Trend Following as a Return Enhancement Overlay ft. Alan Dunne

[00:00:00] Intro

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

[00:00:22] Niels

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

[00:00:35] Alan

Very well, thanks, Niels. Great to be back.

[00:00:37] Niels

I saw Dublin was a busy place last night.

I was watching some kind of European football championship game and I thought of you, actually, since it was going on in Dublin.

[00:00:48] Alan

That’s right, just up the road here in the Aviva Stadium. So very busy around the area yesterday afternoon and lots of security and personnel, but I think it all went off very well. So, yeah.

[00:01:02] Niels

Absolutely.

Italians won, as I understand it. All right. Well, I’m sure people didn’t tune in to listen to us to talk about football, but you never know.

We’ve got a few other topics to tackle today. But as you know, I always love to start out with something that’s been on your radar, come across your desk or that you picked up and you think is interesting that’s going on outside the topics we’re going to be talking about.

[00:01:31] Alan

Well, I guess, I mean, it’s a couple of months since I’ve been on, equities dipped down in April and then recovered. And, you know, we had Nvidia results last night, and the AI boom seems to be very much intact, you know, stellar results on the revenue side and very favorable for guidance. I think, you know, interesting that’s still probably the big theme or one of the big themes in markets.

But one of the things that came onto my radar in the last month or so, which I thought was really interesting. It got some attention, but I thought maybe warranted a bit more was an article in the Wall Street Journal, it’s called Trump Allies Draw Plans to Blunt Fed’s Independence. It was around a report that came out that some of Trump’s advisers were drawing up plans to basically say that the president would be more instrumental in Fed decisions should Trump come into office. I mean, reading the article, it’s not clear how close these people are to Trump.

There was a bit of suggestions that they may not be, you know, kind of his immediate advisors. But that said, even those people who have talked to Trump on the issue, evidently, according to report, were suggesting that there was a desire to blunt the Fed’s independence and be a bit more influential on rates, which, obviously, doesn’t surprise any of us to hear that, I think. If you go back to the last time Trump was in office, he was certainly vocal in calling for lower rates and, at times, a weaker dollar as well.

So, I think the article would point out that it’s not clear legally if Trump could actually demote Jerome Powell. He possibly could, but he would still be a governor on the board. So, he’d still be there.

And there’s no new appointments up until 2026. But it’s not that far away. I mean, you know, kind of we’d be talking about this in an 18 months time.

So, it’s interesting. And I think just more generally, are we entering into an era of where maybe of less central bank independence? You know, the whole idea of central bank independence isn’t that old.

You know, you go back to the mid early ‘90s in the UK, as of the mid 90s, the Treasury used to meet with the Bank of England and decide together. And then you had full independence. Throughout history in the Fed, you’ve had episodes where the Fed chair has been influenced; famously Arthur Burns – Nixon kind of planted stories about Arthur Burns in the press to try and influence him and undermine him.

And even prior to that, you go back to World War Two, the Fed basically bought bonds and the yield curve control to facilitate the war effort. So, I think structurally, it is something that we may hear more and more about going forward. That is will we see more coordination between fiscal and monetary policy? And could that mean less central bank independence?

Obviously, if you make kind of blunt decisions or trying to interfere, it could have adverse consequences, you would have thought it would be $1 negative at a higher bond yield. So, there are reasons not to go down that route. But that’s not to say somebody like Donald Trump mightn’t do that anyway.

[00:04:46] Niels

No, I mean, I think what’s kind of disturbing about things like that, or surprising that it can even be entertained, is, of course, that often you see the West criticize countries in the East for being too governed by very few people. So, I think it’s a really bad idea if the West now starts to go in the same direction, let alone a president who managed, for reasons I don’t quite understand, to hold onto his own business empire while he was president, because normally they have to sell all their assets, so there is no influence, so to speak.

So, it raises a lot of questions. Unfortunately, sometimes these stories and these intentions, there’s a little bit more validity to them when they come out. And as you rightly said, it’s not something that is completely new, but not something that I would hope comes to fruition.

A couple of questions for you on the topics. By the way, I know very little about individual equities, and certainly AI stocks like Nvidia, for sure. But you know, there’s obviously, as you say, another, what do you call it, another set of accounts that kind of beat estimates and all of that stuff yesterday. A lot of that focus is on their data centers.

Now, people might think, well, data centers, that doesn’t sound very AI-ish. But is this the way most people actually get access to their GPUs, which are the ones they, as far as I understand, are very beneficial to AI computing, or whatever we call it?

[00:06:33] Alan

Yeah, I don’t know, to be honest. I just briefly scanned the results this morning, and the headlines were all about the big beat on the revenue side, and then the very favorable forward guidance. And yeah, and basically…

[00:06:48] Niels

No, it’s just because from what I’ve seen, a lot of their revenue is actually data centers. It comes from data centers, which of course runs, I’m sure, their own GPUs in that sense.

Anyways, I wanted to go a slightly different route on AI. Just something, again, when you say, “What have you picked up in the last week?” Well, I did pick up, and I’m not an AI expert, clearly, but I did notice another two leading people have left OpenAI, resigning from the company.

So, one is one of the co-founders, actually, Ylva Sutskova, or something like that, as far as I recall. And the other one, someone called Jan Laike, or Laike, yeah, I don’t know. He was a co-leader of something called the Super Alignment Group. Now, the reason I mention that is, what I find interesting is that, from news reports, is that it seems like they are resigning because they have concerns about the direction of where it’s going, obviously spearheaded by Sam Altman, in terms of the AI’s alignment with human interests.

Now, why I find that interesting is, if you remember 6, 7, 8 months ago, Sam Altman was kicked out of the company, there was a big revolt, everybody sort of resigned and all that stuff. Around that same time, we were actually doing a podcast recording with someone who’s very well plugged into Silicon Valley. And I remember, off the record, he was saying, because we were kind of curious, saying, well, what’s the real reason here?

And at the time, we were told that Sam Altman had actually, and maybe that is what this Super Alignment Group, or whatever, I don’t know what it is, but he’s managed to put together two groups of researchers that had finally cracked some AI stuff. That means that suddenly it took a big leap forward in terms of what it could do, which is kind of the beginning of when you start getting concerns about what it then could do on its own.

I don’t know if it never came out as such, that was the reason for it, but these kinds of resignations coming out, to me at least, not being an expert, sounds like the original reason probably could have been correct, that there are some concerns about what we’re being told, maybe what the board was being told at the time by Sam Altman.

Of course, pure speculation on my side, but interesting anyways. The final thing I just wanted to bring maybe to your attention, which I’m sure has not escaped you, is that we’re going to have another election very close to you in the UK, but we’re also very soon going to have European elections. Now, a lot of our listeners are outside Europe, so it may not mean so much, but there is a current at the moment happening, at least in the polls, where there is somewhat of a meaningful swing to the right in many of the larger countries.

With the way the European Parliament is constructed, you only need some of the big countries like Germany, France, maybe Spain, pushing to the right, and then suddenly the whole Parliament gets a different constellation. Is this something you think investors should be thinking about?

[00:10:13] Alan

Yeah, I think it’s interesting. I interviewed Gary Gerstle recently, so that’s going to be coming out soon, and his book is called The Rise and Fall of the Neoliberal Order, and it’s all about how we’ve seen this shift in global politics in the last decade in response to some of the failings of neoliberalism, the market model, etc. I suppose it’s interesting, it hasn’t just been a shift.

You might have expected a shift away from the right to the left in the sense that free markets haven’t been perfect, so would you see a move back towards more socialism, etc.? And you’ve seen that to an extent, obviously with Bernie Sanders, etc., but equally you’ve seen a rise of the extreme right, as you say. So, it’s kind of on both sides you’re seeing traction, both on the left and on the far right.

Obviously in the UK, as you say, there’s an election coming up, widely expected to be a Labor win, based on the polls at the moment, but even Labor are probably kind of have migrated more to the center. Certainly, in Europe, you know, in Germany, I think it’s AFD have been making ground now, there’s been a bit of controversy there. I just saw something this morning, one of their candidates made some comments and he has had to step down.

So, I mean, I think there’s a bit of fragmentation there, but certainly, yeah, the rise of nationalism has been one of the fallouts of, I guess, the decline of the neoliberal order. So yeah, definitely it’s interesting to see how that plays out in the elections coming up in June.

[00:11:55] Niels

For those of us where maybe we’re not so completely up to date on our neoliberal orders, but just to be sure I understand it, the neoliberal order was this thing about, yeah, we should all open up and trade with everyone, invite China into the world trade organization.

[00:00:22] Alan

Yeah, I mean, the word neoliberalism can be somewhat confusing for people because you’ve got liberalism as well and liberals tend to be more kind of Keynesian, I guess, whereas neoliberalism is more just a belief in the free markets and in free trade and all of those sort of linked to what was called the Washington Consensus, which was similar, you know, free trade, globalization, and all of that. But, you know, the whole theme of his book is how that has been repealed and the question then is what comes next.

[00:12:45] Niels

I can’t wait for that conversation to come out because I’ve heard him once before and he’s very captivating to listen to. So, I’m very curious about that.

All right. Okay. Well, we’re going to stay with kind of the world as our playground because we normally, when we’re together, at least on the podcast, we talk about some of your global macro thoughts, observations, and I know you’ve brought a few topics.

So, I’ll let you jump in where you want and talk about some of the things you find interesting, at the moment, in that part of the financial world.

[00:13:18] Alan

Yeah, there’s a couple of things I thought had been interesting on that side. And obviously, taking a step back, where is the picture at the moment? Obviously, looking at the US, economic growth is still solid.

Obviously, Q1 was a little bit weaker, but that was primarily kind of biased down by inventories and trade. But the underlying coming to domestic demand is still very solid there. But I think, you know, fair to say, maybe the growing sense is that there might be some cracks appearing.

I mean, people are always pointing to cracks. But one thing I saw recently, which was interesting, was a study from the San Francisco Fed. They were looking at the whole area of excess savings again. And you remember, during the pandemic we had a lot of checks issued in the US, and stimuluses.

And so, people accumulated a lot of savings. And if you think about the reasons for why the economy has been robust in the face of higher rates, there’s been maybe three or four arguments.

One has been everybody’s refinanced at lower yields. So higher yields haven’t mattered, because everybody’s locked into low rates. Secondly, the variable lags; long and variable lags of monetary policy. So that’s still there. We don’t know how long the lags are. We could still see the impact of higher rates. I think the third reason has been the much stronger fiscal support, and that’s still there and hasn’t gone away. The fourth one is probably this excess savings that the consumer balance sheets were really strong, and consumers were able to tap into these accumulated savings. And that’s reflected in the savings rate in the US has come down to about 3%, whereas pre-pandemic was about 6%. So, people are saving less out of current income and drawing down their savings.

Now, the interesting thing is, people have been monitoring this, wondering when are these excess savings are going to run out? There’s a bit of uncertainty around the calculations. You have to make assumptions around trend levels.

But as I say, the latest piece from the researchers at San Francisco Fed, they were estimating that that those savings had now run out, and they were being drawn down at a rate of about, I think it was about 80 billion dollars a month. So quite a decent amount. So, the goods of a trillion dollars on an annualized basis, which would be over 3% of GDP.

So, the question is, is this the tipping point, that we had that stimulus there? I think there is a sense that maybe at the lower level of the income levels we are certainly seeing that stress; delinquencies in terms of credit cards, auto loan repayments, all of those are ticking higher. But obviously the middle and upper classes are still doing fine.

The labor market is still reasonably solid, and obviously wealth effects as well. So, there are these conflicting factors. But certainly, from a risk perspective, the point I think is interesting is that maybe the economic risks are starting to mount again because this excess savings is declining.

But at the same time, if you look at markets, you’re seeing the opposite. Like if you look at bond deals and corporate bond spreads, so BBB spreads, I was looking at over treasuries at the low, nearly all-time low, and certainly the lowest pre-pandemic, or as low as we saw back in 2007. If you look at things like the VIX, very low.

So, risk is very much priced very low. And even I was listening to Chris Waller speaking during the week, he was saying, you know, the risk of recession seems to have been totally removed from markets. So just at the point where you could see maybe actual reasons for why we might see a downturn coming on the consumer side, risk being priced does not reflect that at all.

So that was one thing I thought was interesting. As I said, I was listening to the Chris Waller speech earlier this week and looking at the aggregate of all the Fed comments (we also had the minutes out), the general view has been that the Fed’s a bit more hawkish now reflecting the data. One of the things that Chris Waller, he was quite defensive in that there has been this accusation that the Fed’s become too data dependent and flip-flopping too much. He was quite dismissive of that. But I think the problem the Fed made was kind of being very keen to say that we’re going to cut rates last December, without having the ammunition to do that.

When I read and listened to his speech, I didn’t think it was so hawkish. I mean, he was basically saying that a rate hike, from his perspective, is still very unlikely. Even though he only gave the kind of inflation reports we’ve seen recently a C+, as he put it, not an A or a B, he still thought that the next move would probably be a cut.

Interestingly, he said, like, in the absence of a significant weakening in the labor market, he would need several months of good inflation. So, there are two things that could prompt, obviously, rate cuts here. Obviously, if inflation comes down, or if we see significant weakness in the labor market, they could cut rates anyway, which is kind of interesting because there is this view, amongst economists, that we’d have to see higher unemployment to get inflation down. That’s the kind of Phillips curve idea.

He’s saying, well, if you started to see the labor market weakening, that obviously would cut rates anyway, which I think we all know, but interesting that we got that confirmation. So, there were two of the interesting things, but certainly the key takeaway, I would say, is that, certainly on the consumer side, there is probably more of a focus now, given that we’ve seen that trajectory on the excess savings, and it’s interesting how markets are not really pricing that recession risk to any extent at all these days.

[00:19:09] Niels

Now, clearly you follow these things much closer than I do. But when I hear you talk about it like that, something in me tells me that we have actually seen a big shift in central bank policy. I mean, I seem to remember many years ago, a couple of decades ago maybe even, that central banks, when they came out, they were kind of giving us a kind of a forecast.

They were forward looking. They were steering us in a certain direction. Obviously, we had the dot plots, which I don’t even mean that, but just generally speaking about the narrative, the way they handled media, the way they handle everything. And now it’s all month-by-month data-driven stuff, which in itself to me actually creates, and I don’t think that’s really what they want, but it creates uncertainty. It creates ambiguity about where we’re going. (I was just about to swear there, but I didn’t mean to.)

So, it’s kind of interesting. It’s almost like they’re defeating their own purpose in the way they have shifted the way they do things. I don’t know if you’ve kind of feel the same.

[00:20:18] Alan

No, I agree with you. I mean, I think it’s because of that they’ve lost confidence in their models. You know, obviously the models didn’t work during COVID. They didn’t forecast the extent of the inflation spike. So now they’ve lost the credibility.

So, the way central bankers conducted policy, going back four or five years, was that you had a forecast of where inflation was going to be in two years’ time. And you had fan charts around that as you used to see in the Bank of England reports, and you probably still do. But the argument was no point in responding to the most recent inflation number because obviously that doesn’t affect the impact of policy.

So, you want to be forecasting where the rate is going to be in two years’ time and respond to that. But that has totally gone out the window now because they can’t afford to get it wrong again. And so, in theory, they would say, okay, the next move is down because our forecast is for lower inflation. But at the same time, they don’t have the confidence to stick to that because they know, basically, that the margin of error around the forecast is so great.

Even Ben Bernanke, he was brought into the Bank of England to do a review. And he’s kind of saying that they need to, rather than just have these point estimates and even the fan charts, talk more about scenarios.

But how useful is that? I mean, Chris Waller talked about that a bit. I mean, you could talk about every scenario under the sun, if inflation’s higher we’re going to raise rates, if inflation’s lower we’re going to cut rates. How useful is that?

So, I think they are a little bit rudderless at the moment. And because of that, as you say, they’re literally… What was interesting, like Chris Waller was pointing out, they’re reacting to the second decimal place on the inflation number, like whether it’s kind of 0.29 or 0.35. These numbers are just, they’re an estimate, they’re a sample. So, they’re not the actual inflation number. It’s their best estimates based on, I don’t know, call it 1,000 prices or 2,000 (whatever it is) out of the aggregate number of prices in the economy. So, there are huge, huge, seasonal adjustments and all of that.

So, I think you’re right, but it just reflects the fact of the mistakes that have been made in the last couple of years means that they’re hypersensitive to getting it wrong again.

[00:22:43] Niels

Anyways, time will show.

Speaking of downturns, it’s still a little bit of a downturn in trend following performance so far in May. So, a bit soft, not least, of course, because we’ve had some meaningful corrections among others in the soft sector, cocoa down about 20% so far in May.

But I think, actually, probably what’s hurting sort of trend followers in general more so than just a single market like cocoa, with energies, grains, and interest rates, I think we’ve seen some decent reversals in those. For example, nat gas is up 40%, certainly against the prevailing downtrend that we’ve seen for quite a long, long time. We’ve seen some offsets of those losses, mostly I think in metals where, for a change, silver is grabbing the headlines.

So that’s shining a bit more than cost of gold. And also, of course, equities, based on this AI craze and other things, are doing pretty well. Anything from your side, Alan, anything you’ve noticed about trend following performance this year, maybe so far?

[00:23:56] Alan

No, I mean, we’ll get on to it later. Obviously, something to talk about is that it has been a great, great start to the year in a pro risk environment. So, it’s the kind of the side of the trend following equation that people forget about, obviously, with all the talk of crisis risk offset and risk mitigation, but we’ll talk about that in a bit.

[00:24:16] Niels

Yeah, absolutely. Okay, cool.

So anyways, as of yesterday, my trend barometer finished at 66. That’s a pretty good, strong reading. So maybe there’s more recovery to come leading into the end of May. And as of Tuesday evening, because Alan and I are recording, actually, Thursday this week, the numbers are a little bit down for the various indices, which I’ll come to. But I will just throw in and say yesterday, Wednesday was a down day for CTA. So, there’ll probably be a little bit worse than the numbers I mentioned here.

BTOP50 is down about 1% in May, up still 10.44% for the year. SocGen CTA index down 62 basis points, but still up 11.18% for the year. SocGen trend down 91 basis points, up 13.25% for the year. And bucking the trend, the Short-Term Traders index up 48 basis points and up 4.06% so far this year.

In contrast, traditional markets doing well. MSCI World up 4.85% so far as of yesterday and up 9.35% so far this year. World Government Bonds are up another 85 basis points so far this month. And the S&P 500 up 5.52% as of Wednesday evening, up 11.89% so far this year.

All right, as you alluded to, and we are going to talk a little bit about some strategies closely related to trend following, as well as trend following. And the first paper that we’re going to be talking about is something that came from our friends over at SocGen, the QuantMacro paper that was released very recently.

So why don’t you take us into that world and what their findings were?

[00:26:04] Alan

Yeah, so it’s a paper on QuantMacro Heterogeneity and Exposure To Trend from David Regan at SecGen. It’s an interesting topic from the perspective of anybody who’s allocating across different managed future strategies and how they blend together. And this is focused on QuantMacro.

And I guess when we’re talking about QuantMacro, it’s strategies where the price inputs are fundamentally based either using market data or actual economic data. And obviously, these types of strategies can be either directional in nature or more relative value. The whole QuantMacro space, I think it’s fair to say, was quite popular going back maybe a few years and then in a period where trend following was struggling. But maybe trend following has come back to the fore.

But still, from my own perspective, I would see more and more managers have had dedicated systematic macro or QuantMacro programs in the last number of years. There’s certainly a distinct universe that is worth monitoring.

So basically, what they’re trying to figure out here is, are these QuantMacro managers broadly doing different things or are they doing all kind of similar things? I mean, that’s the basic question that they’re trying to assess. And also, then to what extent are they different from trend followers?

And so they look across, I think they have 83 programs that they have data on. Later on, in the second part of the study, they use about 24 of them. And they’re all systematic, all using fundamental inputs. It’s only one program per manager.

Certainly, at a high level, you do see more heterogeneity in this space. They look at the average pairwise correlation of these programs, these QuantMacro programs, and it’s 0.16. And that average pairwise correlation has actually been trending down over time.

So, to put that in context, the average pairwise correlation of trend followers is 0.58, which is, actually, slightly less than I would expect. So, it might have been even a little bit higher. But generally, trend followers are heavily influenced by one factor, the trend factor, whereas, obviously, in the QuantMacro space you have more.

And it sends stands to reason there are more differences. Why? Because some were relative value, some were directional. They’ll use different types of models and different inputs, et cetera. So, there is more, I suppose, potential to be different. And then the second thing is that they use principal component analysis to try and explain the returns and try and understand what the factors are that are driving the returns in the QuantMacro space.

And as I say, for that, they used 24 programs looking back over the last five years. What they found is, so what principal component analysis is, is that you’re trying to find factors that explain the variance of returns. And then each additional factor is uncorrelated with the previous factor.

Then what you’re looking at is how much each factor can explain the variance of returns across the managers. And what they found here is that PC1, the first principal component, explained 24% of the variance across the universe. And then PC2, the second principal component, explained an additional 13%.

So that’s I mean again to put that relative to trend followers if you were to do the same analysis for trend followers. PC1 for trend followers explains 57% of the various returns and PC2 a lot less.

So again, it’s highlighting the fact that clone macro are more different. The question is what is PC1? WithPC1 you can correlate that to trend following. So, you can actually figure out that PC1 is actually, probably, a trend factor and PC2 they figure out is actually an equity factor or the way they define it is it’s negatively correlated to the equity world. But you’d obviously have a positive or negative sensitivity to that factor. So, it’s effectively equities.

So, what that is telling you is a couple of things. One, clone macro programs are more diverse. Two, they are picking up an element of trend. But actually, if you look at the correlation to trend, it varies which is what you expect. If you think about it, if you’re a quant macro manager, at times you might pick up on a similar trend as a trend follower, and actually some of these quant macro firms are multi-strat so they actually have a small element of trend following in there. Obviously, at times, just by chance, you’re going to have the same positions as trend followers as well.

I thought it was interesting in kind of confirming that there is a lot of diversification potential within the space which is what you would expect. But also, if you look across the quant macro managers there is quite a varying degree of sensitivity to different factors and to trend.

So, from an allocator’s perspective I think what’s interesting is that if you’re constructing kind of multi-manager portfolios or multi-strat portfolios, certainly in blending trend with quant macro, you would expect, has benefits but there’s a couple of things that you kind of have to be cognizant of. That is like looking in to see are you picking up additional trend, within this program, and how much. You would infer that from the correlations and the principal component analysis as well. And then, obviously, you know it’s a different type of exposure as well. So, you know you have to be cognizant of concentration risk and stuff like that particularly in the quant macro space.

But pause there. I thought it was an interesting short paper and kind of highlighting probably what I would have expected. But it was interesting to see that the results kind of validate my expectations.

[00:32:01] Niels

A couple of questions for you on this, given your background. What do you think is harder, as an allocator, to analyze in picking a manager, a trend follower or quantum macro fund? What do you think actually is harder of the two?

[00:32:21] Alan

It’s hard to say what is hard. I mean what the data is showing you is obviously that there’s probably more unique factors driving the performance of somebody in quant macro. They were different types of models and different inputs.

Whether it’s harder to pick the manager or assess them, I don’t know. I think they present different challenges. With quant macro, what are the risks or the pitfalls there? Sometimes, particularly if managers are using relative value strategies, you can have quite concentrated individual exposures. Because it’s relating markets to economics, you can have relationships there that can break down. Obviously, we saw, during COVID, markets moving ahead of the fundamentals because they were anticipating lockdowns which is not something you would see in economic data. So, you always have these risks of kind of structural shifts, changing macro relationships, or the exposures.

And I think another challenge with quant macro is knowing the environment, when it’s going to work for you. Because with trend following you know very clearly when it’s going to work. If we see big moves in markets trend following will do well and probably most trend followers will; obviously trend followers will do well to different degrees. But I think you have a pretty good sense of what type of environment a certain type of trend follower is going to do well in. Whereas that’s less the case, I think, with quant macro, particularly if it’s kind of multi-strat or VE as well.

You’re kind of extracting risk premia. You’re capitalizing on need lag relationships. Yes, I think you can have conviction that the manager can generate returns over time but it’s harder to say when it’s going to work. So, I think there are some challenges whereas, with trend followers, you know that there’s an underlying characteristic to the strategy that will work in a certain set of circumstances. And it’s trying to figure out what are the differences between the different managers. So, I wouldn’t say one is more easier or difficult, but as they said they present kind of different challenges I’d say.

[00:34:41] Niels

Yeah, that’s a good point.

Alright let’s move on. But staying with kind of different type of strategies because there was also a family office report that came out. The 2024 UBS family office report came out. I think we both, actually, noticed that. You probably read it more carefully than I did so I’m going to let you lead again. Maybe we talk a little bit about what the highlights were to begin with and sort of how family offices are looking to allocate assets at the moment.

[00:35:14] Alan

Yeah, so this is from UBS and they survey 320 single family offices with an average net worth of 2.6 billion. So 600, they say 600 billion of wealth in aggregate. So, a significant cohort and presumably representative of, I guess, the median kind of family office.

I mean from an asset allocation perspective some slight differences actually between the average across the world and the US. But in terms of the global average, there’s 28% exposure to public equities, 22% to private equities. So combined there’s 50%; fixed income 19%, real estate, 10%, hedge funds only 5%, and no line item to manage futures and trend following.

I was surprised on the back of some recent top traders on blood episodes for. 60% was being mentioned. The number was so low but at the same time I’m not shocked to see it to such a low level. Private debt was only 2% so that was another surprising one, given all the chat we’ve heard about private credit private debt.

And commodities, commodities was zero, I think, which I was amazed to see. Maybe the view is you’re picking up commodities exposure elsewhere. I imagine that’s kind of a little bit cyclical, I would guess, if you went back maybe 10 15 years ago certainly you would have had a higher allocation to commodities and then small allocations to things like gold and art and collectibles and things like that.

So, maybe not as equity centric as you might have thought with the fixed income at 19% – a little bit probably high. Perception of family offices has been long-term investors and not overly worried about drawdowns as maybe other investors that you know because this is multi-generational wealth.

And there had been a notable increase in allocation to fixed income in the last year. And obviously that, I guess, reflecting the fact that yields have gone up and fixed income is more interesting but at a high level they would be the main points.

[00:37:45] Niels

And you know what I mean by my next question, but people might be a little bit surprised when I ask. Is there any allocation to whiskey?

[00:37:53] Alan

(Laughter) Not that specifically. So, obviously, we spoke to Tad Fellows from Long Angle under The Allocator Series, recently. He runs a group, it’s kind of a community of investors, but they’re all high net worth, ultra-high net worth, and younger investors, I understand, but they would be kind of family office type investors as well.

It’s interesting if you compare what they found surveying their members. They were at about 60% across public and private equity, so a little bit higher than this UBS report. But then 35% in alternative assets or so, 30%, 35%, and then I think about 10% in cash and fixed income, so lower on cash and fixed income and a bit higher in public and private equity. And then higher in alternative assets.

Some of the things he talked about were more esoteric investments like whiskey aging, which is buying kind of one year bourbon and holding it till it becomes five year and then you’re able to sell it on. So interesting, I hadn’t come across that one before. There was no specific mention of whiskey. It was interesting, I would say, yeah, his group are probably a little bit more higher and in terms of the risk appetite and reflecting that, and a little bit lower on the fixed income side.

[00:39:12] Niels

Yeah, he was trading the whiskey curve, I think, you know the one five year type.

[00:39:17] Alan

Yeah yeah.

[00:39:18] Niels

But also, importantly, his organization, and I think maybe certainly him himself, are very interested in, and very pro trend following. In the world we live in today.

[00:39:31] Alan

That’s right.

[00:39:32] Niels

Actually, on the topic of trend following, the next topic that you brought along, which I thought was interesting. I don’t know where I came across the same thing very recently. It could have been the same source as you, of course, but it’s a different way of thinking of trend following. We have always talked about it, or not always but we talk a lot about it, as a (in lack of a better word) crisis alpha strategy.

And then you brought up this topic about trend following as a return enhancement overlay instead. So I’m very curious to hear where we’re going to go with this topic.

[00:40:10] Alan

Yeah, well, there are a couple of things, I suppose, I’ve been thinking about. One, as we’ve said, this has been a very good year for trend following to date, and we’re in a pro risk type environment. Then, obviously, we’re seeing, from the likes of the UBS report, people not allocating as much to trend following as we would kind of expect. So, partially linked to that, I was thinking is, are we missing that piece of the argument around trend following?

Obviously, you’ll find plenty of articles on the benefit of trend following as a risk mitigation strategy and crisis risk offset and but not much on this characteristic of what trend following can do for you in a pro risk environment. So, I was thinking, do we need something like… What’s the opposite of crisis risk offset? It’s returning overlay or something like that to highlight this characteristic.

If you think about it, what are the characteristics of trend following and a trend following portfolio? There’s systematic, and agnostic between long and short, highly diversified. It kind of links to those characteristics that the Katy talked about in terms of what are the characteristics that allow these strategies to deliver a crisis alpha?

Those kinds of characteristics are valuable in times of stress. Why? Because they can gain you short equities, get you long bonds, get you into positions in commodities and FX that can be a source of diversification. All of that we understand, and all of those arguments have been well made over time, but equally those characteristics are valuable in in a pro risk environment as well if you think about it. The big challenge, now, is deciding how to be positioned in equities. Obviously, the trend is out, we’ve had a long run, valuations are high-ish, fairly high in some instances and there are risks. I’m talking about cracks appearing in the economy, but there’s always cracks, there’s always risks.

So, what do you do? How do you decide when it’s time to jump off the equity bull market? It’s very hard to do that, so obviously having exposure to trend following is advantageous in this environment, as well, from the perspective of giving you that equity exposure, but then having mechanical rules for determining when to reduce that exposure if the trend starts to turn down.

So, you know you’re going to get out and your portfolio exposure to equities will be reduced under a certain set of circumstances. In an environment like this interestingly we’re seeing strong trends in other markets as well. So, I wanted to have a look at the data, and I think it also links to the idea of return stacking which we’ve been talking about as well and does that make sense? I think there is a place for it in terms of when you stack trend following on top of passive equities you are getting this kind of overlay. It’s a mechanical overlay of modulating not just your equity exposure but also your exposure to other assets as well.

So, I love, historically, the returns on the S&P 500, and I added an overlay of the SocGen trend. This would be kind of, I suppose, a return stack type portfolio. So, adding a 30% exposure to the SG trend excess returns. Which is what you could achieve on a kind of notionally funded basis. That gives you the same volatility as the S&P 500. So, you have two portfolios S&P or S&P plus SocGen trend overlay.

The results are interesting. I looked at calendar quarterly returns, since 2000, and what you actually find is that definitely, in the bottom decile quarters for the S&P, having the overlay is beneficial. So, we all know that. Everybody has written at length on this but, actually, in the (sorry, that was the bottom quarter) top quarter as well the combined strategy is better as well. So, it’s not just it’s not just in the crisis periods that you get the benefit, but you get the benefit in the crisis periods and in the very favorable periods. Actually, in the middle periods it underperforms a bit.

We all have seen that chart before of the smile where you plot S&P versus SocGen trend and it is a smile type return. And in the very favorable and in the very negative periods for S&P, trend following tends to well, but you kind of forget that and it’s easy to make arguments around that in crisis periods we do tend to see trends. Bonds will rally, currencies, whatever it is, yeah, but also it does seem to suggest that, in the very favorable periods for equities, you tend to see more trends as well. Presumably that’s because if equities are doing very well the economy is hot, so we’re seeing probably moves in commodities just as we’re seeing at the moment.

So, interestingly, the magnitude of the difference is greater on the downside. So, the combined portfolio does do relatively better in the worst period, so maybe that’s a reason why we haven’t acknowledged this aspect of trend following to the same extent.

But I do think it is something that’s been lost a little bit in the marketing of trend following that, it’s not just crisis risk offset, that there is this return enhancing overlay benefit as well which we might hear more about going forward.

[00:45:55] Niels

Yeah, I love the idea, I love the idea of changing the narrative. Obviously, we’ve spent countless episodes on discussing this topic of narrative, so I think this is definitely worth having a go at as well. I’m, of course, not surprised by the value of combining the two. We know that, as you said and what we do, if I just take our own returns, even back to the 80s, and combine it with S&P 500 what always surprises me, and I think it surprises the people when they see it, is because you kind of expect, okay, if you take 50% trend and 50% DUNN you get kind of an average but actually you almost get the sum of the two because the compound effect is so high. That, I think, shocks people when they see it for the first time.

The other thing is I think you’re right that maybe investors would be more open to the idea of the term ‘overlay’. We know, certainly, pension funds, as far as I recall, you know they’ve used currency overlays and different types of overlays to their strategies, to their portfolio. So maybe a return enhancing overlay would be good to propose to them. One thing I wanted to ask you is, because we’ve been so focused on the crisis alpha aspects we have certain metrics that we that we kind of focus on when we try and showcase that, if we were to go down this route and try and get people interested in the overlay side of things are there any different metrics measures that we should point them towards?

[00:47:40] Alan

I think there is that that perception that it’s just that there’s like an inherent cost,, that it’s protection, and there’s a cost associated with trend following by virtue of showing returns and that it’s not just something to be a drag on your portfolio and then dampen vol. That it’s actually a proactive additive feature and also the systematic element it means it’s facilitating staying in the equity market, I guess. So, I think it’s that characteristic as much as anything else. Obviously we can talk about the return characteristics but it’s also the fundamental characteristic of the strategy being trend following and systematic that then maybe that has to be emphasized as a way of participating in the equity markets without having to try to infer, from all of the noise, as to what when the market’s going to turn, which it will, at some point. We will know there will be a significant drawdown at some point and, as we’re saying, the risks are rising but whether it’s going to be in a month’s time, or a year’s time, or two years, who knows.

[00:48:52] Niels

You’ll relate to this Alan. Back in the ‘90s I had a colleague called Tom and Tom used to work at the Virginia retirement system and the Virginia retirement system was very important for our industry because it was really, I think, the first pension, well, maybe not the first pension fund but they were very vocal about implementing a portfolio of fund of funds in the CTA space back in the ‘90s I think. He had a great he had a great line. He said, “Well people should realize that…” and whether he said managed futures or trend following or CTAs I don’t know, but let’s just call it trend following. He said, “What people should realize is that trend following allows them to own equities.” I think that’s, I mean it’s so true, but we never talk about it in that way but that’s exactly what it does.

All right so we’ve covered a few different topics and we’re going to take a little bit of a detour to a topic that fascinates me in many respects. I’m not entirely sure I can fully understand how they magically can take out all the bad stuff and get left with a very smooth return stream. We are not talking about private equity this time, because we know how they do it, but we are talking about multi-strategy funds because you saw a paper, well, no, you didn’t see the paper you saw the person who wrote the paper, Brian Hurst, give a presentation about this so, again, very excited to hear about this topic.

[00:50:35] Alan

Yeah, like yourself I’ve been very curious about this space, the growth of assets, the consistency of returns and wondering what’s going on. I’m curious to learn more about it and Brian Hurst, from Clear Alpha, Brian used to be at AQR for many years, left there and I started a multi-manager, multi-strat firm in the last year. I saw him give a presentation on this topic and there is a paper for anybody interested, on their website. It starts off talking about how multi-manager funds, with full pass-through fees, and how their returns…

[00:51:18] Niels

Can you explain that? Maybe people don’t quite understand. What do they mean by full pass-through?

[00:51:23] Alan

Yeah, so full pass-through means basically all of the costs. So multi-manager funds obviously have big teams of portfolio managers called pods. Each individual team is called a pod. I understand the likes of Millennium can have up to 300 pods, but it could be anywhere from 20, 50 to 100 or more. Basically, in the old fund of funds type model, the underlying manager had a fee, and the fund of funds had a fee, and that was all wrapped up together.

In terms of the management fees in this model, basically all of the expenses associated with all of the managers, as well as the performance fees are passed through. So, it’s more of a platform is how it’s positioned. All of the sign-on costs associated with the individual pods flow through to the underlying investors.

It’s like you’re participating in the overall profit and loss of the platform. You’re subjected to all of the cost and then out of that, as well, comes the performance fees for the individual managers. So, it’s a different model than saying we’re just going to charge 2% management fee and 2% of performance fees and the fund provider will take care of all the costs.

It’s a different model of the view to say we’re going to pass through all of the fees and expenses but that will allow us to attract better talent so yeah.

[00:52:56] Niels

Sorry to interrupt here. I’m really just curious, have you come across any studies that actually have calculated what are these fees? I mean if you calculated into a management fee meaning fixed cost and performance fee, like we do, we know that it’s not, obviously, I mean everybody says 2% but it’s not 2% and 20% anymore in our world, but let’s just call it 1.5% and 15%, on average, whatever. Do you know what it would equate to?

[00:53:27] Alan

I haven’t seen any studies but I understand it’s like up to 7%, 8%, 9%, 10% of fees.

[00:53:33] Niels

They make it sound like this is an advantage but I don’t see any advantage in this from a fee perspective. Talk about a narrative, I mean they’ve been incredibly successful, okay, backed up by some numbers, okay fine. They’ve been very successful in creating this aura around, “Oh it’s not a problem that we’re paying $10,000,000 to this guy as a sign on bonus,” but clearly, all of those costs, if it was a manager, the manager has to pay that not the client. So, it doesn’t strike me as being advantageous to the underlying investor whatsoever, but maybe it’s overcome by the fact that they can apply more leverage and what have you.

[00:54:20] Alan

No, you’re right. It’s something that you would have thought would be a big stumbling block but obviously they’ve been able to overcome it in terms of performance.

So, this paper starts off by highlighting that the returns have been better. These new funds have generated more alpha, stronger sharps than hedge funds more generally, and then is asking why is that the case? I guess sometimes the standard answer on this is better able to attract talent and compensate managers and good risk management, so they’ll know when to cut managers quickly.

I suppose the key point about the paper is that I was maybe a little bit surprised. I thought I might learn something more. It was interesting that from Brian, the Hearse perspective, it really is the structural construction of the portfolios of basically finding uncorrelated strategies and applying leverage and that’s it. That’s the same idea of blending uncorrelated strategies.

The old fund of funds obviously didn’t apply the leverage and that’s where they came unstuck in the sense of you blended strategies together and suddenly the vol was under three or four percent. So, you really needed high sharpes. They’re taking the same basic idea but just applying it to the nth degree in the sense of having hundreds of pods and leveraging up.

Now, this paper is all about just showing the mathematics of how it works and it’s all very clear and fairly obvious. It relies on finding good strategies, they don’t have to be rock stars. In good, he’s calling like a point 0.70, 0.75 sharpe. In our world, in CTAs, we call that very respectable but not necessarily too sharpe. If you find twenty of those strategies with a 0.70 sharpe, they’re all lowly correlated, as he says. I think that’s 0 to 0.10, then obviously the numbers suddenly become very good with the application of leverage. That makes sense.

I think, obviously, it’s what to make of that? Are there a lot of these types of strategies out there? Obviously, there are some strategies which periodically offer very nice returns. The popular strategies in this space are things like the basis trade where you are you’re buying the treasury bonds and telling the futures. At various times there’s a premium to be extracted and you can apply leverage and it’s pretty close to risk free money.

Other things to do are things like index rebalancing. In some shops there’s a lot more long/short equity, but there’s a constant search to find all of these strategies that have that level of sharpe.

What was interesting in the paper is he does point out that there is a sensitivity to correlation, that it works very well if you have lowly correlated strategies, but as soon as the correlation starts to rise then the portfolio volatility starts to pick up so you’re going to have to deallocate from some managers to hit your target volatility. Then the second thing is, it’s not just about the average correlation but it’s about the correlation in the tales. So, I think this is an important point to think about when looking at this space is.

Don’t think in terms of average correlation but think of what can happen in the worst-case scenario? The worst thing that can happen is, if a lot of these pods have the same strategies and then there’s a problem, and they start to suffer a loss, and then obviously when their assets go down you have to rebalance the portfolio and degrows a bit. If everybody is doing that at the same time, then that can push the market, and then you can get into a potentially crisis event.

This is kind of like the type of scenario we saw in 2007 with the quant crisis, you might remember. I think it was ‘07 where basically a lot of long/short funds had a similar position. So, critical to doing the multi manager approach well is making sure you don’t have the same exposures in every way as everybody else and not overly exposed to individual factors.

So, the risk management, the platform, being able to look into the individual pods, and I understand it does actively rebalance. So, if a load of pods are long Apple, they might take an offsetting position against that. So, that’s part of the magic but, you know, it’s early.

You could see, in scenarios, of where it could come unstuck and obviously March 2020 is an example of that. It was large basis trades and, obviously, we were in the midst of COVID. In that time the Fed came in and basically bailed out the whole system. Will they always do that? Who knows, maybe, maybe not. That’s the type of a scenario where you could see more of a challenge, I think, for these types of strategies.

[00:59:35] Niels

Yeah, fascinating stuff. It’s definitely something that I think both you and I would like to talk more about in the sense that we were actually approached by one of the big multi-strat funds. I think both of us are open to doing a miniseries on that, but we definitely nee a few more of the larger names come forward and be open to have a conversation. Like we did with the CTAs. I think it could be a good one, but we can’t just focus on one or two entities. We need to have a little bit of a broader spectrum.

So, if any of you listening today are working for some of the big mod firms and have contacts in the hierarchy, reach out to us at our usual email address, info@toptradersunplugged.com and then we’ll pick it up from there and see if we can create something of value for you, the listener.

Thank you so much. This was great. This was great, this was fascinating, and I appreciate all the preparation that you did. I was telling you yesterday that my day changed a lot, so I didn’t have as much time to prepare as usual, but I guess now-a-days we talk so much about AI. I guess I could just plug in a few topics and all the preparation will be done.

[01:00:57] Alan

Exactly.

[01:00:58] Niels

And maybe if I just used the new ChatGPT 4.0, all the questions will come in the voice of Scarlett Johansson, if you follow the narrative out there.

Anyways, we’ll be back, as always. Next week I’m going to be back with Katy and I think this will be an interesting one because she may talk about something that she had not talked about before because they are launching some new product which I’m excited to learn more about and I think could be quite useful to hear her perspective on this. So, I’ll leave it at that.

If you have questions Katy, as always send them to info@toptradersunplugged.com and I will do my very best to bring them on the show. From Alan and me, thanks ever so much for listening. We look forward to being back with you next week and, in the meantime, as usual, take care of yourself and take care of each other.

01:01:59 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.

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