The value of Unpredictable Alpha ft. Anthony Todd

[00:00:00] Anthony

I think what we’re going to see, Alan, is a redistribution of that asset allocation within those underlying portfolios. Because if you structure your portfolio on the basis that CTAs have pretty much no long-term positive drift but are just there for crisis alpha, you’re going to structure your portfolio one way. If you actually look at it on the basis of well, hold on a second, actually, they have significant positive long-term drift, significant positive Sharpe and they provide crisis alpha, you’re going to build your CRO or RMS portfolio in a different way. So that’s where I think the allocation will come from.

[00:00:39] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes, and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we will 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.

Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:29] Niels

Hey everyone and welcome to another edition of our Top Traders Unplugged series where today Alan Dunne and I are joined by Anthony Todd, Co-Founder and CEO of Aspect Capital, as part of our conversations with industry leaders in the world of managed futures and with a bit of a bias of course towards trend following.

First off, Anthony, it’s great to have you on the podcast. Thanks ever so much for joining us today. We have really been looking forward to our conversation. I hope you’re all set for Easter in your household.

[00:02:06] Anthony

Yeah, it’s terrific to be here. It’s going to be I think a pretty quiet Easter in the Todd household. My daughter has got chemistry finals coming up in a few weeks’ time so she’s going to be working away. My son’s got exams coming up so he’s going to be revising. So, it’s going to be a very, very low-key quiet Easter, but thank you.

[00:02:25] Niels

Sounds good. Now, before we dive into all the different topics that we’re going to discuss, I would like to set the stage for our conversation so that the audience knows a bit about your background, as we normally have your research director Martin Lueck on the podcast of course. So perhaps you could share just a few highlights from your journey that ultimately led you to running Aspect Capital today.

[00:02:48] Anthony

Yeah, happily. As I said, wonderful to be here. In terms of my background, I wish I could say that it was all carefully planned in advance. It wasn’t at all. It was all just a series of happy coincidences. The first coincidence, actually, Marty and I go back a very long way. I read physics up at Oxford and there I was fortunate enough to meet up with Marty. He was also reading physics there and Michael Adam, so obviously the A and L of AHL.

I then went straight from physics, joined a broking firm called Phillips & Drew, later got taken over by UBS, worked in the government bond desk there for a number of years. I actually joined, remarkably, at the start, the very start of pretty much a 40-year bull market. So, when I started working for Phillips & Drew, I remember 10-year yields there were around the 14%, 15% level. So, it was a remarkable time to be working in the fixed income markets.

I think what struck me and one of the great draws, for me, into systematic investment management, into the CTA sector, was sitting on the trading desk at Phillips & Drew surrounded by a whole raft of different traders and I could see that there was a common trait amongst all the successful traders, and that was the application of a highly disciplined approach, not necessarily I wouldn’t call it systematic, but a very disciplined approach and a relentless focus on risk management.

That approach always fascinated me. Of course, meanwhile, stage left, Mike and Marty were then joined, obviously, by David Harding in 1987 building a highly successful, completely automated systematic investment management business. I left Phillips & Drew in the late ’80s, went to business school, went to INSEAD, a brief spell in consulting like everybody else who did an MBA at the time, and then was approached by Mike, David, and Marty to actually join AHL.

It was just too good an opportunity to turn up. At that stage, AHL had about 200 million under management, a team of about 20 people and was just beginning to go through a significant period of growth. So, I was very lucky enough to join them in 1992 at an early stage with that kind of growth spurt. I stayed there until 1997. I had a fascinating time there over that five year period and then spun off in 1997 with Marty and with Eugene Lambert, who had been head of trading system development at AHL and founded Aspect. So that’s the short history.

[00:05:27] Niels

That is the short history. It’s a fascinating story. And of course, I did have the pleasure that people should go back and listen to interview the founders of AHL together a few years back when they had their 30th anniversary I think it was, so it must have been around 2017 or something like that. Anyways, yes, that’s not for today. Today, it’s all about you and Aspect.

Now, Alan and I have created a list of topics that we’re going to talk about, things that we find interesting, things that often come up in conversation, and of course something that is inspired of some of your latest research. And I hope we’ve found a way to structure it in a logical order. But before I hand it over to Alan, I thought it would be great to hear a couple of big picture or touch on a couple of big picture topics.

The first one being not really related to our industry but really kind of where you see the world today, a big global macro overview framework, because I think that will set the stage for some of the topics we will discuss later on if you don’t mind.

[00:06:36] Anthony

Yes. I think in terms of the macro environment, the first thing I always say, Niels, in answering questions like this, you have to bear in mind we’re not economists at all. Everything we do is entirely systematic. So, I think if you ask anybody in the business, anybody in the company, we’re all going to have a view about what’s actually happening in terms of the global economy that has no bearing on our models, on our research, on the positions we’re taking at the moment.

But I think, looking at the world at the moment, I think what’s actually particularly striking is that we’ve just seen a complete seismic shift in the market environment. If you look at the period post the GFC, we saw an extended period of coordinated central bank intervention, QE on a global basis, zero interest rate policy, significant levels of government intervention.

It was that significant government intervention in the market, central bank intervention in the markets, which distorted market price behavior and limited the ability for markets to trend effectively across multiple fronts. I think if you look at it now, of course at the time when the CTA sector was going through quite a challenging environment, there were lots of hypotheses as to why that might be the case.

Had the sector become overcrowded? We can talk about that little bit later. Had markets just changed? Was trend following just not fit for purpose any longer? We always very much took the view, and I think it is one of the advantages of having worked in the sector for 30 years, or in Marty’s case actually pretty much 40 years, that we could actually look at these hypotheses about market behavior, examine those hypotheses, and very much reach the conclusion that this time wasn’t different.

Market behavior hadn’t actually changed. The sector had not become overcrowded. And actually, the right thing to do was to retain a consistent approach, not speed up, not slow down, not change the sector allocation, but just maintain that style consistency. What we’ve actually seen now of course since that shift in the market environment I talk about, we’re now in an environment where we’re actually seeing that level of coordination has very much gone out the window.

You see last week, by example, the Bank of Japan actually raising rates for the first time in 17 years. You see on the other hand the Swiss National Bank, first G-10 economy cutting rates. So suddenly, that level of coordination has actually gone out of the window. We’re moving from a QE environment to a QT environment. We’re moving to a more inflationary environment than we saw certainly 10 years ago, renormalization of interest rates, and that’s creating a wealth of opportunities across multiple fronts.

So now, in terms of big picture where we sit, a very exciting time again to be in the CTA sector, our business development team is at its busiest we’ve actually seen for five years. We could talk about some of the trends we’re actually seeing with investors in a moment.

[00:09:47] Niels

Yeah, absolutely. This was great. I think you touched on a lot of important points that will be relevant for our conversation. The other big-picture topic that I wanted to maybe set the stage with is now we’ve talked global macro, even though as you say we don’t use it in our models.

But the other thing that would be interesting to hear your perspective on is really big picture state of the union of our industry, the managed futures/CTA industry, and in your perspective, in your experience, what you feel has changed and maybe what you feel has stayed the same over that 30-year period.

[00:10:29] Anthony

The big change we’ve actually seen, looking over a 30-year period, I think that the major change we’ve actually seen is just a greater level of understanding of the CTA sector itself and the drivers of returns. So again, if I’m looking back over a 30-year period, there’s no doubt 30 years ago there was a high degree of skepticism as to whether really a systematic, rules-based, disciplined trend following approach could actually generate the system returns in the markets.

I think that battle has now been firmly won. Again, if we look back at the origins of Aspect back in 1997, back at that stage, we were beginning to see at AHL just gradually emerging interest from institutions in the sector. It was pretty much front-page news if a pension fund invested in the sector. It would be a major breakthrough. But the point was that the majority of managers at that stage were ill-equipped to be able to meet the requirements of institutional investors.

So, if you look at managed futures back 30 years ago, fees were absolutely sky high, level of transparency was minimal, regularly referred to as a black box strategy. Volatility was extremely high. The products were typically packaged up in a guaranteed principal-protected format, sometimes with entry fees, often with exit fees.

So, institutions under the covers could actually see here was a valuable source of diversification, a valuable source of returns uncorrelated to stocks and bonds. But in that format which I’ve just described, it was completely unpalatable for institutional investors. That was very much the catalyst behind founding Aspect Capital.

What we wanted to do is build a business that would meet the requirements of institutional investors. So that meant building a business with a heavy emphasis on research and development. So, research-led focus as opposed to a sales-led focus, providing a high level of transparency. And in addition, absolutely making sure that we could provide a managed account, a flexible managed account platform to enable investors to customize solutions.

So that to me, in answer to your question over a 30-year period, that’s been the biggest shift we’ve seen. If you look today in terms of the sector, the level of institutional investment we see, the level of awareness, the level of understanding, is night and day compared with what we saw 30 years ago.

[00:13:22] Niels

Yeah, I completely agree. It’s such an important point on how the industry has changed over the years, for good and for bad. I think you mentioned a lot of really good, important things. But I think also, of course, now that we have to cater much more to institutions, there’s always a risk that we lose some of the origins that actually were also pretty special to our industry. But that’s for another day.

Alan, sorry to have you waiting for so long to jump in with your first topics. But where are we going to go?

[00:13:54] Alan

Well, Anthony touched on the investor landscape and how that has shifted and is shifting over time. So, I’m curious to hear your thoughts on that. But also, you do talk about how night and day versus 30 years ago, but one thing that myself and Niels often talk about and were talking about recently is despite the very strong evidence around the benefits of trend following and managed futures, there still is a subset of investors who remained probably under-allocated relative to how much you would expect to see in a portfolio.

How do you see that challenge? Do you still see that as being a significant challenge in terms of getting people to invest as much as you might think should be the right amount to invest?

[00:14:41] Anthony

Yeah, two points down. I think in terms of the investor landscape, trends we are actually seeing at the moment, it is a really interesting time. I think one of the strongest trends we’ve seen, over the course of the last seven or eight years, has been investors focused on private markets, illiquid private markets rather than liquid alternatives.

So conversation after conversation after conversation with potential investors over the course of the last few years, I think investors have absolutely understood that it’s so important to build a more diversified portfolio. But they’ve achieved that through investing in infrastructure, in real estate, in private equity, and most recently, this headlong rush into private credit.

I think in terms of trends, we’re seeing increasingly talking to institutions and to consultants, we’re finding that investors are bumping up against their ceilings in terms of allocation to illiquid assets and are beginning to turn their attention to towards liquid alternatives. So, I think the tide is beginning to turn there.

In terms of demand that we’re seeing, I would say the greatest amount we’re seeing, at the moment, is from private wealth managers who typically tend to be, if you like, first movers, tend to be highly agile in terms of their approach, the institutions as they begin to shift their focus from illiquid alternatives to liquid alternatives. Again, beginning to see strong pockets of demand coming through on a global basis.

But to me, it’s strong echoes of what we saw post the GFC in 2008. Of course, in 2008, very strong returns to managed futures sector and against the backdrop of collapsing stock markets. I think there was just a general expectation that we’d see strong inflows in 2009, 2010. Actually, it took until late 2010 and really 2000 and 2012 before the strong flows really came into the sector.

I think that’s the lag effect we’re seeing again, now, that a lot of institutions are conducting asset liability studies, they’re consulting their consultants, looking for advice as to how to navigate this completely new economic and market environment. So, it is taking time, but the signs that we’re seeing talking to investors, talking to consultants, is the tide is firmly moving in the direction of liquid alternatives.

[00:17:14] Alan

Interesting. I know you’ve had a paper out recently around the role of trend following and maybe highlighting the more pro-risk characteristics of trend following at times. Obviously, we’re seeing that in the markets this year very much. A very strong start to the year for trend following in an environment of positive equity market returns.

Historically, a lot of the sale or the positioning of trend following at least for a period was around crisis alpha and the diversifying characteristics. Do you think that perception is shifting that it can be seen as a return enhancer as much as a diversifier in portfolios?

[00:17:54] Anthony

Well, Alan, it’s a really interesting point. I think what we’re seeing here is a return to how managed futures and how the CTA sector was positioned 10, 20, 30 years ago. So, if we just look at the market environment that we’ve been in over the course of the last 10 years, as I mentioned earlier, due to government intervention, central bank intervention distorting market behavior, we had a challenging market environment for the CTA sector really from 2009 through to 2018.

In that difficult market environment, the one key argument that managed futures could rely on, could heavily depend on was the ability for CTAs to provide that crisis alpha. So, I think in an environment where there was only marginal positive drift in long-term performance in the whole sector, focusing on the long-term benefits in terms of crisis alpha, I think that absolutely made perfect sense.

But I think the more closely we look at it, we’ve reached the conclusion that we have to look at it on the basis that the last 10 years, so that 10-year period 2009 through to 2018, that was the abnormal period. Now, in terms of what we’re seeing in terms of removal of that government intervention, we’re seeing much more of a return to normal market conditions and a return to more normal performance from the CTA sector.

The CTA sector when I started working in it 30 years ago, the positioning was very much here’s a strategy which is agnostic in terms of market direction, highly diversified, and has the ability of providing uncorrelated returns. The early arguments were not about crisis alpha. It was all about portfolio diversification. I think that’s what we’re returning to now given the market environment we’re seeing at the moment with a wealth of opportunities across multiple markets and strong positive returns since 2020.

It’s much more a return to that original positioning, that here’s a strategy which absolutely does provide that crisis alpha. So, let’s not forget about the returns generated by the CTA sector during the technology bubble collapsing 2000, 2003, the GFC in 2008, the collapse in stocks and bond markets during that inflation environment in 2022.

So, it absolutely has that very, very, very valuable crisis alpha set of characteristics. But in addition, over the long term has significant positive drift and has the ability to be able to provide strong returns over the long term uncorrelated with stocks and bonds.

[00:20:41] Niels

One of the things that I certainly have been also talking about for the last couple of years and something that to me actually became more evident once we started having talks on a more global macro level. I remember we spoke with Peter Zeihan and he talked about the Bretton Woods Agreement, how the New World Order developed for 70 years, and how globalization was coming to an end, very much so with, as you said, around the 2019-2020 level.

But in your paper, you cite something that is very interesting, and very visually, that describes that in a different way, and that’s the correlation between stocks and bonds. I’d love for you to talk a little bit about that because I sense, and I obviously agree with your points, but I sense that this has not really registered with institutional investors yet. So, I’d love for you to share some of your insights on this.

[00:21:42] Anthony

I think the point there and I think the chart that you refer to is one were we’re actually looking on at the performance of global bonds during extended equity drawdowns. We can see that, historically, the fixed income markets were able to provide that crisis alpha if you like. During the period from 2000 to 2003, the technology bubble collapsing, during the GFC in 2008, once again, fixed income markets were able to provide that strong counterbalancing return. You had that flight into quality.

But the fall in 2022 demonstrates that that’s not something that investors can 100% rely on. So, in an environment, a more inflationary type of environment, a more inflationary type shock, it can create a correlated meltdown in both stocks and bonds simultaneously.

I think that’s what’s really catalyzed a lot of institutional investors, a lot of private wealth managers to look at their portfolio construction and question, well, if we were to see a similar kind of collapse again, we need other sources of diversifying returns. And of course, managed futures historically has been able to provide those very strong counterbalancing returns during extended equity market drawdowns.

[00:23:12] Niels

Absolutely. I’m going to link in the show notes to your website where people can find the paper. But also, in addition to what you explained, I think what people may be surprised is that even if you went back 125 years, what you’ll know is that it’s the norm that stocks and bonds are positively correlated. I think people have been conditioned to believe that that’s not necessarily the case because we had this strong negative correlated period for the first two decades of this century.

[00:23:45] Anthony

I think on that point, I always find it fascinating. If you look at the growth of the CTA sector, as I’m sure many listeners to your podcast will be aware, one can trace back the history of the CTA sector right the way back to Richard Donchian launching the first managed futures fund in 1949. But the sector really took off during the 1970s. If you look back at that period in the 1970s, once again, Niels, that was another really a strong example of an inflationary environment and two energy market crises: collapsing stock markets and collapsing bond markets simultaneously. Again, it was that type of environment with strong trends, negative trends in stocks and bonds, positive trends in oil markets, providing a very rich environment for an agnostic, rules-based trend following type approach.

So, if you look at the number of CTAs around today, they can actually trace the origins back to the 1970s. And of course, if you look at the work that Mike Adam and Marty Lueck were doing back in the early 1980s, that was very much building on the work that Michael Adam’s father had done building systematic trend following models during the 1970s.

[00:25:01] Niels

Yeah. Indeed. I do like the fact that you introduce, instead of crisis alpha, you introduce this unpredictable alpha, because I think certainly everybody is aware that we live in very uncertain times and it’s very hard to predict anything of course, but it’s even harder today than it was a few years ago. So, I like that term.

[00:25:21] Anthony

Thank you. I didn’t come up with it.

[00:25:25] Niels

You will take the credit, I’m sure.

[00:25:29] Anthony

I’ll pass on the thanks to the team.

[00:25:31] Niels

Sure. Now, we talked earlier about what has changed since we began in this industry, and there’s one thing I can think of as well. That is that back when you started, and I started, and many of our peers started, firms were really single strategy type firms. Only in the last, I don’t know exactly when, maybe 15 years or so give and take, we’ve seen some CTAs, including yourself, starting to branch out and to become multi-strategy firms not to be mistaken by the multi-strat firms that we see today.

So, I’d love to hear your thoughts about why you decided to go in that direction, what drives this expansion of strategy and how that might help serve your clients.

[00:26:25] Anthony

Thank you. You’re absolutely right. We were very much a single channels, single product focused business up until 2014 and then started the whole process of building out a much more diversified range of models. Some of that we did organically, some of it we did through acquisition of either companies or other teams.

So, if you look at Aspect today, we have a range of different models and programs spanning of course medium-term trend following, but also encompassing machine learning, volatility-based strategies using options, alternative markets, Chinese markets, short-term models, RV macro as well.

What was the thinking behind that, in answer to your question Niels, was what we were finding increasingly during that period, the build up to 2014, during the period of 2011, ’12, ’13, that in our discussions with our investors, what increasingly they were looking to do is to narrow down and shrink the number of manager relationships that they were managing but deepen those relationships.

The whole ongoing due diligence process was becoming just more and more complex I think as strategies became more complex. Therefore, it made absolutely perfect sense to look to deepen those relationships, but as I said, actually narrow down the number of relationships. So, we were just finding walking into client meetings that we didn’t have the ability to be able to have any kind of conversations beyond trend following.

If an investor was interested in exploring other strategies, maybe short-term, maybe RV, maybe equity-based, maybe vol-based, we were ill-equipped to be able to engage in those discussions. So that was very much the catalyst behind building out that broader range of models. What that enabled us to do is two things.

First of all, those programs are available to investors individually. So, we have current assets in each individual program. But I think most importantly, what it’s enabled us to do is to build customized solutions, build tailored portfolios for investors. So, if investors want a particular combination of models, a particular combination of underlying strategies specifically to meet in particular investment requirements, we’re now in a strong position to be able to build those customized programs.

So, if you look at our total assets under management now, something around close to 30% of our total AUM is now in customized solutions. So, it’s very much that thinking that in every institution is different, every institution’s portfolio construction is going to be different, every institution’s requirements are going to be different.

As you know, Niels, we’ve had a long history of forging very close long-term relationships, long-term partnerships with investors, and key to being able to do that is to be able to build these customized tailored solutions to meet specific requirements.

[00:29:51] Niels

I’m curious about one thing. What you say makes total sense. But I have one question since I’ve never been in situation where I’ve been able to offer these kinds of solutions, I don’t know the answer to it. But how well-equipped do you think clients are, external investors really are, to judge or to have a strong opinion about, an informed opinion about, how to mix and match these types of solutions or opportunities?

Because if I look at just trend following, a lot of people wouldn’t necessarily say, yeah, I definitely need trend following by themselves. So, I don’t know how well-equipped investors are to see all the insights that we actually offer in these programs. How do you balance giving them all this choice, but also guiding them, because you obviously have a lot more knowledge about what goes on inside?

[00:30:51] Anthony

Yeah, Niels, it’s a very, very good question. I think that you’re absolutely right. There is a risk. There would be a risk of almost flooding an investor or consultant with a whole range of different models. At the moment, as a business, we’re now running over 200 different individual models as I said spanning trend following, short-term, RV, vol-based, equity-based.

Walking into a client meeting and saying we can customize anything, here are 200 models, you tell us what you need, that’s an absolute recipe for disaster. That’s a recipe to the end of the conversation. So, there’s no doubt, in terms of discussions with investors. Some investors will be looking to us to provide the very best program that we can provide in a particular sector.

So, if an investor comes to us and says, look, I appreciate you run all these different models, but what is your strongest model, your strongest program in the trend following sector, we’d say, okay, it’s the Aspect Diversified Program. That’s the program which has a 25 year track record. Now, there will be other investors we talk to they will say, well, look, actually, in terms of trend following approach, I understand trend following, but what I’m looking for is a couple of other components.

One, I might be looking for a first responder type of utility function, which we can actually provide with our option capability. They might also be looking for some combination of other strategies which over the long term are expected to improve the Sharpe ratio of that underlying trend following of carrier wave. On that basis, we could actually combine our trend following strategy potentially with a range of other RV type strategies combined for instance with our alternative markets program.

So, in terms of the conversation with our investors, as I said, some investors will just simply be coming to us just looking for the strongest program we have in a particular field. Others, there will be much more engagement about how we can combine different programs. It’s typically at the program level not at the model level. It would be rare to go down to those 200 different models and start picking and choosing from those.

The conversation in terms of customization happens much more at the higher level, at the individual program level.

[00:33:30] Niels

That makes perfect sense. So clearly, that’s one thing that we’ve seen change in our industry, the fact that we have now a number of firms, including Aspect, that offer a wide range of systematic trading strategies. The other thing that we’ve seen in recent years, more recent years, but not necessarily offered by CTA firms per se, more people who want to be part of our industry but do not want to develop the underlying models themselves.

So, they’re starting just to replicate returns mostly done by looking at historical performance numbers and then doing some kind of regression of this to come up with their positioning. How threatened should we be as managers do you think by replication strategies and how do you view them in general? Are they good for our industry? Are they a threat as I mentioned? And maybe, are there any risks that you see with these strategies that people should be aware of?

[00:34:37] Anthony

First, we’ll say, do they actually represent a threat? They are gathering assets at the moment. So de facto, yes, they do represent a threat. Obviously, the key challenge I think for the underlying managers is we have to demonstrate our ability to outperform those replicators over the long term, and I’d be very, very confident that we’re in a strong position to be able to do so.

In terms of the concerns, you asked about the risks, I’d highlight three risks, Niels. I’ll break it down into three individual sub-risks. But our overall concern, our overriding concern is that the replicator funds don’t reflect the finer details of the underlying CTA strategies. That to me potentially can lead to significant underperformance over the long term.

To me, investors need to focus on three key questions. First of all, the replicator strategies in terms of how they are built, there’s an inherent position lag in their responsiveness. So, question number one is, how committed are these replicator funds going to perform during very sharp market corrections? The question is, are they going to be able to perform competitively in that very tough market environment in exactly the kind of market environment where investors are looking for those diversifying returns?

The other element is that of the replicator funds we’ve looked at, they tend to try to replicate the performance using a relatively narrow set of markets. So, if you look today for instance in the Aspect Diversified Fund, we’re trading over 180 different markets, we’re trading 240 contracts. A lot of these replicator funds are effectively using principal component type analysis but are actually narrowing down their replication, trying to replicate that performance with a much, much, much smaller subset of markets. So, if the market returns are generated outside that market set, again, there’s a risk they’re going to underperform.

I think the other element is that if you look at the majority of competitors today in their main strategies often are running a combination of trend following models with what we internally call modulating strategies. So, we have an 8% allocation to our trend following models, a 20% allocation to what we term as I said modulating factors, which are other persistent drives of market behavior such as carry, such as relative carry, such as cross-sectional momentum, such as sentiment value, relative value.

Again, I’m not convinced that these replicators are well placed to be able to replicate the performance from those modulators, nondirectional RV, highly diverse strategies. So those would be the three key risks that I’d point to.

[00:37:45] Niels

I think that those are all fair. You know, I’ll tell you one thing, because I agree with you, that one of the things that’s very interesting, that’s this thing about trading a very few sets of markets versus a typical CTA trading a lot. And you would think a period like now where cocoa is such an interesting market for those of us who are fully diversified. But actually, I have to say some of these replicators have kept up pretty well with the CTA indices. So, it’s an interesting discussion.

[00:38:18] Anthony

It is an interesting discussion. As I said, to me, we will only know the answer to your questions as to whether they really are a threat in five years’ time. It’s going to play out over the long term. But in my view, at the moment, within the CTA sector, you’ve got an extensive number of very strong competitors who’ve invested very heavily in research and development continue to evolve their models over the long term.

If I were an allocator coming to the space, would I back a collection of good managers who’ve invested heavily in research and development or in a replicator who’s trying to replicate what those underlying managers are doing? I would just go for the former. I just think the risks are too great to go down the other route.

[00:39:15] Niels

Alan, where are we going to take our conversation now?

[00:39:19] Alan

Just coming back to what we were talking about maybe a little bit earlier around the role of trend following in a portfolio, Anthony, you mentioned where you’re seeing the investor interest obviously from private wealth management and those types of investors would be running multi-asset portfolios. Just curious. Obviously, we touched on how trend following can have that role as a diversifier, as a crisis alpha generator but also as a return generator.

Are you seeing any changes from that perspective now in terms of investor behavior? I’m thinking in terms of, are allocations now funded as much out of the equity side, whereas for a while we had an argument around fixed income replacements? So, the role of trend following in a multi-asset where it’s been funded out of and also from a sizing perspective, any changes there would you say?

[00:40:17] Anthony

I don’t think we’re seeing a shift of that type, Alan. But again, it’s one of the big shifts we’ve seen over the course of the last 10 years, and this was very much consultant driven I’ll say quite broadly within the US pension funds sector where consultants were recommending to their pension fund investors that they should carve out part of their portfolio as a crisis risk offset or CRO or risk mitigating strategies, RMS component.

Typically, those CRO or RMS collections of programs would comprise, would be a combination of trend following, global macro, typically systematic global macro, diversified risk premia, and in some instances, ultra long duration bonds. So actually, that perception that during significant market crisis, with the exception of 2022, fixed income markets can provide a valuable source of diversification.

In answer to your question, I think that the aim was very much to provide a combination of first responder, second responder performance in the event of a market crisis, but also material positive long-term drift. So, material positive long-term drift, it was expected to come from systematic global macro and diversified risk premia. I think the shift we’re going to see now, as we see a return now to CTAs having far more positive drift than was seen during that period of 2009 through 2018, I think as investor perception shifts, that CTAs don’t just provide that crisis alpha, actually, they can provide significant long-term drift.

I think what we’re going to see, Alan, is a redistribution of that asset allocation within those underlying portfolios. Because if you structure your portfolio on the basis that CTAs have pretty much no long-term positive drift but are just there for crisis alpha, you’re going to structure your portfolio one way. If you look at it on the basis of, well, hold on second, they have significant positive long-term drift, significant positive Sharpe, and they provide crisis alpha, you’re going to build your CRO or RMS portfolio in a different way. That’s where I think allocation will come from.

[00:42:33] Alan

I’m just curious. Niels touched briefly on the multi-strats, the platforms, where do you see those in terms of this whole debate around constructing portfolios both from the perspective of generating returns and providing downside protection and diversification? Do you think CTAs are now better placed to be seen as competitors in that space or are they seen as a very different allocation would you say?

[00:43:01] Anthony

Alan, I think it’s seen as a very different allocation because a number of those multi-strategy firms have been able to generate very, very, very strong, high Sharpe ratios over an extended period. So, I think they are very much there to provide that long-term positive performance irrespective of bond and stock market performance. They perform a particular role in investor’s portfolios.

I think what is interesting though, and again, obviously there’s been a headlong rush into those strategies over the course of the last few years and the performance has absolutely justified that. But I think we’re beginning to see some degree of caution there, on the basis of A, of course that the massive level of passthrough fees. So, investors are beginning to question that. But also because of the imposition of longer term lockups. We’re seeing lockups of three, four or five years in some of these multi-strat programs.

So suddenly, in terms of asset allocation, they have to be bucketed with those illiquid assets I was talking about earlier. Back to what I was saying, I wouldn’t bucket them at all in same way that you’d bucket infrastructure, real estate, private equity, private credit, but in terms of liquidity profile, in terms of asset allocation.

As I said, I think a number of investors we’re talking to are reaching the limits that they’re able to hold in illiquid assets. And those multi-strategy funds which were liquid, providing a reasonable degree of liquidity five years ago now are far less liquid than they were then. That I think actually creates liquidity concerns for the underlying investors.

[00:43:39] Alan

Absolutely. Just one final one in terms of the role of trend following in a multi-asset portfolio and also maybe how it links to what we were talking about around customization, particularly in the environment we’re in now where we’re in a risk-seeking environment. Trend following portfolios would tend to be risk-on long equities, and in this type of environment, investors sometimes worry about having that equity exposure within their trend following exposure, as well as being long equities.

In response to that, with some managers, we’ve seen moves to cap the equity beta or develop specific programs that do that. Do you think that’s a sensible thing to do or is it for particular clients? How do you think about that when you’re having conversations with investors?

[00:45:32] Anthony

It is interesting actually because so far this year, a number of investors will be looking on the basis of stock markets performed very strongly so far this year, CTAs performed strongly so far this year, therefore, drawing the natural conclusion that the majority of the performance actually comes from stock indices.

I think what’s particularly striking into the CTA performance so far this year is the drivers of performance have been quite broadly spread. And that’s my point about you remove the distorting factor of central bank intervention, it’s suddenly going to only freeze up markets to operate far more normally, and that’s created a wealth of opportunities on a broad front.

So, the divergence, I mentioned earlier how that degree of central bank coordination has now completely gone out of the window. We’ve actually got uncoordinated central bank responses at the moment. That’s driving some very interesting returns in the currency markets, particularly in the yen, particularly in say the euro against the yen, very strong trends there so far this year.

You look at some idiosyncratic moves in the agricultural sector. Obviously, strong moves in the cocoa market so far this year. Worth highlighting incidentally that since the beginning of January so far this year, in fact, what we’ve been doing is reducing our position. We reduced our position very significantly in the cocoa markets. So, we haven’t been building a position there at all. Quite the reverse, we’ve been selling into that strength.

But also in the agricultural sector, some very strong trends in the corn market, in the wheat market as well. So broad spread a series of drivers in the ags markets. And yes, that mood of optimism that we’ve hit peak inflation in the majority of global economies. Of course, yes, that’s driving very strong stock index returns. We’ve been able to capture those as well.

So, your point Alan is well taken. If the vast majority of our returns so far this year were in stock indices, then yes, I actually can understand the degree of concern that there was that concentration of risk, but it’s not. The returns have been far, far, far more broadly driven. Specifically answering your question, Alan, in terms of stock market risk, yes, we actually do cap the aggregate level of stock market beta in the portfolio.

Obviously, that stock market beta can come from stock indices, but it can also come elsewhere. It can come from the bond sector in certain environments. So, I do think there’s a logic behind doing that where you cap that level of beta. Again, I think it’s an important consideration, because of course if you cap it too severely, you can end up in a situation where you’re dramatically underperforming the competition.

Of course, it is one of the advantages of a trend following approach, that it is agnostic about market direction, it’s able to generate returns both on the positive side and on the negative side. So, I think capping that beta, capping that risk is a sensible response, but where you cap it, I think that’s a very important consideration.

[00:48:52] Niels

Maybe something that points in the direction of what Anthony was talking about, something that came out I think maybe yesterday, a report from With Intelligence, I think it’s called, where there was an analysis of hedge fund flows. They actually write in the report that CTA and managed futures had the lightest outflow among all primary hedge fund strategies in 2023. So, despite actually not having a fantastic year, it was kind of a quiet slightly negative year for some managers. So that all sounds fine.

But I wanted to, and I don’t know if you want to talk about it, Anthony, but to me, one thing that really hasn’t changed too much, that’s this thing about when CTAs experience bad performance, we see investors leave. If we have flat performance for a period of time, we see investors leave. And then if we have really strong performance, like in 2022, we actually also see investors leave. I don’t know. Are investors becoming a little bit too difficult?

[00:50:02] Anthony

It’s a wonderful observation. On that basis, you wonder how this sector actually still exists, don’t you? I think you’re right. I think we all know. A lot of people actually listen to this podcast who know the CTA sector well. It is a very difficult strategy to own. It’s not a particularly high Sharpe ratio strategy over the long term. The returns are bursty. The returns are unpredictable and they’re very difficult to time.

Unfortunately, some investors do try to time the returns and typically top and tail returns. How do we counter that? We have tried to counter that through working closely in partnership with our investors, providing that level of transparency, making absolutely sure that whether our performance is good, bad or indifferent, that we’re there very much proactively informing investors about the drivers of returns.

So, to try to make sure that when we actually do see those drawdowns, those drawdowns are inevitable and they’re explainable. We’re transparent and they are expected. To draw a good example there, I’ll give you a specific example Niels. If you look back at the SVB crisis back in March, almost exactly a year ago, that was clearly a very, very, very sharp shock to the sector and obviously to markets in general.

The majority of CTAs obviously were short fixed income markets going into March, going into that SVB crisis. When that crisis hit, our investor relations team, our risk management team, our research team, were working over the weekend to understand exactly what were the key drivers of the performance, where we lost money, where our risk management systems working effectively. How did our range of different filters, trend following filters, how did they respond?

That meant then on a Monday morning, we were able to proactively talk to our investors and explain exactly what happened during the course of the crisis, explain the performance, explain exactly what the drivers of performance were. So as a result of that, and the pattern of doing that over multiple years, in environments such as that, and that was a very short, sharp sudden drawdown, we didn’t see any investor outflows at all.

I think if we hadn’t been so transparent, I don’t just mean during that environment but over multiple years, and investors suddenly woke up and saw that sharp correction of their portfolio, it could have led to redemptions. We didn’t see any redemptions at all.

[00:52:50] Niels

That’s a great example. I think the last 10, 15 minutes, I think we’re going to try and look maybe a little bit into the future, not specifically. But one of the things that are buzzwords in our industry right now, it’s AI and alternative data. We’ve seen a number of our peers and friends in the industry adopt either one of them or both of them. What is your view on this and how do you make use of it if you do?

[00:53:21] Anthony

I think in terms of alternative data, that has been an area of strong investment for us over the course of the last seven or eight years, particularly in our systematic global macro program, but also elsewhere. When we talk about alternative data, we’re talking about non-pure price-based data.

So, looking at data for instance such as nowcasting data, so more instantaneous measures of certain key economic indicators, or it could be looking at flow data. Those would be two prime examples. So yes, we can see that those sources of data can provide a valuable additional diversifying sources of return.

I think it’s important, and I’ll come on to AI in a moment. In terms of some of the central tenets of our research process, one of the crucial central tenets is that everything we do is hypothesis-driven. So we don’t undertake research on the basis of just trust the data. We looked on the basis that any effect we’re trying to identify in the first place has to be backed up by a hypothesis about market behavior.

That’s a very different approach from if you like a data-driven approach which is much more if you have enough data and strong enough statistics, then just trust the results. We don’t work on that basis. As I said, it’s all about starting with a clear hypothesis about market behavior.

I think the second key tenet, which comes back to my point about how we work in partnership with our investors, is making sure that positions we take in the market are intuitive and they’re explainable. To me, this is one of the great attractions with a trend following approach that, that you pick any individual market, we’ve been talking earlier about what’s happening in stock markets, what’s happening in the agricultural markets, what’s happening in the currency markets, all the positions we’re taking are entirely intuitive.

The third key element is that style consistency, avoiding style drift. Maybe we’ll talk a little bit later about how our models have evolved over the course of the last 25 years. But it’s interesting in terms of the investment philosophy we had back 25 years ago was the aim of capturing trends, capturing medium-term trends over two to three months or longer across a diverse set of markets.

That’s what we do today. So, we’ve been entirely consistent in our approach. The reason for mentioning those three tenets is to me, that’s so important when we’re looking at new, interesting areas or research such as alternative data. So, we do use alternative data, but we have to make sure, again, that the work we’re doing, the research we’re doing is hypothesis driven, that we’re avoiding style drift, and positions are intuitive.

In terms of AI, as a derivative of AI, machine learning, we’ve had a significant investment in machine learning over the course of the last seven years and actually run, not in our trend following program but in our multi-strat program, we run a sleeve of 24 machine learning models. But those machine learning models, they are constrained. So again, all hypothesis-driven, and the positions we’re taking entirely intuitive and explicable.

So, in terms of turning attention to of AI, we see huge advantages in the application of AI I think particularly with relation to increasing productivity in research and increasing productivity in terms of coding. But we’re moving cautiously on the basis of that we need to make sure any work we do using AI, that the work is hypothesis driven, we’re not just asking AI for a solution.

I think the fourth consideration, particularly with AI, is protection of IP. Some of the approaches, some of the techniques one can use with AI would require you to open up your systems, open up your models to the wider market. Although we can provide a high degree of transparency to our investors, we’re highly protective of our IP.

So, in terms of both areas, just to summarize in terms of both areas, yes, absolutely, we’re very excited and have significant investments in both areas, but we move carefully, cautiously, and make sure, as I said, that our approach is consistent with those central tenets.

[00:58:08] Niels

It makes perfect sense. Alan, do you want to go through your last round of questions and topics before we slowly start to wind down?

[00:58:19] Alan

Anthony touched briefly on the evolution of their models over 25 years. Obviously, a big development has been development of, I imagine, the modulating strategies and machine learning strategies. But maybe just from a pure trend following perspective, Anthony, have those core models evolved dramatically from the core ideas that Marty would have developed back in the AHL days? Give us a sense on the areas and how they have evolved.

[00:58:51] Anthony

I think it’s really interesting looking back at it, Alan. As I mentioned earlier, right at the early days of Aspect, back in 1997-1998, our aim was to build a medium-term trend following program capturing trends over a period of 2, 3 months or longer over a broad set of diversifying markets. There’s an element, at the very highest level, that’s exactly what we’re trying to do today.

But to me, what’s interesting is the level of sophistication of the underlying models, it’s night and day by comparison with where we were back in late 1997-1998. If I can just pick on a couple of individual factors, the first and most obvious one is just the number of markets we trade.

Back when we started trading in December 1998, the portfolio consisted of 64 markets. Today, as I mentioned earlier, we’re trading 180 markets and trading multiple contracts in those individual markets. We’re now trading over 240 contracts. So, the portfolio is far, far, far more diversified. I think in terms of data, the data we were using back in the early days, we were just principally using daily price data.

The level of granularity of data we’re using today is significantly finer in terms of granularity compared to the data we were using back 25 years ago. I think in terms of the models themselves, you could break it down into two particular elements. One is just trend identification. So, the filters we use to try to identify in each individual market whether we’re in an uptrend or downtrend, those filters are significantly more advanced than they were 25 years ago. And then how do you translate if you like that trend strength into a position in the markets?

We talk about the application of a position function. That’s the way we translate a trend signal into a position in the market. Again, a significant amount of work, a significant amount of research. It has actually gone into refining those position functions over the years. I think most recently, Alan, if I’m looking over the course of the last five years, a significant focus of research has been put into trying to improve our responsiveness at turning points in markets.

A prime example of a turning point I’m referring to would be the SVB crisis in March 2023, but retaining the overall level of responsiveness across the entire portfolio. Obviously, one way you can improve your responsiveness is just speed up, just speed up the models.

We looked at that and I think during that tough period of performance between 2009 and 2018, a number of investors, a number of commentators, a number of our competitors took the view that market behavior had changed, the markets had become faster to respond to market news and therefore the right thing to do was speed up.

We looked at that in extensive detail and we could not reach that same conclusion. Those most dangerous words in finance, this time is different. We could not see any evidence that market behavior had changed so we retained our aggregate level of responsiveness but did a lot of work trying to identify ways of improving our responsiveness at those turning points.

It’s only a sample of one so far, but the results we saw around the time of that SVB crisis were strong out-of-sample evidence that the research has been very much on the right track there.

[01:02:57] Niels

We’ve talked a lot about your path, your journey, and how Aspect has evolved so far over the last 25 years. So, I’m kind of curious maybe looking a little bit into the future. I work for a firm where we have done the transition from founder to a new owner, but a lot of our friends in the industry, including yourself, it’s still the founders that run the firms, but at some point, maybe it’s far in the future, I don’t know Anthony for you.

At some point, maybe there’s going to be a next generation of leadership, ownership. I don’t know. So, I’m just curious whether you think about Aspect 2.0 or whatever point we’re at, what it might look like, and maybe we’ve talked about this already, but looking into 2024, what excites you, what are the threats you see maybe for our industry?

[01:03:52] Anthony

Yeah, it’s interesting Marty and I were discussing this the other day, and Marty’s immediate response was, look at AHL, there’s no A, there’s no H, there’s no L and the business seems to be doing pretty well without them. So, I think that there are strong lessons from there. Our philosophy right from day one Niels was to build a business that would outlast the founders. How did we go about doing that?

First thing was to make sure we built a very strong team around us, but also build a much more collegiate approach to decision-making, devolve decision-making as opposed to just having decision making concentrated at the top. It was very much a focus of Marty and I over that 25 years to try to delegate as much responsibility as we possibly can to our senior managers across the business and avoid that top-down approach.

If you look at the caliber and experience of the researchers that we have at the moment, and of course it’s not all about research, I look at the trading team, I look at our middle and back-office team, I look at our finance team, I look at our business development team, there’s real strength and depth there.

I see this because as a business by example, everybody who’s been in the company for five years automatically gets a four week paid sabbatical. It’s just very much a congratulations, go and take time off, go and recharge your batteries and come back. And I get an email every time somebody takes a sabbatical. Now, the number of people now in the company who are on their third, an increasing number of people taking their fourth sabbaticals is extraordinary.

I think that, hopefully, demonstrates something about the culture of the company, but it also just demonstrates the strength and depth and level of experience you’ve got across the entire company. So, Niels, your question is well taken. Marty and I are very aligned to it. As I said, I think it’s very much an essential feature of the business is build a company where there is going to be that consistency of approach, no change in terms of how investors’ money will be run irrespective of who’s actually driving it.

[01:06:08] Niels

Yeah. Absolutely. Maybe finally, Anthony, anything that we haven’t talked about, maybe that we missed bringing up but also maybe something you just want to round things up with, maybe also a view into 2024 or things that we haven’t talked about perhaps.

[01:06:28] Anthony

I think in some respects, in some areas of the markets to me, I mentioned earlier that the private wealth managers, that’s where we’re seeing strongest demand at the moment. There’s no doubt that at the moment, although we’re seeing strong pockets of demand, very strong pockets of demand for trend following from certain areas, there are still other areas where the view is either why do we need to diversification. Haven’t you looked at the stock market over the course of the last a couple of years, why would I look to diversify? Or as I said, there’s this focus on private markets. So, to me, there is a degree of echo that I’m hearing back from when we started the company back in 1997. Actually, I think there are a lot of similarities there.

Remember back in 1994, the Fed had been behind the curve in terms of interest rates, actually and suddenly put up interest rates very dramatically. A stock-bond market crisis in 1994. But then they managed to execute that soft landing and we saw this benign period, this Goldilocks style economy during the period 1995 through 1999, not too hot, not too cold, and a remarkable bull market in stocks which abruptly came to the end in 2000.

Now worth bearing in mind that although during that time and when we were setting up Aspect, it was difficult to find investors who were looking to diversify their portfolios. As I said, the focus was very much on internet related stocks. It was very much on the technology area. CTAs actually provided incredibly strong returns over that period of 1995 through 1999.

So to me, the sentiment that was said was that we’re not economists, but there just seems to be a strong sense that we’re moving into a soft landing type environment. Are we at bubble levels yet in technology stocks? I’m just not qualified to opine on that. But I think for investors, there are interesting similarities, interesting lessons to be learned from that period, that during that soft landing environments, managed futures were able to provide very strong back-to-back positive years for an extended period.

But when the crisis hit in 2000 and investors really needed that diversification, then managed futures was able to provide that crisis alpha. So, to me, just referring back to Alan’s comments, this repositioning of the whole sector, that to me is so important at the moment because I think that it’s a very remarkable environment in terms of the range of opportunities for managed futures at the moment in this potentially the soft landing environment.

But maybe, just maybe there’s a risk there of a crisis looming at some point. So, investors shouldn’t also ignore that crisis alpha, those crisis alpha characteristics of the managed futures sector.

[01:09:34] Niels

Yeah. Well said, Anthony. Thank you. That was a great way of wrapping up our conversation. It’s been fascinating. I really appreciate it and appreciate you for coming on the podcast and sharing your thoughts and insights. And of course, we hope we can do this sometime again in the future.

To all of you listening in today, I hope that you were able to take something from today’s conversation onto your own investment journey. If you did, please share these episodes with your friends and colleagues. From Alan and me, thanks for listening. We look forward to being back with you on the next episode of Top Traders Unplugged as we continue our journey into the CTA industry.

In the meantime, go check out the show notes for this episode and all the other resources you can find on our website, and not least, take care of yourself and take care of each other.

[01:10:25] Ending

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