Trend Following…What should it mean to Investors? ft. Richard Brennan

[00:00:00] Intro

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

[00:00:23] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Richard Brennan and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global markets through the lens of a rules-based investor. Rich, it’s great to be back with you this week, almost in the same time zone. But still, how are you doing down under? Since I’m on equator, you’re still down under for me.

[00:00:45] Richard

Welcome to the southern hemisphere, Niels. It’s great to have you here. I hope you’re enjoying the weather. Over here, we’re just starting to get the cold snap starting to come in. We’ve had a very extended summer and now we’re going into the colder climes so the mornings are starting to get a bit chillier.

But the good thing is where I am located, which is close to what they call the Tropic of Capricorn, it’s beautiful weather. It’s more like I suppose southern US around Georgia, that sort of stuff, that sort of weather. It’s got a bit of humidity in the air and it’s always very pleasant. So, this is probably our best time of year for where I am in Queensland. But you’d be enjoying Singapore. Is it fairly hot over there?

[00:01:34] Niels

It’s always hot here. Actually, and this is the funny part, Richard. When I arrived here like a week ago, people were telling me that at the moment, it’s unusually hot. And I’m thinking, how can it be even hotter than it normally is? But anyways. By the way, what did you call it? The Tropic of Capricorn. It sounds like something from a travel brochure. It sounds very exotic.

[00:01:58] Richard

It’s one of the latitude lines that tells us we’re getting closer towards sub-tropical zone.

[00:02:07] Niels

Fantastic. Good stuff. All right, before we get into too much of the travel and leisure world, before we dive into the topics, which some will be familiar topics for people, there’ll be a few new things, always great when you’re on here. But of course, I’m always interested in hearing what’s been on your radar the last few weeks since we last spoke.

[00:02:29] Richard

I’ve been looking at our prospects in trend following which as you know, Niels, for the last four or so years, it has been a fantastic regime for us. And I was thinking to myself, how long can this regime persist? I’ve been looking at cocoa, the rise and rise of cocoa thinking that traditionally, we’d have the expected about a decade ago that we’d have a rapid snapback and things would mean revert a lot more than they’re currently doing.

But I’m noticing it’s not just restricted to cocoa. Now we’re seeing the precious metals move. Now I’m seeing coffee moving significantly. I’m seeing energies moving significantly. So, it’s a wonderfully trending environment. I was thinking about the episode you had the other day with Aspect Capital and his comments regarding the change in regime associated with the lack of the central coordination between the central banks.

I personally think this is a situation we’re probably going to find extends significantly into the future. So, I’d like to think of this regime as almost like a return back to the ’90s, 1990s, that sort of area. And I’m starting to think more and more about what you and I have both raised in the past. Perhaps that decade of tough performance with a coordinated central bank intervention was the anomaly here.

I’m very hopeful of future prospects because I can’t see the central banks returning to that suppression of volatility that they were so coordinated with during the last decade or so after the GFC. So, I’m very bullish and optimistic. Even though I can’t predict what’s going to happen in the future, I think that maybe we’re in a regime where we shouldn’t anticipate that trends are going to end early and classically mean revert. Maybe we will have these superb outliers and opportunities that just keep on trending.

[00:04:42] Niels

Yes. It’s funny you mention that because I have no idea when I asked this question what’s been on your radar what you will answer. When I made my notes for our conversation this morning, I had something very similar. I was going to tell you about certain things other than cocoa that I found very interesting this week. So, I’m going to do that in any event.

But as you rightly say, we see some opportunities right now, say, in the currency markets where the euro, pretty weak, although not multi-year lows, but it’s still low in the last five, six months, and actually pretty close to the low of the last year. Clearly, of course, driven by, as you say, the divergence in central bank policies and what happened this week on that front.

Of course, the yen, a 34 maybe year low for the yen versus the dollar hitting 153 this week. Clearly, an interesting trend for our group of peers. We have the oils, you mentioned that. We have a one-year high in gasoline this week and other markets again driven by something slightly different, most likely what’s going on in the Middle East and potentially some supply issue on that front.

And then as you also mentioned, we have gold $2,410, breaking out, up 3.5% for the week, although I think it’s probably more related to the Middle East and geopolitics and so on and so forth. But of course, also this week, the Wall Street Journal did run a story that you can now buy gold at Costco in the US which they began selling last year. So, we’ll see.

And then on the other front, even though stocks have been treating us really well, probably Japanese stocks still treat us pretty well this week, we did see some challenges in the last couple of days for US stocks at least. The S&P 500 had its worst day since January on Friday and has had now two week-to-week or consecutive weeks of losses.

So, I think you hit it on the nail when you talk about the divergence happening in our portfolios, meaning it’s moving from one market to another, one sector to another. And those really are the environments that we like. And, of course, with the news we had this week in terms of inflation where we’re sort of looking at a five-year outlook now according to the Michigan surveys coming out at 3%, it’s going to be tough for the US to just cut rates the way they thought they would do in the beginning of the year.

With Switzerland cutting rates already this month, with Japan hiking rates and with the ECB somewhere in the middle here, I think you’re absolutely right that this feels like a different regime to what we’ve been used to for quite a while. So yeah, I think you and I have talked about it in the last couple of years.

Certainly, I’ve felt very optimistic and confident about this type of strategy in this environment and certainly what’s happened so far this year strengthened my conviction in the strategy but also in why all portfolios need to have an allocation to trend, and not 3%, which we’ll come to later in our conversation just to tee that up a little bit.

If we talk about trend following this week, besides the all-reliable cocoa market, I think trend follows had some good opportunities as mentioned in in currencies, but also, interestingly enough, short-term interest rates in the US because of what’s going on in the inflation. The downtrend seems to have picked up to some extent, and I think some managers will have certainly benefited from that.

On the other hand, I think also there’s been a little bit of mixed signals coming out of other sectors during the week, grains, equities, because depending on where in the world you’re looking at equities, it was a bit of a mixed week. Energies, not everything went up necessarily this week, and then also longer-dated bonds, metals. So not everything. Not everything behaves like gold at the moment.

I think the worst sector, at least from what I can tell, this week has been meats that didn’t do so well. But the good news is my trend barometer hit probably the high for the year or close to 64. Yes, so let’s hope that it really is an indicator that at the end of the month if we’re here that we are looking at a positive month for the managers.

Although yesterday was not a good day for trend followers, I think the month so far is still okay, in the black. BTOP 50 up 1.72% as of Thursday night, up 11.22% for the year. SocGen CTA Index up 2.1% for the month. As of Thursday, up 11.96%, so very strong. SocGen Trend up 2.3% for April, up 14.8% for the year, and the Short-Term Traders Index was up almost a percent in April, up 2.18%.

Looking at the traditional markets, MSCI World down 2.5% so far in April, up 5.7% in 2024. World Government Bonds struggling again, down 1.4% in April. And finally, the S&P total return index down 2.44% so far this month, up 7.86%. Before we dive into the topics, Rich, any thoughts on my long rant about that?

[00:10:56] Richard

No. But I think what we were hearing with deglobalization, with this breakup of centralized regulation, we’re seeing these trends arising from a lot of different fronts. I’ve noticed in the podcasts you’ve been having recently this increased use of the word idiosyncratic trend.

I think that whereas in post-GFC we were getting specific factors dominating, overall macro factors, dominating overall trend performance. So, a range of different trends could be accounted for by virtue of some economic factor. I think that’s now changing to these multiple different factors now impacting the market from this breakup of this centralized coordination with assets starting to move on their own, in their own nature.

So, I actually view this as a healthy symptom where we’re not the same victims that we were to impacts of correlations and things like that that we had been in the past. So, there are a lot of positives at the moment. This is the time now, I know we’re going to get into the topic, but this is the time now we don’t accept 3% trend following allocation.

This is the time now to argue the strong case for why trend following should be a much bigger allocation in a traditional portfolio.

[00:12:26] Niels

Absolutely. Even though you and I will probably agree that it’s really not about timing the percentage of allocation, it should of course always be a healthy allocation. We know that. We talk about differences in central bank policies and so on and so forth, and as I was hearing you talk about it just now, I’m thinking that besides everything that’s going around and going on in the worldwide now geopolitically, etc., maybe another thing that is somehow having an impact but it’s very hard to pinpoint it, it’s also the major shifts we see in demographics around the world.

I know that sounds odd that demographics could have any impact or relation to trend following, but that does actually have an impact on economic activity, on demand and supply in certain commodities, etc. So, I agree with you. I have felt this for a long time, that the decade, the 2010s, but even maybe the first 20 years of this century really was the odd one out and we’re now heading back to a much more “normal” trending environment.

Now, before people get too excited and run out and buy whatever ETF they can get hold of, we always have to caution and say a trend follower is not going to make money all the time regardless of how great the environment is. Actually, it could mean that we just have some more shorter periods of really outstanding performance and then still we have our usual many months every year where we’re going to lose some and maybe have one or two big down months.

So, I don’t think that side of things will change, but I think the opportunity set will be increasing. As we mentioned in one of the monthly trend updates we posted, you and I Rich, trend following heaven might just be opening up a little further. Anyways, of course, it leaves you with a question, and that is, how much of a material application do you need to trend following? And this is of course what we’re going to be talking about first.

Now, this is something that is inspired from the conversation I had with Andrew last week without a doubt. In that conversation, we discussed a recent paper from Man Institute about how much you really should allocate to trend following. Of course, the number that they came up with, Andrew challenged, let’s put it that way. I feel I’m more on your side, I have a feeling where we’re going to head with this topic today.

But I also think upfront, I don’t necessarily agree with everything you’re going to say today. I think that’s the beauty of the group of people that come on every week is that we can actually have these respectful disagreements on the topic, and also disagreeing with some of our friends who may not be on the podcast every week but that we know pretty well.

So, everything I’m going to be saying today is obviously always with the utmost respect, but we also have to be true to our own beliefs and our own opinions. I’m sure I’m not going to be disappointed with your beliefs and opinions today, Rich, so let’s dive into it.

[00:15:51] Richard

All right, Niels. Yes, you’re right. We all do beat to our own drums.

[00:15:56] Niels

We’re talking our own books, and I’m going to mention that I’m sure later as well. It’s all about that.

[00:16:02] Richard

That’s right. So, I’ll start this by rebuking the 3% allocation that Andrew talked about last week. As you said, this is off the back of Man AHL’s paper which I think was called “Honey, I Shrunk The Trend Following”, where they used the BTOP 50 as a proxy for trend following to determine what sort of allocation would be optimal in terms of Sharpe and also investor preferences and a range of different factors that would be optimal to allocate this BTOP 50 allocation into a traditional 60/40 portfolio.

So, the first thing I’d like to say is, firstly, we’re dealing with the BTOP 50 there, which to me is a quasi-trend index. It’s not what I would regard as 100% trend following index. It’s quasi. Because if you remember, Niels, last year I think it was, we engaged in that small research project where we looked at the performance of the long-term trend following managers, such as DUNN and a range of others, to determine what would be the improvement in their overall Sharpe ratio with a level of allocation into the traditional 60/40 portfolio.

In that evaluation, in every instance using the long-term track record of these validated trend following fund managers, so not the BTOP 50 for instance, these are trend followers, we obtained that everywhere we looked, a 20% allocation, always improved the Sharpe. This was looking over about a 23-year track record.

Then I remember you asked me to say let’s do an optimizer here and see what is the actual optimal allocation for the group of trend following fund managers that we examined? I think we examined the constituents of the SG Trend Index in that evaluation. I came up with a figure of the 60s percent. So, I know that might appear very high, but Man AHL, using the BTOP 50, which is a quasi-trend index, came to a 40% allocation.

Also, the BTOP 50 and the ways that they’re comprising these indexes is not necessarily based on track record. You and I, with previous podcasts, have looked at the differences between the performance of the long-term track record of a validated trend follower versus these indexes which might include shorter-term track records because they simply meet the AUM requirement to get into that index.

So, when you’re looking at the long-term track record, everything to me points to at least a 40% allocation. There’s obviously a lot of opposition in industry about trend following, and Andrew is obviously meeting this head on when he’s marketing DBMF out to the institutional managers out there trying to get an allocation.

He’s expressed the great difficulty he’s been having in convincing them over material allocation and he’s come up with this figure of 3% being as much as can be realistically expected when trying to incorporate levels of trend following into these traditional portfolios. You mentioned your concerns with that last week, and I’d just like to sing your praises here because I totally agree with you.

A 3% allocation is not going to move the needle at all. We need a material allocation to actually move the needle. What we have observed is that we have seen a significant issue arising for the traditional portfolio. We’ve seen that the past two decades up until 2022, we had the bonds being negatively correlated with stocks, the US stocks, and that provided an environment where bonds provided a significant cushion to any crisis that unfolded within the stock sector.

So that basically gave rise to the 60/40 portfolio, a 60% allocation in US equities, a 40% allocation in bonds. That was sort of like the gold tick stamp of portfolio management for the last two decades effectively. But in 2022, we saw that negative correlated relationship flip to now a positive correlated relationship, where bonds are no longer offering that level of protection, a protective cushion.

This very much concords with its 100-year history before the last two decades where bonds and stocks were positively correlated. So, the 60/40 portfolio was a phenomenon associated with a symptom of this negative correlation emerging over the last two decades. What we’re experiencing today probably associated with quantitative tightening and the lack of the central bank coordinated intervention is now the flipping of this relationship back to its traditional stance of a positively correlated relationship.

So, what we’ve got is a problem on the hands for the traditional investor. As investment professionals, I don’t think it’s in our interests to say, well, a 3% allocation towards trend is going to offer you any degree of assistance. We must be honest and say, look, we need a material allocation of trend because there’s a couple of things we can demonstrate.

Over the two decades that we had the preeminence of the 60/40 arrangement, 60 equity, 40 bond, when you replace the bonds with a 40% allocation of trend, you find that 60/40 in trend has always outperformed 60/40 in bonds. It has outperformed in two ways. One, it’s less correlated. Two, it’s given more lifting power for the overall portfolio.

So, at least from the research I’ve undertaken, we’ve always had this instance that up diversified or systematic diversified trend following of the long-term track record of the fund managers has always been an optimal diversifier. Bonds has been something that has provided protective cushioning, but it hasn’t given the necessary lift to supplement the lift provided by equity.

So we’ve seen this historically, and now is the time, particularly with this breakdown of the relationship, for us to significantly enforce the principle that a material allocation in trend is deemed very warranted because it’s a bit like if we were doctors providing healthcare advice to our patients, and we said to them, look, you’ve got this significant disease here but we’re going to give you a 3% allocation because it’s too difficult trying to convince you otherwise.

It’s in our interest to actually force ourselves to say, look, as investment professionals, this is the need to why you need a material allocation in trend. We need to give them the medicine they need. Remember, I think it was Marty Lueck talking about the medicine the client needs, this is a medicine needed to stop this significant problem, which could be a big problem in the future for pension funds, superannuation funds, etc. It could be a massive problem for them in the future. We’re providing a solution here with a material allocation.

[00:24:04] Niels

Well said. Obviously, I agree wholeheartedly with the points you make. I’m pretty sure in the last week or so, I had a question that I didn’t think was a question that you and I will talk about. So, I think I’ve kept it for a later episode. But I actually think you’re touching on something here that is related to that question, so I apologize for not having prepared it and cannot say exactly who raised the question.

But it’s something that I thought about a long time ago, but completely forgot about it, and that is, where does fiduciary responsibility fit into this? If you are a pension fund or a consultant or whatever. I don’t know exactly who has fiduciary responsibility or not. I think it’s depending on the designation you have with the authorities in the US. But if you have it, it’s your job to come up with the best investment solutions and always put your client’s interests first.

If you’re armed with a lot of evidence, research, and as we often talk about, there’s never been a white paper written that doesn’t confirm what you just said. Where does fiduciary responsibility come in? I know this is putting this at an extreme. Could you end up getting into trouble for not having an allocation material to trend following when all the evidence, including what the consultants know deep down (because I’ve interviewed them), and they said, yeah, of course, if we run our models, the allocation should probably, as you rightly say, be 40%, 50%. But we could never say that to a client. And I’m thinking, “Well, hang on. We have a problem.” So, I think it’s quite an interesting topic, conversation. I hope it doesn’t go away.

[00:26:01] Richard

I do believe we’ve got a fiduciary obligation because supposedly we’re acting in the client’s interest. There are two aspects to trend following. There’s the business of trend following and then there’s the investment practices of trend following. As far as a marketing angle, it’s easy to say I’ll just accept the small allocation because it’s a hard task to try and convince these institutions of the need to have a material allocation towards trend.

But I’ve never been in that game personally. I believe, as a specialist, as a professional, it’s necessary to make the hard decisions, to give the investors the true account of what you see and to convince some of that. That, to me, I’d say at least in my landscape, it’s a more ethical stance to take in investing as opposed to just acquiring AUM for your own personal needs, if you know what I mean.

[00:27:07] Niels

Speaking of acquiring AUM and marketing, it’s a nice segue I have a feeling, Rich, to another topic, maybe a little bit controversial but for different reasons that we’re going to be talking about next. But let’s dive into it.

[00:27:28] Richard

Let’s talk about why Andrew is having this problem in getting allocations towards trend. I personally think a lot of it is to do with the investors lack of understanding of what we do. There’s a term out there called managed futures and there’s a term out there called CTA. There’s a term out there called the liquid alts.

Now, we of course know what that means, and people involved in our industry know what it means. But to the man on the street, when they hear those terms, I personally think it just offers confusion. When they hear the term managed futures, they’ll say, isn’t futures a derivative that’s very risky? They’ll probably think back to the Nick Leeson days and the futures debacle that occurred with Nick Leeson and they’ll think to themselves, “Gosh, I’m so pleased I’m dealing with my boring old stocks and bonds.”

So, I don’t necessarily think the term managed futures helps our cause. It creates confusion. Secondly, the nature of trend following these days is far broader than just investments in futures. We’re seeing people investing in stocks in isolation, without the use of futures. Trend following to me is something that applies to any liquid asset class. It’s not necessarily just restricted to futures.

So, by putting ourselves in this bucket of managed futures, I don’t think that necessarily helps our cause. When talking about CTAs, no one off the street really knows what a CTA is. “Commodity trading advisor,” they’ll say to themselves. “Do you just deal with commodities?” And then you’ve got to say, “Well, no. We deal with fixed income, we deal with equities, we deal with commodities soft and hard, we deal with all of these different asset classes.”

So, CTAs isn’t the term that I think gets broad appeal in the market, especially when we talk about liquid alts. Being bucketed in with liquid alts, people are going to say, “Is this an alien description? What is this we’re talking about liquid alts.” So, I think the way to get across to the traditional investor who is used to the nature of the stocks and bonds they trade is to show the similarity of trend following to those instruments.

We can talk about you will buy and hold your stocks and you will buy and hold your bonds, but trend following is like a buy and hold strategy, but we go both long and we go both short looking at material trends. We bring things back to the simplified understanding of what they’re used to as opposed to talking in terms of the jargon and that we are distinctly different, all of those things. I think we should bring the conversation back to the commonalities.

Look, I do keep in contact a lot with Mr. Parker as you know, and we have these continual conversations about this, that we don’t think that under these umbrellas of managed futures, CTAs, liquid alts is really helping our cause at all. I do tend to agree with this, and I think it’s in our interest to simplify and maybe just talk about trend following. I think people would understand what trend following is more than liquid alts or more than CTAs are more than what managed futures are.

We talked about systematic trend following, how we’re globally diversified, how we have investments not only in your favorite stocks and bonds, but we are also long and short in those aspects. But we also invest in other asset classes such as commodities, and we might have some small exposure into these different asset classes like cryptocurrencies, those sorts of things.

If we just explain things in these simplified ways, I think it will assist our cause more than currently how it’s being umbrellaed and marketed within the managed futures, CTA space or liquid alts space.

[00:31:30] Niels

It’s hard for me to push back on that I actually thought there was something in there I could push back on a little more. I think maybe it comes later. What I’ve noticed is that when different people with different interests talk about these things, as we started out by saying, we’re kind of always talking a little bit about our own book.

So, on one side, people will say, well, we should be classic, we should be original, we should stay with how it was done back in the day. And on certain things, they will criticize people who have evolved. But then again, in this sense, and of course I think it’s completely fine to focus on- maybe we should as an industry focus more on what it is we’re doing, i.e. trend following, rather than using managed futures and so on and so forth. I think that makes perfect sense.

But of course, as soon as you also then yourself start to move into other types of markets like cash equities, well, one, you are moving away from the origin. So, you might still be classic trend, but you’re moving away from where we all started, that was liquid exchange-traded futures. So, when we do that, I also think we lose something meaning, cash equities, yeah, sure, they can still be liquid. That’s okay.

But some of the other markets that we’re now able to embrace because we can just say, well, we’re trend following on Korean swaps of some sort or whatever it might be, I think we’re certainly losing the liquidity part. Now, some managers will argue that trading these alternative markets is better. Some will argue that trading hundreds of markets is better, including cash equities.

I’ve always been of the opinion that I can’t find any evidence of that statement, that it is better. But it’s for sure going to be different, and that’s fine as well. So, where we are in our conversation right now, I have no problem in trying to change the way we describe our industry back to more trend. I just think we need to be careful, and I think we’ll come to it later in this topic, about how we talk about other firms who may be evolving because it looks like we all want to evolve as long as it suits our own marketing purposes, if you know what I mean.

Because at the end of the day, one of the arguments for embracing cash equities all of a sudden, in the last few years is of course, well, if we trade markets that people know or are familiar with, then there’ll be a higher likelihood that they’re going to embrace trend following. The only counterargument I would say to that is, as you and I started out talking about, why should you even have trend following in your portfolio and why should you even have it in a meaningful way is of course that it can do things and it can be non-correlated and it can be negatively correlated at the time you really need it.

My concern is, if we start now being trend followers on the same markets people are trying to diversify away from, we’re going to lose that correlation benefit to some extent. We may not lose it completely. But trend following only equities is going to be more correlated to long-only equities than trend following on a fully diversified portfolio with currencies and commodities and so on and so forth.

So that is a real concern that I have. It’s almost like (and this has been around for a long time) when people talked about oh, yeah, I’m going to diversify my portfolio into hedge funds. Deep down they were saying I want to diversify my equity exposure into hedge fund. But then they were picking hedge fund strategies that all they did was investing in equities, long-short this, long-short that, relative value this, relative value that.

So, they’re just going back into the same markets they’re trying to diversify away from calling it something different. We know full well, if you look at the hedge fund indices, they are highly correlated to equities, and so on and so forth. So, I think we need to be careful, even though I completely understand we’re not going to be talking our own book here.

But over-embracing some markets because they are more familiar to people, I think we risk taking away some of the true benefit of trend following, namely, in particular, commodities and liquidity.

[00:36:34] Richard

I totally agree with you. One of the hallmarks of what I think our game is, is diversified exposure across asset classes. This is why we can offer an uncorrelated relationship to any single asset class like stocks or bonds or both combined because we are spread across a variety of different asset classes. So, the hallmarks to me of a methodology that embraces trend following is diversification broadly across asset classes.

If for instance someone came to me and said, I’m a trend follower in equities, I would say, well, that’s not trend following because it does not capture the essential requirements of the uncorrelated nature of trend following.

[00:37:21] Niels

I have two questions. Sorry to interrupt. I have two questions. I think that’s a very important point you’re making. So, it leaves two things. And maybe this podcast is an important part of changing the narrative about this. Who knows? But then it raises two questions.

In order to call yourself a trend follower, is there a minimum of trend following let’s call it models, percentage, that you should have? You referenced the conversation with Anthony at Aspect this week we published, Alan and I, where he says we have 80% trend and 20% diversifying. We know a lot of managers are not 100% trend anymore.

So, the first thing we need to ask ourselves, in order to be called a trend follower, do we need to impose some kind of rule about how much should be trend and how much could be something else? That’s one thing. But then the other thing that you raise is say, when you say if you’re just doing equities, you’re not really a trend follower, then my question is, how much are we allowed to be focusing on these markets?

We know some people have gone 50% equities. Is that still trend? If we have some clear definitions, I think that could be useful. I don’t know what the definition should be, but I think it’s an interesting conversation. Because every time you see a white paper from some kind of consultant, they have their own definition of what is trend and what is not trend and whatever. So, I think this is a useful conversation, Rich. I’d love to hear your thoughts.

[00:39:01] Richard

My thoughts relate to the process as opposed to the name. In other words, what are we trying to achieve with our process? One is an uncorrelated relationship to existing investments. Another is this lifting power I talk about. So, to me, the hallmarks of trend following is its ability to offer both those concepts over the long term. Let’s think of trend following in isolation without any form of consideration of how it allocates into traditional trend following.

It produces a sign distinctive return stream that has two properties. One is over the long term, it differs to say the buy and hold, and it differs to this because in the long term, even though we have quite a volatile strategy, we don’t have the same level of drawdowns as a buy and hold in the S&P or the buy and hold in the Nikkei or whatever. We’ve actually got a much more restrained drawdown profile. But also, we haven’t lost any of that lifting power.

A good example is that, for the past period of time, we’ve been outperforming the equities market in one of its strongest bull runs. This is where bonds have sort of failed us because they’ve always been a predictive cushion, but they’ve never offered this lifting power. But this is something that trend following has done. It has offered these two aspects.

In relation to should we exclude people because they’re only trading trend in equities and things? Look, I do think it’s important to get some form of consistent scheme to make people aware that if we call ourselves something, they know generically what we’re trying to do and they’re trying to see what are the outcomes of the process we’re trying to achieve.

So, I think that’s important we get some clarity there. There does need to be some broad diversification used by diversified systematic, especially if we call ourselves systematic trend following. I do believe that there are minimum thresholds that need to be obtained to fit into that definition. Because otherwise, we can muddy the waters so that we get a blend of 50% mean reversion, 50% trend.

What are we called then? 70% mean reversion, 30% trend, what are we called then? Or 30% pattern recognition, 70% trend, what are we called then? It’s starting to say we’re trying to appeal to all forms as opposed to a process where we are experts in a particular field focused on delivering this outcome.

That’s what I prefer, because as an investor, it’s clearer what’s trying to be achieved there as opposed to some form of blend that is confusing. You don’t know what’s under the hood. It just gets confusing for me. I don’t know how you feel on this.

[00:42:02] Niels

I’m going bring up another topic, but I think there’s one thing, I think you want to relate the conversation a little bit to Corey Hoffstein. Obviously, interestingly enough, Corey, who is a great member of the systematic community, he had a lot of interesting observations about Andrew’s comments, and so it caused a little bit of a good social media reaction.

[00:42:28] Richard

Andrew has got a bit of pushback from a lot of different fronts from last week.

[00:42:31] Niels

Yeah, unfortunately. And if Andrew is listening to us today, I still can’t find any of his comments on X. He’s really hidden them well, even though he did say he posted them.

[00:42:43] Richard

He responded to each of Corey’s threads within Corey’s threads, so it’s not obvious. It’s hidden there. As he said, he’s a professional in replication, he’s not a professional in X.

[00:42:56] Niels

Yeah, exactly. Well, luckily for that. But did you want to bring something up before I throw in a spanner here?

[00:43:03] Richard

Corey Hoffstein has got an innovative approach. Even though we know what return stacking is, and it really is a broad principle, as trend followers, we’ve been applying that since day immemorial. However, Corey Hoffstein’s approach, I think, is a clever one because what it does is it says, all right, let’s recognize that there’s resistance by the institutions, etc., retail traders, etc., to change their portfolios.

Here’s an ability to be able to add a return stacked addition of a material allocation in trend to get all the benefits we’ve talked about but without having to significantly deconstruct or change their existing traditional portfolio. So, I think that it’s a novel approach, a clever approach to do what is ethically prudent to get a greater material allocation of trend into their portfolios which is being achieved here.

The only concern I have with a return stacked approach is that it does necessarily mean increased leverage. I do know for instance there have been times where stocks, bonds, and trend following have all been positively correlated, and that’s particularly in those, you know those short, sharp reversals we get? In those instances, I think with a highly levered return stack solution, it might be exposed to significant volatility in those short, sharp reversals.

So that’s a problem I face with any form of leverage applied on top of a traditional portfolio. I’d always prefer a restructuring of that traditional portfolio to reduce this exposure towards particularly bonds, retain exposure in equities because there’s lifting power in equities, but there’s no lifting power in bonds, it’s just a correlation offset, and just swap that out for a significant material allocation in trend which offers cushioning because of its uncorrelated properties. So, this is something.

Bonds have only been a wonder of the world by virtue of its negatively correlated relationship, but now it’s positively correlated. But at least trends, by virtue of their very highly diversified nature, have always been over the long-term uncorrelated because they’re diversified across so many different asset classes. So, we can’t guarantee it’s going to offer crisis protection, but we pretty well can guarantee it’s going to remain uncorrelated over the long term by virtue of the fact it’s spread over so many different asset classes.

So that’s all I’d say. I love his innovative solution to get more appetite into putting a material allocation of trend in through stacking criteria. I just am concerned about the weakness possibly in the short, sharp reversals. But I think otherwise, it’s an innovative solution that I think needs to be commended.

[00:45:59] Niels

It’s very much along the lines of what Eric has done over at Standpoint, and Matt, where essentially, you’re giving investors a product or solution that they need but in a package that they want. And that in itself, of course from a pure marketing point of view, makes a lot of sense. Even though, as you also mentioned, this is by no means new. It’s not new innovation. This has been around for a very long time. But of course, maybe it made less sense to do that when bonds didn’t give any return or indeed were a negative return, etc.

But you touched on something that you sent to me before we were recording during the week where again it goes back to, I think one of the things that has been a concern , we talked earlier today about should we stick with some of the origins, so to speak, what does it really mean to be a trend follower and so on and so forth? I pointed out that some of the origins also include the markets we trade, which have been futures only, etc.

But in this thing about trend following and how it’s evolved, one of the criticisms, for sure, has been that bigger CTAs started to focus more on asset gathering by using correlation and volatility to manage the risk in order to smooth out the returns. That’s been something that you and I have heard from our friends, that has been a problem.

It’s been so much of a problem that it was almost made to sound like, well, it’s not really trend following anymore or it’s not even managed futures anymore because we’re doing these things for our own books’ sake, meaning so we can raise more assets, more gathering. But then I was thinking, okay, but then what about the fees? What about the fees?

Our origin was really that we were fully aligned with our clients. Most of the compensation for trend followers in the ’70s, in the ’80s, in the ’90s, came from performance fees. As the industry started to become institutionalized, this is where I think the catering or the smoothing out, the lowering of volatility in the return stream started because institutions didn’t necessarily like 20% returns and 30% drawdowns and so on and so forth. So, I think that’s the origin of that.

The client base for trend following changed dramatically starting around the year 2000, which incidentally is also when we started to get some of the SocGen indices coming on board and so on and so forth. But with that catering, so how could they lower volatility, how could they cater more in that, also came this change of fee structure. By lowering the volatility, maybe the drawdowns, it could make it even more appealing if people would just charge a flat fee.

I can’t remember who were the first ones to just do a flat fee. But clearly, you could certainly argue that smoothing returns allows you potentially to raise more assets because it looks like a safer investment and so on and so forth. That’s been the criticism of using volatility and correlations in the risk management. It was only done to make it look safer and smoother and so on so forth.

But then in fairness, if I was going to push back on that a little bit, it’s to say, well, we are also now losing the origins when it comes to how managers are compensated. Because when you have a flat fee, you clearly only make money from gathering assets. That’s the only way you can build your business is just to raise more assets.

[00:50:22] Richard

It gives you no incentive to offer a unique return stream. Under this new arrangement, it makes you have an incentive to be more like the rest.

[00:50:34] Niels

Yes. So here is my point. Here’s the question that I’m raising knowing full well that we’re talking our own book here and I’m doing it with a big smile as you will be able to see but no one else will be able to see. But I struggle with understanding why you can say that some managers are smoothing their returns using correlation management and dynamic position sizing only to become able to raise more assets.

But then at the same time, you are, yourself, launching products that are only based on management fee, because ETFs and mutual funds, that’s management fee pretty much only. And therefore, at the same time, the people criticizing the bigger managers are also now going in the same direction. They just don’t do it in the risk management, they do it in the fee structure because now they’re becoming asset gatherers themselves by launching flat fee products.

So, my point is, we should just stop criticizing each other because we all do things at the end of the day what we believe is best for our businesses. But I don’t think it has to be something where we point fingers at one group doing this and one group doing that. But I just want to make sure that it’s important that we don’t just look at incentives when it comes to how we manage risk.

The incentives are very clear when it comes to also how we get paid for what we do. And I worry a little bit. Then again, clearly, we come from a performance fee only point of view, so I’m talking my own book in that sense. I worry a little bit, as you’ve pointed out there, that we lose the incentive to improve if we don’t have any material compensation from performance fees, because why should you if it’s all about raising assets.

Now, this is not as elegant as I had it in my head when I started the conversation with you. It’s a little bit rambling here. I think that that’s an important part. Of course, we can always just rely on investors being smart enough to figure out what they prefer. Do you want a manager who has no alignment with you, or do you want a manager who’s aligned with you? Okay, it’s the choice of the investor. I understand that.

But I do think, when we talk about being true to our origins, true to trend following, etc., there are more than just parameter settings and whether you are fully trend or 80% trend or whatever. There are more things that are part of that conversation. It’s not just about the risk management, it’s also about what is our alignment, what is our incentive to keep improving these strategies?

[00:53:30] Richard

I agree with you that I’m not in the camp where I like this sort of management fee only ETF structure. I don’t like that. I like the performance fee. But to be able to be in a position to offer a performance fee, you need to offer something that’s unique and not being achieved by the balance of industry. That’s the reason for that performance fee. It’s offering something that an investor wants because it is different to what the rest are doing.

When you had Aspect Capital on your podcast last week, and I was listening to them, I noticed their comment that they decided to start embracing new strategies into their models to basically recognize that investors or clients were trying to reduce the number of managers they were using and they were trying to get broader coverage but reduce the number of managers. They were at these client meetings recognizing that if they only offered trend, they couldn’t participate in the other discussions. And so, it sounded like logical business sense for them to start looking at these other alternatives and basically offer these more comprehensive solutions.

But to me, that is not trend following. That’s now blending. That’s now multi-strat. So, I understand that’s a business case. That’s a business case decision, because clearly, if you can offer all things to everybody, you’re going to have more appeal. The harder case is offering something distinct and unique and encouraging people that they need it. That’s what I think the performance fee needs to be given to.

So, I don’t like the fact that we’ve lost the performance fee because what that to me says is over the course of time, we’re just going to become the same as others. We’re going to lose that distinctive unique return stream we used to be able to deliver with a degree of confidence, and now we’re just giving blends or many portfolios that are across a variety of different strategies. To me, I don’t like that departure.

This is where I talked about if Richard Donchian saw how our industry was going today, he’d be rolling in his grave. I tend to feel this is the argument I have and probably what Jerry has with me. We don’t like the way the direction of industry is taking towards the bland, the same. We want this distinct uniqueness. But where I might depart from Jerry a bit is Jerry perhaps has acquiesced a bit more to the idea of the loss of the performance fee.

I’m still very much in the camp of I think that’s probably the stupidest move we’ve made, as a sector, in losing that performance fee. To me, that was the whole rationale for delivering these magnificent performance results. Yes, volatile. Yes, we understood that they are volatile. But now, the game is steady as she goes, linear distribution, linear return stream, same as everybody else, no difference, and we’ve lost our joy.

[00:56:49] Niels

Yeah, I agree. And I certainly remember, I don’t know, 15 years ago, when people started talking about it, they didn’t use the word replicate trend following, they used words like smart beta or whatever they called it, where they made it sound like oh, yeah, this is so easy to do so we don’t have to charge a lot for it. And that’s something that I really disagree with.

There’s nothing easy about what we do as trend followers. I’m sure there’s nothing really easy about what Andrew is doing as a replicator at the end of the day. So that’s the other thing we lose. When we start removing the performance fee, we do make it sound like it’s easy, because why would you pay more than 85 basis points for what we do, and I think that’s completely wrong.

But it’s also being demonstrated, I think, through the performance numbers, because clearly, in a period we’ve seen in the last two or three years, the managers who have stayed true not only to trend but to performance fees have done somewhat better than many of these more asset gathering strategies.

[00:58:00] Richard

I’ve noticed that as well. It’s really interesting the fact that those traditional firms which are really focused on trend following, have been in the business such a long time, they haven’t really changed their models much, they’re now experiencing returns above and beyond what their backtests were delivering. That’s a testament to me of how they’re not overfit curve fit solutions a bit like the bland shapes we’re seeing these days from this multi-strat allocation method where effectively it’s fitting for the regime of the day. I miss the uniqueness of what we were doing.

[00:58:03] Niels

Rich, this has already taken up an hour and we’re only through the first topic, so I know we’re going to have to save some of this for our next conversation. But I still want to give you a chance to if there were one or two things we could tackle in say another 10 minutes or so that you felt was actually a really good fit to what we’ve just talked about and an important point in terms of the time we go through at the moment. I’ll let you pick and choose.

[00:59:16] Richard

I’m going to drop the next two topics and focus on the last one because this now comes on to my favorite area called complex adaptive systems. The other two topics were more related to what we were talking about now and I think we’ve probably said enough about that. So, here we have a bit of a change in direction.

So, this is where we have this research coming out of PNAS Nexus and it was undertaken by Christian Diem and his colleagues from the Complexity Science Hub in Vienna. What they did, they looked at VAT data, VAT data I think from I think it was Hungry and they were able to using the VAT data look at the impacts.

[01:00:06] Niels

So you mean value-added tax.

[01:00:07] Richard

Value-added tax. In Australia, we call it GST, but over in Europe, they call it VAT. I don’t think the US have it, so it might not be applicable over in the US.

[01:00:17] Niels

That’s sales tax. I think they call it sales tax.

[01:00:20] Richard

But it just shows you how traditionally, economic models, when they’ve looked at assessing or predicting the impacts of crisis events like COVID pandemics and all of those things, they have typically used sector wide models that basically bundle up industries into one sector and then look at the impacts of the crisis on that particular entire sector.

Now, what this more granular level of approach does is it looks at the impact for instance using VAT records or GST records in Australia. They’re looking at the impact at the firm level as opposed to the aggregated level of the industry sector. For instance, they examined I think it was 243,000 companies in Hungary using the VAT data, and that dataset enabled them to reconstruct I think over 1.1 million supply relationships.

Looking at the network relationships between those firms, there was 1.1 million supply relationships, which therefore gave them the ability to represent the entire national economy by virtue of the VAT records, the VAT data. This is sort of like alternative data that gives us this additional granularity that allows us to look in more detail at the specific impacts of crises on things.

So, then what they did using that data was they then looked at the impact of crises using this much more granular model, and they found that the impacts of crises using the aggregated industry sector models were underestimating the impact of crises by up to 37%. But using this much more granular level, they were able to see these crises unfold and their damaging effect on specific firms within industry sector groupings, and that accounted much more for the actual economic impact of these crisis events.

So, it’s been a very successful research study undertaken for Hungary which potentially could be applied across Europe, certainly in Australia with the GST. But even just the principle of using tax records or individual firm records allows them to get much more granular levels of detail associated with impact. So, I just want to look at some real-world applications to explain how this data can be used and what it can convey.

Imagine a scenario where a natural disaster impacts a region critical to say the automotive industry. The traditional way we’d analyze that, at the sector level, might predict a blanket impact on the entire economic sector. However, this firm-level data which is much more granular could reveal that only specific companies crucial to electric vehicle production are affected as opposed to gasoline-based vehicles, etc. And that would therefore necessitate a much more targeted policy as opposed to a blanket policy to address the crisis evolving in that particular area.

So, there are a few examples I’m going to show just to demonstrate its wide application. Let’s assume there are only two companies in a metal sector. Company A sells most of its products to the automotive industry. Company B sells most of its products to the construction industry. If Company A, which sells to the automotive industry, were to experience a halt in production due to a natural disaster, for example, this would have a major impact on the automotive industry but hardly any of the construction industry.

But at the sector level, however, it would appear that the outage would affect both automotive and construction industries equally. So that’s an example how you start getting the more granular level. This therefore allows you to have much more targeted policy. When we come to the COVID pandemic in Australia, Niels, the government here had a blanket policy of applying to all industry.

They basically had a big protective cushion that could be applied to all the industry, but that was abused by so many of the industries over here. Some notable industries made significant amounts of money at the government’s expense from exploiting that loophole. But something such as this firm-level data would be able to have much more targeted policy that is actually addressing the crisis.

The importance of these much more granular models is that it allows us to predict the impacts of crises much more elaborately looking at the network of relationships that exist in complex adaptive systems like DUNN, the firms that exist within the economy, their reliance and dependencies on suppliers, their reliance and dependency on their consumers.

In all of these networks, you start seeing the flow of basically the crisis emanating and where it’s hitting the economy in various areas. It’s a much more detailed way. Plus, it much more fully explains the impact of crises. Because we know, for instance, from these traditional economic models, we’ve experienced this with traditional economics, nearly all the time, they totally underestimate the magnitude of these crisis events. This has been a repeating phenomenon.

But the good thing is we’re seeing the use of this alternative data as a way to perhaps at least address things in a much more granular and a much more exacting way, recognizing that these systems are very complex.

[01:06:04] Niels

It obviously brings up the whole point about alternative data in trend following, Rich, which I’m glad you didn’t bring up earlier because then our conversation would have lasted another 15 minutes, I’m sure. Is that even trend following when you start to look at alternative data and so on and so forth? So maybe a topic for another conversation, perhaps we’ve, what do you say, roughed in our feathers. I think we have for one hour.

[01:06:31] Richard

Andrew, he is going to have to come back and have a right of response I think.

[01:06:35] Niels

We do this of course out of love and respect for our industry and our friends in the industry. So, I’m sure they fully understand why we want to have these civilized conversation and debates about that, and why it’s important that we don’t always agree with each other on all fronts. I think one thing we do agree on in any event, and that is to a large extent, that trend following is a wonderful strategy that everyone should have some exposure to in their portfolio and achieving that we still have a long way to go.

Hopefully, we’ve taken a little bit of a step in the right direction today. Rich, I appreciate you. I appreciate all the efforts you put into preparing this conversation. It’s been fun, insightful. I always learn something from talking to you. Let me mention a couple of things.

First of all, you can sign up for my weekly email updates over toptradersunplugged.com/TTU-news or minus news, whatever it’s called. There’s going to be a new, I teased it last week, I think we’re getting really close, a new version, the 6th edition of “The Ultimate Guide to the Best Investment Books Ever” where we’ve added another 100 books.

So, we’re now above 400 interesting books on different sides of investing, whether it be mindset, whether it be trend following whether it be global macro, lots of good stuff. For those who have already received it, signed up to it, not to worry, I’ll make sure you get a new version or the latest version. But hopefully, there are people out there who want to sign up for that as well. Just go to the website, there should be plenty of ways for you to find it.

Next week, while I’m still out here in the heat, I will be joined by another one who will be able to raise the temperature of trend following, namely, Rob Carver. So, this will be your chance for him to tackle some questions. As usual, you can email them to info@toptradersunplugged.com.

From Rich and me, thanks ever so much for listening, and we certainly look forward to being back with you next week. Until next time, take care of yourself and take care of each other.

[01:08:58] Ending

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

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

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