do, maybe we can become better at execution or whatever. But the way we develop the models and what the models are based on, I doubt it’s going to change. But that’s just my current view of course. You never know.

[00:54:52] Katy

I have to agree with you because that’s why I’ve been so fascinated with trend following my entire career. It’s amazing to me that a strategy that’s based not on fundamentals but based on where is the world moving and following people’s behavior is actually a pretty robust strategy. I think it has to do with what you said that, at the end of the day, we’re still people trading in financial markets.

We have overreaction, underreaction, and we have behavior. This behavior tends to repeat and change over time, which provides trends in markets. So I think we’re still going to be humans even if we have tons of AI at the end of the day.

[00:55:39] Niels

Maybe just to circle down to the first point we brought up, which was Nvidia. If you think about it, even if AI, two years ago, had predicted Nvidia is going to go to the sky, a $2 trillion market cap, the stock price is going to go sky high, well, a simple trend following model would have captured that no problem, because at the end of the day, for a market to go from 100 to 200, it still good has to go to 105, 110.

That’s all we need to know to pick up in order to get our models excited about it if the asset is included in the portfolio. So yeah, I think that maybe we will be okay. Maybe we’ll still be talking about this 10 years from now.

[00:56:28] Katy

I think so because what we do is we don’t ask why, we ask what. We say, what is happening? Let’s go. I think that strategy, it just doesn’t get hung up on trying to predict what should happen. It’s really about following the theme, whatever those themes are, whether it’s Nvidia or cocoa. It’s following the themes of what is moving and asks the why later. That strategy has worked for decades because things change.

[00:56:59] Niels

I imagine you know much more about this than I do, but large language models. I guess the point of them, in the financial industry context, is prediction, trying to predict what’s the next word. But as you rightly said, and I think it’s a good way to end our conversation, if there’s one thing we don’t do, in the trend following world, is predict. So maybe that in itself is a red card to AI in our industry. Because why do we need prediction when our strategies are built on not predicting anything?

[00:57:31] Katy

Exactly. We’re following as opposed to predicting and asking why later when it’s more obvious.

[00:57:41] Niels

Katy, this has been wonderful as always. I always learned something from you. It’s good appetizer to next week where I’m joined by Andrew. I’m kind of thinking what on earth I’m going to ask him about since we’ve been going around the ETF space today. So I’m going to ask the audience to help me out here. Hopefully, you can send me some questions for Andrew. info@toptraders.unplugged.com is the usual email.

So by all means, now that you’ve listened to Katy, maybe you didn’t agree, maybe you did agree with some of the stuff we talked about today and you want to put Andrew to the test next week. So by all means, send me some questions, easy or difficult, that I can tackle with him.

If you appreciate these conversations and you want Katy and me to still be doing this 10 years from now, do leave us a rating and review on iTunes, Spotify, Amazon, wherever you listen to your podcast. It certainly helps the podcast to continue to grow. From Katy and me, thanks ever so much for listening. We look forward to being back with you next week. Until next time, as usual, take care of yourself and take care of each other.

[00:58:49] Ending

Thanks for listening to the Systematic Investor podcast series. If you enjoyed this series, go on over to iTunes and leave an honest rating and review and be sure to listen to all the other episodes from Top Traders Unplugged. If you have questions about systematic investing, send us an email with the word “question” in the subject line to info@toptradersunplugged.com, and we’ll try to get it on the show.

Remember, all the discussion that we have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions.

Thanks for spending some of your valuable time with us and we’ll see you on the next episode of the Systematic Investor.