TTU124: Harold de Boer, Head of R&D and Managing Director at Transtrend

[00:00:07] Harold

Computers have become a disadvantage over the years because we have so much computer time available. In my little phone, there is more computer time than in the big computer we had in our office in the early ’90s. If you have no clear idea and you test it anyway, you can do over and over testing. Within five minutes, you can do long calculations, and you very quickly end up in some kind of historical optimization thing instead of having a good idea.

[00:00:42] Intro

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

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we will have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their product before you make investment decisions.

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

[00:01:37] Niels

Hey everyone, and welcome to another edition of Top Traders Unplugged where today, Alan Dunne and I are joined by Harold de Boer, Managing Director at Transtrend, as part of our mini-series focusing on the one investment strategy that beat everything else in 2022, namely trend following and managed futures more broadly.

First off, Harold, it’s great to have you back on the podcast. Thanks so much for joining us today. We really have been looking forward to our conversation. How are you doing? I hope you had a good start to the new year.

[00:02:03] Harold

We had a good start. Yes. Absolutely.

[00:02:07] Niels

Hopefully, some relaxed downtime over the holidays.

[00:02:11] Harold

Well, somehow the flu decided that it was time for me. So I didn’t have to do any Christmas visits whatsoever.

[00:02:24] Niels

No. Okay, fair enough.

Now before we dive into all of the different topics we are going to discuss today, I would like to set the stage for our conversation so that the audience knows a little bit about your firm’s background. Perhaps you could share a few highlights about what type of strategies you focus on and maybe where the business stands heading into 2023.

[00:02:48] Harold

Transtrend, we started off as a research project within our current trading firm, physical commodity trading, so clearly, a background within that firm. The idea was that there were firms making money in what they considered to be their markets. So they thought if these firms are making money in the futures markets, then we should do that ourselves.

That became a research project in which initially, the people behind it thought we would only trade commodity futures. But we decided to go into these dangerous things like financial markets and stock markets and currency markets as well and soon found out that trend following was the best way to do it. To do trend following really well, you have to do it in diversified way, not only in the commodity market. That’s our background and that’s what we are still doing.

[00:02:48] Niels

Fantastic, good stuff.

Now, in our conversation today, Alan and I have created a long list of topics that we often get asked about and that we find interesting, but maybe we won’t have time to cover all of them so we’ll kind of pick and choose as we go along. But why don’t you, Alan, kick it off with the first topic that we wanted to speak about.

[00:04:07] Alan

Great, thanks Niels. Good afternoon, Harold. It’s interesting, you touched on how you guys started off with a research mindset looking at the markets. The first topic I wanted to get into is the investment philosophy, which I guess was informed by that research. At a high level, how would you describe the investment philosophy of Transtrend?

[00:04:33] Harold

We’ve been discussing that a lot of times because initially, the whole idea was that we found out that the trend following way turned out to be the best way to do it. We also found out that all the conventions about trend following, that were there in those years, were the ones that should not be applied. So, we had to be trend following without embracing the conventions. I think that is technically true for any good investment that will continue to do well.

Be careful that you don’t embrace conventions. It’s something very typical with human beings that we so much like conventions and if it’s not the managers, ourselves, it’s of course also the allocators. It’s not for nothing that most allocators allocate to traditional investments or investment styles that are highly correlated with it. They like to use consultants, and consultants like to test the standards, and the standards are always the conventions.

Money has to be made by not sticking to the convention, but by doing something different. That’s a constant challenge. The constant challenge over, now, more than 30 years is to beware that we don’t become a new convention. That’s also something that has been hitting the industry many times. The industry became a new convention and then the CTA industry as a whole did not perform well. If there’s no convention, we do well.

[00:06:08] Niels

Sorry to butt in here. I know Alan has a few other questions, but I’m just curious on that particular point. Can you give an example of what you saw back then? Because you’ve been there for decades. What did you see back then trend follows do, and how did you want to make it different? I just want to understand that.

[00:06:27] Harold

There’s many things. We very soon found out one of these rules is that you should always have a stop in; you should always have a stop in the markets. We soon found out that you should never use a stop, and we have never done it. In the beginning, that was really working against us for getting clients because clients heard no, no, CTA’s are about stops. So we went to conferences where people were talking and they didn’t realize that we could hear them. They said, “Well, those two people are from Transtrend.” “Yeah, they’re good,” said one of them. The other one said, “Yes, but they don’t use stops. That’s bad. Yes, that’s bad.”

That’s typically how it functions. If you just look at the industry in those years, the first topic, of course, was the turtles. The turtles became very successful. The idea there was that they would all be doing the same thing. They had been trained for the same thing and they would become successful. I still like the conversations of Jerry, often on this program. He is, of course, one of these original turtles and his track record is great. Who also has a great track record is Eckhardt, who is, of course, the one who was teaching the turtles. They’re doing completely different things and they’re both doing well.

If you look at the first year that CTAs ( as a group) did very well was in 2001, 2002. There was this internet bubble collapsing and CTAs did very, very well. But the turtles weren’t the best performing models in those years. Even a few of those turtles didn’t survive that period. I think John Henry, who wasn’t a turtle, but was also in that area and did that kind of CTA, didn’t survive that area. He had been very successful before that.

If all that money that had been in trend following CTAs in those years would have been very close to the turtle strategy, do you believe it would have been doing well?

[00:08:24] Niels

Well, some of them are still doing well, I guess.

[00:08:26] Harold

Now, if so much money is really doing exactly the same thing, it’s never going to be a success. The turtles continue to be a success because all these new entrances, which really grew for Europe, had some different ideas and different philosophies. That’s why the industry as a whole did do well.

We can only do well when we do different things, and yet we have this strange thing. I like the discussions with Jerry, for instance. He says, “Yeah, but sometimes what you’re doing is not good.” Yes. But it’s good because we do something different than Jerry and Jerry does something different than we do. That’s why we, together, can do well.

When investors start to do things alike, which is very strange for an alternative investor to do all the things we’re saying, because, again, we should be non-conventional. But yet, we like to embrace conventions, and the turtles is a convention.

If they did well, and the ones that did best were the ones that were constantly evolving and adapting. That’s why Jerry is doing something completely different and Eckhardt and the other remaining turtles are doing different things as well. Both of them are still doing very well. But that’s typically something that happens.

[00:09:41] Alan

So is it fair to say, it sounds like you share a similar philosophy in some respects. Obviously, trend following is at the heart of what you do. So, there’s a common belief, presumably, that markets trend over time for various reasons. But equally, there’s a different philosophy that, would you say it’s around execution or risk management or around a need to be constantly evolving? How would you describe that difference?

[00:10:13] Harold

It’s somewhat comparable with religions. I’m Christian and Christianity is, in fact, only about one thing. It’s about love. But that’s very complicated. So many people make rules. The 10 commandments and many more rules, and you have to wear the same clothes, or you have to go to church on Sunday, or you have to do a prayer before you eat. You can make many, many rules.

The nice thing is the ones that are essentially the biggest believers are hiding the most behind the rules, and the ones that are less uncertain, don’t know so much about the rules but know about the principles, the philosophy, the idea. The idea of Christianity is love. Well, with trading, it’s not about love, but it’s about something else. But it’s not about love.

[00:11:07] Niels

The love of the markets.

[00:11:08] Harold

Yeah. That, of course, it’s the type of love I may be enthusiastic about and see what’s happening and understand that markets are constantly changing. The nice thing about these markets is that they are constantly changing and they are not a constant. The world is changing and changing markets are part of it. If the world isn’t changing anymore, there wouldn’t be any trend. So, enjoy the ride and enjoy being part of big change.

This change, and profiting from it, is going against that we have a philosophy; we have a rule and we stick to the rule. But you cannot have that same rule. Of course, all of us changed dramatically all the turtle trading, but, of course, it was done on the trading floor with people running to bring the orders in. Now no one does that anymore (I hope at least, because they will be somewhat feeling alone on that exchange floor).

The world is changing and we adapt, and we all should adapt. The ones that dare to deviate the most are the ones that will be ahead in adapting and the ones who move ahead in finding new directions. CTAs were doing well because they were ahead, and turtles were ahead. Then there came a new sort of CTA, a group of CTAs growing from Europe, that took some other directions and they were very successful as well. Then we had what some people call the CTA winter, let’s say the whole 2010s.

We are very good in just saying that QE was the excuse or all kinds of other excuses. No, it’s not. It’s a cheap excuse. The real excuse is that we started to become too much of a sector. For commercial reasons, that’s completely understandable because most investors ultimately don’t want something that is different. They want to have a rule, top down. They first allocate to a style and then to a manager. So if you are not a style, you do not get any allocation. It has to be a style. As soon as there’s a style, investors are afraid for deviation from the style, deviation from the index.

The thing that they typically should embrace is the one they are most afraid for. Any investor should say more dispersion is good, it brings me more diversification. But at the same time, they are afraid for it. So if you want to sell the most short-term, you have to make choices that aren’t very good. People don’t want to have non-conventional things because that have to be explained, they’re scary.

In essence, most investors want alternative investments to do everything the same as the standard investment benefits, but only if the return is on different moments. But that doesn’t work. Alternative investments come from making different choices.

[00:14:09] Alan

But why do you think that contributed to that tough period? How did the evolution that everybody became more similar result in that kind of challenging period from a performance perspective?

[00:14:27] Harold

Markets, just like nature, require biodiversity. Again, if all of us would have done the same as the turtles in the 2001/2002 period, we wouldn’t have made that much money. You can only have a large size in a market when you are doing different things at different moments. If everyone is buying at the same time, it has a huge market impact.

That has been completely neglected in this whole period in the 2010s. I think the most extreme example of that has been AQR. They have been making a lot of stories with that demystifying managed futures story. Somehow in our industry, we don’t like criticizing other managers. But the nice thing with the story is what they essentially said is, “Look, all these managers that have been doing trends, we can do the same thing with lower costs and then we will be better than them.”

That’s the story they did and it was doing very well. The storyline was, it’s just trend, so we can do the same thing. They didn’t do it only with trend, they did the same story with other strategies as well. If they do any investment style, they say it’s just the same thing. What they really did, the only really new thing about what they were doing was that they were selling hypothetical returns. We’ve always seen hypothetical returns being better than real returns.

Instead of saying it’s hypothetical so the only thing that’s not hypothetical about is that it is hypothetical returns. Now, instead, they said it’s because of the lower costs. But what they were completely neglecting, directly you can read it in the paper, is market impact. They assumed a world without market impact. In a world without market impact, yes, you can have an indefinite number of investors all doing the same thing because it has no impact.

But when investors do all the same at the same moment, and they should know market impact, market impact will be gigantic and there will be no returns, and the markets don’t function. This whole idea, you could see that it commercially was great. I don’t think there’s ever been a CTA that has attracted so much funds in such a short term as AQR with this program. But they also proved that they were completely wrong, very consistently and convincingly, because they were doing bad, and they underperformed, which is what you can expect when everyone is doing the same thing.

So what happened in this whole winter, in the CTA winter, all CTAs started to make different choices again. It was the best thing that could happen to the industry. All CTAs made different choices. Winton completely got away from trend following. But all of us made different changes. So we became less the same again.

What happens? The dispersion between CTA performance is enlarged again, as it should be, and we have had two great years. Some of us did do very good this year (or let’s say 2022, that’s already last year, of course now), and others did do very good in 2021. But the whole industry together did do well by doing different things at different moments. It’s just because not all were doing the same thing again.

The story is you have to adapt, you have to change, you have to make different choices. That’s something that we should embrace.

[00:17:55] Alan

Maybe before moving on to the next bit, could you give us a sense on some of those choices that Transtrend have made, over the years, in terms of that drive to be unconventional and differentiated?

[00:18:08[ Harold

The largest change is we have of course over time made choices that others didn’t make before. We’ve been making a lot of synthetic markets. So, we trade not only outright markets, but we also trade a lot of synthetic markets. We have chosen a clear direction in which we are not so much looking at a system applied to one market, but really looking at it from a portfolio perspective. Diversification is the key element of it. So we constantly start to look at it from a diversification angle instead of from just these few markets.

If you really concentrate on that, you make different choices. Instead of saying cut your losses, which is a typical thing that you do when you look at an individual market, on a portfolio level, that is different because if the loss in one market is compensated by a profit in another market which is coming from the same market move, there’s nothing going on.

Look at last March, for instance, when Russia invaded Ukraine. We of course were not pre-informed by Putin that he was going to do something like that. (Stupid man, he forgot to call us.) But we had a diversified portfolio. One of the leading teams in that period was already raising yields. Central banks were leading by raising their yields, their currencies were stronger. This included the Eastern European currencies, so Poland, Hungary, Czechoslovakia. It’s not Czechoslovakia anymore. Czech Republic, that’s what you call it.

Of course when Russia invaded Ukraine, these long positions in these currencies were largely losing. But for us, that wasn’t a problem at all. Because at the same time, we had long positions in lots of commodity markets and they were largely growing. So we could have been idiots and tried to get out of these eastern European currencies by selling them at the moment that everyone wanted to sell them and cut our losses and so on.

But if you just look at it at portfolio level, and you say, hey, we have a nice diversified portfolio, something extreme is happening, it leads to profits in some markets and losses in other markets. Great. As a total, we make profit and there’s no reason for us to do something. This is when you look at it from a portfolio level instead of individual market level. By doing that, we can better take advantage of being diversified instead of just trading individual markets. But your whole operation has to be set up like that.

If you have somewhere an energy markets team, or somewhere else a stock markets team, and somewhere else a security markets team, the currency markets team would be thinking in this case, “Okay, we’re losing a lot of money, we should do something.” But if it’s one program with one team, you’re not distracted by those kinds of local problems that are not problems for a portfolio as a whole. So that’s one of these elements.

Look at it from a portfolio perspective and that’s why we’re doing all kinds of changes and all kinds of choices we make.

[00:21:27] Niels

Now, I don’t want to get into the detailed debate between AQR and your approach, but I do want to bring up something that Cliff Asness wrote during 2022. I think it is an interesting, and relevant point. During this period of lower than average returns, which by the way, could also just be a function of the fact that central banks had it very easy in keeping things stable with fewer trends, etc.. etc. There definitely was this tendency for managers to do more than just trend in their strategy to compensate for lack of trend return.

I think he wrote a paper that basically argued that maybe we have become too concerned about the Sharpe ratio (this is not his words, this is kind of my memory of it), and we add these non-trend components. But it also means we’re kind of losing the ability to really deliver strong returns when the trends come back.

Actually, in fairness, you can say that that particular firm delivered very strong returns when trends came back in 2022. More broadly, not just about their strategy, but more broadly speaking, what are your thoughts? What are your observations about this temptation we’ve seen where perhaps some managers have gone more to the call it trend following plus type strategy rather than just core trend?

[00:23:03] Harold

Well, you refer to the reason there are managed futures. The storyline in that paper of theirs is that others in the industry changed and they stuck to their strategy. They didn’t change. That’s why they did well in 2022. The fact is, they have a Morningstar rating on their program and they were downgraded in 2021 or 2020. That downgrading was not because of performance. It was for only one reason that Morningstar wrote: because AQR had changed their program. That’s why they got downgraded. They forgot to mention this in this article they wrote.

Change is good. I like change. But then don’t write a story in which you kind of tell that others are changing, and you didn’t, because they did as well. That’s good and I welcome the change. I would have liked them to write what they changed and why that resulted in doing so well in 2022. Also, there were excellent trends in 2021 as well, and they didn’t perform in that year.

So it will be more fair to say, “Look, hey, we make some choices like any CTAs make choices and the ones we make lead to not performing in 2021 and doing very well in 2022, and choices others make lead to different outcomes in different periods.” But the story in itself is not complete. There’s a few things in that story that wouldn’t pass our compliance department.

[00:24:43] Niels

I don’t want to really make it about them and you. I want to make it more broadly about the industry if we can, because the thing is, I think it all stems, deep down, from what we believe investors want. Investors don’t like these periods of no or low or negative performance. Then to make it up in a year like 2022, they obviously prefer steadiness, consistency and all of that stuff, which is very hard to deliver in a pure trend following package. I think we all know that.

So it sounds like you’ve not deviated from trend. Obviously, I work for a firm that has the same view. But there certainly has been a tendency in our industry to try and smooth things out a little bit if I can put it that way.

[00:25:35] Harold

Yeah. What is much more relevant is the kinds of techniques that you use when you’re doing research. We’ve had a sustained period in which interest rates were low and coming down. If you do all kinds of optimization techniques, whether in determining how much to allocate to which market, or what kind of techniques to use in others ways, and you have done that over the years (let’s say after 2008), then you will have ended up in something that was doing very well as long as the interest rate were coming down and interest rates were low.

We have really got fewer changes. One of them was that there was a pandemic that we had not seen long enough to be out of the testing period for investment managers. That doesn’t only hold for CTAs. It holds for all investment strategies. All of them that have done too much optimization did badly in the pandemic and were vulnerable when the interest rates started to rise.

If you have more strategy that is less optimized, that also holds for the very classical CTAs, even the turtle type of CTAs, they have been doing very well the last few years because there was no optimization to a short-term period. Others that have too much optimization have had their difficulties.

That is not just for CTAs. It holds for all investment styles, quantitative (what do you call the English word?), pitfall, that’s the English word, It’s a quantitative pitfall. You take a certain history, and you optimize based on that, and you forget that things that haven’t happened in that period can hurt a portfolio a lot later on. So I think that’s much more an explanation for what’s happening and why some are doing better and others are not doing better.

One of these elements, for instance, is commodities. If you have been optimizing the last few years – the last decades, commodities, performance in commodity markets tended to be less good than in financial markets, in bonds and so on. So the CTAs that traded much more interest rate instruments and much less commodities have not been doing good both in 2020 and 2021. So the CTA return in 2021 will most likely not have been trading a lot of commodities, but did trade a lot of interest rate instruments, and those same interest rate instruments did very well in 2022, and that’s why they did much better this year. That’s the number one explanation there.

We often think that CTAs make a choice and then we compare with an index as well. But ACR, in their paper, forgot that the constitution of the index is changing. There was a time that AQR was not in and there was a time that AQR was in. There was a time that these traditional CTAs (that were more the turtle type CTAs), let’s say, are not in anymore, but were in, in the past.

If you say the index is changing, it’s not because the managers in the index are doing different things. Now, there’s different managers in the index with different styles. Which managers are in? The ones that have been getting the most funds. Why did they get the most funds? Their performance was the best. Why was their performance the best? Well, they did less commodities and more financial markets. So, that’s why the industry as a whole, without any one of them changing, did more financial markets and less commodities.

[00:29:17] Niels

Yeah. It’s a good point about the fact that the index really does change in terms of constituents. Alan, why don’t you dig into some of the research topics you wanted to bring up?

[00:29:25] Alan

Yeah. Just to close out on that, I think what Harold was saying was obviously, you could maybe pick some holes in the paper, but it did raise that general point about, what is the objective for CTAs and trend programs in general? Is it just absolute return or is it absolute return plus crisis alpha to use that expression? Is it absolute return plus crisis alpha plus mitigating drawdowns?

Harold, you’re talking about the choices, but presumably the choices you make are determined by what your objective is and what you’re trying to achieve with your portfolio. From your perspective, are you developing a program in Transtrend that’s purely just focused on absolute return or is it absolute return plus one eye on those two other factors?

[00:30:14] Harold

It’s a little bit linked because one thing that we clearly don’t want to bring is an index return. You now also have CTAs that want to bring the CTA index, which is a stupid thing, because there’s no CTA index. The index of CTAs is the average of all the different CTAs. This likely would be some kind of pet effort, and you want to become that pet that is barking and at the same time, catches the mouse and so on. That doesn’t work.

So CTAs, there’s different animals, and they together form an index. The performance of them together as an index. Don’t try to bring that index performance, but do well. If all of us do well, the index is doing well. That’s the number one thing. Don’t try to bring an index performance, but bring absolute returns, and really absolute returns.

If you do that and if you don’t want to fall in the trap by doing the same thing as the other people and all the other investors at the same moment, you have to differentiate somehow, and differentiating can bring returns and there can also be lower correlators. So looking for absolute returns, trying to do so in doing things that others are not doing is aimed at bringing good absolute returns. But it will very likely lead to non-correlated or local related or at least not linear correlated returns.

That’s exactly what we are doing. We never make a choice of saying, hey, we want to do this because that will be good for tracking error or high tracking error or low tracking error or for correlation purposes or whatsoever. No, we do something because we think that’s the best investment. Any kind of other limitation you bring in, they sometimes sound well. They constantly demand for allocators that want something that is, let’s say, we had it also, diverse demand for styles that would be doing well if the interest rates would come down and if stocks would be coming down. But it should not be standard CTA which of course didn’t do so well.

Well, we’ve had this period of two years that CTAs have been doing very well. I don’t think any of these alternatives, especially designed for that, some kind of amendment of a real program has done better in that respect. So, just concentrate on what you should be concentrating on which is profiting from the good trends that are there in the market, and make sure you do so in a way that differentiates.

[00:32:53] Alan

You touched on some of the pitfalls you mentioned in terms of the research process and that example of optimizing a program based on maybe the last 12, 15 years or so, the post financial crisis era. Obviously, that makes a lot of sense in terms of one of the things to kind of avoid as part of the research process.

What are the other big things when you’re thinking about developing systems or reevaluating systems, how do you think about that? How do you avoid overfitting to any particular environment? Is it about just using very long time series? How do you, at the same time, balance that with adapting to changed market environments?

[00:33:44] Harold

By not being led by computers. When we started, computers were something pretty new. Using computers and using trends, because trends of course without computers are especially more difficult, we still had these charts in our office in which every day, they wrote a new price, added to it and the charts became longer and longer. But of course, with computers here, you don’t have to do that. That can be done much more efficiently.

The type of trend techniques being used with computers available of course also has changed than without. Lines were logical to do when you have no computer available, but all kinds of moving efforts type of things. It’s much easier with a computer so it’s logical that’s changed like that. Computers were something that was an advantage.

Computers have become a disadvantage over the years because we now have so much computer time available. In my little phone, there is more computer time than in the big computer we had in our office in the early ’90s. If you have no clear idea and you test it anyway, you can do over and over testing. Within five minutes, you can do long calculations and you very quickly end up in some kind of historical optimization thing instead of having a good idea. Later on, you say that you have an idea.

When we started a complete simulation of the things we had in mind, it took us one week. So computer wise, there was no room for all kinds of historical optimizations. That has really become a shipwreck over the years because the storyline (this is again what CTA is doing and is expected to do), the storyline had become a habit. We also sold it that way. It’s the people doing it, it’s the computers doing it.

So the only thing people, who started to work in this industry, were probably thinking, the only thing we have to do is to use computers, we don’t have to use our brains, we just can use computers. We don’t have to have efficiency about markets, fewer markets. Now we can just calculate, optimize, and then it becomes completely empty.

The only way to deal with all kinds of situations that you have not seen before is based on intuition or understanding, real understanding of what can happen and be prepared for that. By having more computers available, the pitfall is that you don’t think you need it, but you still need it.

So we have been more selective over the years on people and especially when they are very good at using computers. You have to be careful if you have been doing too many simulations because you have no idea. We had to become more harsh on that element within our teams also. If someone was doing too many attempts and was proud of having all these attempts, “Look how fast I can do calculation,” we said, “Well, if you had any understanding of what you were doing, you wouldn’t need that many attempts. So maybe you’re in the wrong position.” That’s really something that has to adapt.

That’s what I really don’t like about presenting hypothetical performances. It’s not for nothing that there is something within our industry that has a high level within the CFTC rules as well. It has always been easy to do hypothetical returns, but it has become more easy the last few years. The only thing that changed, in the last 10 years, is that it has now been even more accepted by regulators to present hypothetical returns, which is something we as an industry should not embrace.

[00:37:35] Alan

You mentioned going back a few moments, the example of the market reaction to the Ukraine breakout of war and how you had these positions in Eastern European currencies that you were offside on but you had gains elsewhere. So it sounded like you made maybe a discretionary decision not to respond. Is that correct? Is that part of the philosophy? It sounds like it is, that kind of human plus computer is better than a computer.

[00:38:04] Harold

Absolutely. We’ve always used discretionary decisions and there was one very important discretionary decision that we took around the time as well. I forgot to mention one currency. We were trading the Russian ruble as well, and you can imagine that we didn’t want to continue that. There was absolutely nothing in our system that said we had to stop trading that market.

That’s not fundamentally different than in let’s say, 1998, when in Malaysia, Mahathir closed the market for external investors so we couldn’t trade palm oil anymore. That’s something that always happened in these environments. So this whole idea that ‘computer does it’ is not right. An extreme example is during the credit crisis, getting trends was not so difficult. But we were trading these currencies with all kinds of banks and some of these banks didn’t want to accept trades from other banks anymore.

So of course, that was the attention there, and that’s not systematic. That is using the human skills to do well in that environment. So the human impact, the human input, is much larger and has to be much larger than we like to tell often in our industry, because the story it’s computers, it’s absolute. It’s truth was selling better than the reality. Even the people that use it the most, I also like that Jerry also sometimes likes to say that he does nothing like that. But then you hear him, three sentences later, saying and you hear a lot of choices.

He makes very good choices and he’s doing well because he made these choices and it’s not his computer doing it. Why does anyone trade which markets? It’s a personal decision. It’s not a computer saying it. But somehow, we think that maybe it’s kind of technical or just profiling but we like to say it’s nothing to do with computers.

We changed the address on the standard questionnaire that says how much of your program is discretionary and how much of it is systematic. We used to say it was 100% systematic. But we found out that we could fill in it’s 100% systematic as well as 100% discretionary, and we’ve changed it into that if only because there is no system that we use that we have not discretionarily determined we were going to use.

[00:40:34] Niels

On that theme, one of the things that I guess it’s been in our industry for a while, there’s been a few futile attempts. You referred to something earlier without focusing on one specific firm (there has been many firms doing the same thing). They were starting to say, “Well, trend is easy, so we’re just going to charge you 1% flat fee.” That’s a decision. That’s a business decision.

But on top of that, in 2022, there was tremendous growth, actually, in CTA replication of ETFs (in particular in one CTA replication of an ETF). So I wanted to ask you broadly (I think I know, already, where you’re going in terms of whether you like or dislike replicating CTA strategies but feel free to talk a little bit about that), if you think there is a risk in that, could you talk a little bit about some of the weaknesses that you might see in CTA replication strategies?

[00:41:46] Harold

Okay, there’s two. I think one of them, I read their story, was they trade only once a week, I think every Friday or something.

[00:41:57] Niels

It’s Monday, actually.

[00:41:59] Harold

It’s Monday. Okay, it’s Monday.

[00:42:02] Niels

That changes everything, right?

[00:42:06] Harold

Then they didn’t trade this week because this Monday, only European markets are open. So they had to wait till the US markets for next Monday. Same for Asia, except for Korea. That was open as well on Monday.

Now, when you’re managing a really large size, you cannot do that much in so little time without having a huge impact. So if a few CTAs do so, and if each of them use a different day, the impact is not too large. But as soon as more do it, it doesn’t function. That’s one element. As soon as you do it and become sizable, you cannot just trade on one day. It’s impossible to do really sizable positions.

If you want to have a $100 million CTA, okay, but not if you want to grow in size. This is, of course, also what really hit AQR. They were managing way too much different styles by assuming no impact, and of course, it has an impact. You cannot trade without impact because markets would not be moving without impact. The market impact by participants trading is the only market impact that makes markets move.

So denying this impact is very stupid. This is one element. The second element: the storyline is that investors want just the CTA return, so the index, and don’t want the deviation around it. Which essentially means that you’re bringing down the diversification possibilities for an allocator. Isn’t it great if you have different CTAs that both are doing well in a kind of environment, but have low correlation so you have more diversification?

This idea of doing the index is the passive approach. But if you want to do an alternative investment, you want to have a broad base of alternative investments that are different. The more different they are, the more they offer to your portfolio. So for the end allocator, most certainly if it is a large allocator, you don’t want that. You shouldn’t want that. You want diversification. So you want things to choose from. You should enjoy that different CTAs are doing well.

[00:44:18] Niels

I understand that. But I think that the argument they have, and I have some sympathy for the argument, and that is that many investors don’t know which CTA to pick or which three CTAs to pick and so they just want the overall exposure. Yeah, I agree with you that dispersion of returns has come back to some point. But you could also say, to some extent, that many trend followers over time deliver the same returns but not necessarily at the same time.

[00:44:51] Harold

If they do deliver the same return over time, then it doesn’t matter which one you choose. So it’s this idea that you want to get close to an index. Every time when people are wanting to have a low tracking error to whatever, it’s a risk for some, that’s not a real market risk. Which means that the ones that don’t want that risk of paying a risk premium that is available for free for those that don’t care about it and carry that risk premium.

I think in investment, the only way of making returns in investment, ultimately, is receiving risk premium. If you want to afford certain risks which are not real risks (in this case, tracking error is not a real risk), then you’re paying less premium for that. It’s as simple as that. So fundamentally, it doesn’t make sense.

[00:45:52] Niels

Yeah. Of course, Transtrend is so big that you’re in all of these indices that are now being replicated, of course. So that’s also an interesting point that there is a lot of concentrating. I agree with you that a lot of people just want the index. We’ve been taught now that passive investment is better than active and all of that stuff. That’s where the money flows. So I can kind of understand why people say, “Oh, yeah, let’s just do something, ‘passive’ in the CTA space as well.”

[00:46:23] Harold

Passive is not good. I’m completely against passive being good. Passive is bad. In everything in our society, passive is bad.

[00:46:32] Alan

I was going to say, I think maybe the point is people want greater certainty of getting the return series of managed futures and trend following.

[00:46:44] Niels

They don’t want to be an outlier. They don’t want to be down one year and the industry is up.

[00:46:50] Alan

I think that’s behind the philosophy.

[00:46:52] Harold

Yeah, but maybe they should realize that that costs them money. Because if you want to be there where things are happening, you need the outliers. Our world doesn’t function without outliers. We need people that make different choices. If you are an investor and you have enough money to diversify, choose the potential outliers and don’t choose the ones that are making no choice at all.

[00:47:18] Niels

Now, one thing where you could say that having exposure to many things, just like we talked before, trend replication or CTA replication, you get exposure to “many managers” in one index. Another area of our industry that seems to be embracing having exposure to many things is, of course, when it comes to the number of markets we trade. There, I think you’re in agreement with many people we’ve had on the show that trading more markets is better.

Now, I’ve also been saying (and I’m on record for saying) that when I look at the industry returns, if I compare those managers that I know well that trade maybe 50, 60 markets compared to those who trade 200, 300 markets, I really don’t see the difference in overall returns. Maybe the returns are different year by year, but overall long-term, they’re not really that different because you’re going to have to trade smaller and you have many markets, and so on and so forth.

You don’t have to spend too much time but what’s your overall pros and cons with these fewer liquid markets, but not too few of course? So either 50, 60 of the liquid classic market or going much, much broader. I think when you and I spoke a few years ago, I seem to remember that you had been on a journey where you really expanded into a lot of markets. But at the time, and this was when we sat down in Miami with Katy Kaminski, I think you said at the time that you had contracted the number of markets a little bit.

[00:48:51] Harold

Yeah, we have. Because the philosophy of “the more markets the better” is not right. One of the reasons why it became slower, and the system became slower, is if you have too many markets that are somehow correlated, the portfolio as a whole quickly becomes very slow in adapting, picking up new trends and so on.

This is one of the consequences of something that happened over the last decades. When the credit crisis happened in fixed income (trades and fixed income) and stock markets were completely different, there was a year (one and a half years) between the moment that it hit the interest rates and the moment it hit the stock markets.

That’s not thinkable nowadays. Markets are too connected now. So while something is happening in one market, it has an impact on other markets. Also, if it’s a nonsense impact, it has an impact. It immediately does. Which means that the way correlation works changes. Also the way diversification works is different.

In the past when these different markets were really doing different, having these different markets in one portfolio automatically went right. Later on, we had to make some more choices to make sure that we really are in different trends – that there can be different trends. Diversification is the source of what we are doing. That’s what we are aiming for.

Other trend followers, or the first type of trend followers, in essence, have a different strategy. For them it can be wise to trade just a lower number of the larger markets because you can adapt to them easier. For us, having maximum diversification is what we’re aiming for, in which you don’t need to adapt that quickly. That’s also why we can hold positions in markets that are less liquid. But in essence, it’s another strategy.

Diversification is our main thing that we are focused on instead of being able to stop a reverse. So I think it’s also dependent on the style that determines what effect it has. Yes, we did bring it down because the old way didn’t do it anymore. We had to adapt a new way of getting invested in different trends, so we are now looking at different trends, and try to trade these different trends.

But a trend can be, for instance, what stocks are the most utilized sensitive. We have short positions in those, that’s one group of stocks. That’s all kinds of stocks in there. That’s a trend. If we want to add to it, we sell some of those. If we want to size down the position, we buy some of those. We can choose which ones to buy or which ones to sell.

That’s looking at it from a trend perspective instead of from a market perspective. We are not looking at what is Disney doing. No, we are talking about the strength of Disney as a part, Amazon as a part as well, just the parts of it. So, it’s one trend, and that’s the way we’re looking at it. Then you can trade these different markets, but you do not need more markets, and you really need to get positioned in these different trends.

[00:52:53] Niels

Before you answer, Harold, can I throw in one more, which is actually a very current example, and that’s the recent price cap in Dutch nat gas.

[00:53:03] Harold

Yeah, okay. Reliability of the market, for us, is part of the very important elements. So, when we are talking about Turkey, for instance, we all know that the central bank is not the leader but the President is the leader. Then you have to question whether or not we trust if money is standing there. Why did we stop trading Russia? Of course, the reliability came down and we didn’t want to be positioned in Russian markets anymore.

LME, we stopped trading LME completely. We have been trading it for more than 30 years. This exchange completely proved to be completely unreliable. They have to make changes and we will not trade there anymore if they are not making these necessary changes. Currently, they do not make these changes because the moment they make a change, that will be the point where a lawsuit is going to hit them. So the changes they should make are not being made.

Reliability is very, very important. You talked about politicians intervening or central banks intervening, but look, the Fed does some things now and then also. All central banks do emission rights. Yes, when the price of power gets too high in Europe, then all of sudden there are more emission rights available. Politically, they were somewhere in a closet hidden.

So it’s part of our world. Politicians are part of our world just like the weather is and other factors that are determining trends and we have two types of freedom. But if it leads to some kind of unreliability, that we see in Russia now and we’ve seen in the past in some other countries as well, that can be a reason to get away from it or an exchange that becomes unreliable.

We trade futures because we do not want counterparty risk. That’s the essence. The counterparty risk is a great system. That’s why when the Hunt brothers were in the silver markets in the ’80s, yes, they made a mess about it. But everyone at the other side of the trade had no problem with it.

We had this Norwegian trader in energy markets a few years ago, Einar Aas or something he was called, a big mess for those markets. But he came down with no problem. When our friend from Barings was trading the Nikkei, on the Singapore exchange, no problem for anyone and you’re deciding to trade. That’s what we like.

When that element is going away and when there’s this whole idea of counterparty risk, all of a sudden, if someone doesn’t like his position and gets the exchange at his neck, that’s wrong, that’s fundamentally wrong. So that’s something we don’t want. So that’s when we get out as we’ve done with LME.

[00:56:00] Niels

I’d love to hear your thoughts about capacity. It’s kind of tied a little bit to fees. So here’s my observations during the year. Well, first of all, we kind of know that usually, returns suffer when strategies become too big. I’d love to hear your thoughts about, generally speaking, of a diversified trend following strategy. You mentioned another firm that you felt became too big, where you’re thinking in terms of your own strategy when you think of stopping taking in more money, but also fees.

Because what I’ve observed is that a lot of money flowed into the big names from pension funds. When it came in, during the quote-unquote “CTA winter”, some of these pension funds were able to negotiate very low fees. Because as we’ve talked about before it’s just trend, it’s so easy, right? Okay, now the trends are coming back and people are realizing it’s not great only to make 1% flat fee when you could make 15% in a performance fee for example.

I have seen some evidence that some of this money is being handed back to these low-fee mandates so that you free up some capacity. I’d love to hear your thoughts about that as well. I have no idea, of course, what your investor base looks like. So I’m just thinking out loud here.

[00:57:28] Harold

Okay, well, we have to realize that this is absolutely a capacity-constrained strategy as we discussed. It becomes even more capacity constrained if you’re doing more the same as other CTAs. If ten CTAs do exactly the same thing, it’s one, and then the capacity constraint is even much larger. So that’s also one important reason for this embracing dispersion because it also is necessary to do well. All of us can do well if we you do more different things at different moments. So that’s one element there.

During the CTA winter, our amount under management has been coming down as well so in that sense, it helped from a capacity point of view. We will not bring down fees to attract more money because that doesn’t fit with having a capacity-constrained strategy. So this idea of offering more, no. We know it’s capacity constrained. We are aware of that. That means that if we want to do our best, we think it’s worth paying for it.

We can only do that by doing it this way. If we would, let’s say (and that is what we often forget), if we would allow an unlimited amount of other investors in for low money, you could say, well, good luck for those investors. No, but it’s also a negative impact for the existing investors, because the impact on the execution will be on their side as well.

Looking at what it means, we’ve seen< over the last years< this tendency of this spreading idea that liquidity is available for free has a certain impact on markets. Which means that if you are not aware of it, it can very quickly become very expensive. So in that sense, if you don’t adapt to it, the performance of CTAs becomes even more capacity constrained than it used to be because of all this much more passive money in markets.

We have really changed the way we do our business, the way we execute, the way we look at trading in the sense that it’s not that the computer says something and traders do it. No, we determine under what conditions we will be willing to buy and under what condition we will be willing to sell. By doing that, we are much more of a liquidity provider instead of a liquidity premium payer.

So, that’s a very crucial element of what we are doing, the choices we make. We believe that the capacity of our program, at this moment, is larger than it has been in the past when we did manage above 10 billion. Now we are way below that but our capacity of the program is larger than it was at that moment because of all the changes we made by trading a different moment and much more trading in a way that is in itself less capacity limited.

[01:00:33] Niels

Okay. That’s very interesting. You already touched a little bit on liquidity, Alan, so I don’t know if I will just jump into the next one and just ask you, because this is a big subject.

S, I don’t necessarily want to go into too much depth. However, ESG is something that I think you’ve written about. Also, it’s something that we all get confronted with even though it’s sometimes hard to fully embrace it as a concept, this is very relevant for our strategy, maybe for us as businesses, but our strategy, etc., etc.

Personally, to be completely open about it, I’ve had my own thoughts about Chinese markets where I think it’s very hard to argue that ESG is being lived up to in that market. Yet, there has been certainly, and again, I don’t know if you do it, but there has been, certainly, a movement towards embracing Chinese futures markets, which probably did quite well for some managers in 2020 or 2021. I can’t remember now. But to me, there’s this little bit of tension between ESG and the market.

So what’s your view on this? I’m sure you’ve heard this question before.

[01:01:17] Harold

ESG has become a very strange thing. In the European Union, they’ve even made some rules saying that when you do ESG, it becomes a compliance issue because you have to actually explain the kinds of ways you are doing it. So we have to say we do not do ESG. Otherwise, we have some compliance issues.

But saying we are not doing ESG is at the same time complete nonsense. E is for environment. What’s the number one factor that determines prices of agricultural commodities? Too much rain, no rain at all, and so on. That’s a typical environmental issue. Why have the energy prices been rising so much since 2021 in Europe? No wind, too much rain, no rain, the number one reason for rising energy prices.

Even if we would say we only look at prices, then we know that we are alone in energy markets because of an environmental issue. So we are trading ESG. It must become very, very difficult for a trend following CTA to not be ESG because that means that all market moves you see you have to say, “Oh, this is an environmental move. We do not want to participate in that so we’ll take that one out.” It’s almost impossible.

So yes, we are in there and we should be in there because what it’s essentially about is change. When we are in a big change, for instance, we are in a big change – there’s energy transition, less fossil. Anyone saying that he does not invest in fossils or doesn’t want to invest fossils is living in a fairy tale because we have fossils too deep into our fates. We use plastic everything and we cannot travel on a plane or whatsoever without using fossils. I myself have some panels on my roof but I know they were produced by using a lot of fossils. So we are completely fossil in everything.

But there’s a change going on to become less dependent on fossils and that gives huge risks for everyone involved. If you look at the metal markets; when costs move from becoming less diesel to more gasoline; you need less platinum and more palladium; and then it becomes electric and then you need more copper. So, this is one of the leading trends in metal markets.

Futures contracts are not there to invest in copper or to invest in a firm or to invest in wheat. They are there to carry the price risk in these things. We don’t buy wheat, no. We are carrying the price risk on wheat. We are carrying the price risk on oil, we are carrying the price risk on a weapon-producing firm or whatsoever.

We are carrying the prices. That is the only thing we do. We have no impact in the sense that we have no control. We cannot say this hawk is peeing too much so we let him pee less. That’s something we cannot do. When you’re holding a long position in hawks, we only carry the prices of that.

When there is change going on like necessary changes (many of these ESG things require a lot of changes in society), this brings huge risks. Futures contracts are ideal for transferring risk. Returns come from carrying risk and getting a premium for it. Then you have to trade all these markets that are especially in the center of this whole change. So, you have to change coal, you have to change oil, you have to change metal contracts, you have to change all these firms that have to make big changes because that is where the risk has to be carried. So participating in that change is something we do, but we will not call it ESG. We just call it responsible investing.

[01:05:37] Niels

Let’s leave it at that because I know Alan has a little topic he wants to dive into before we start to wrap up.

[01:05:44] Alan

Yeah, just one broad topic, I guess maybe stepping away and looking at this from the allocator’s perspective, so obviously, the clients and investors that are coming to you. What would you say to them to think about expected returns? Is it just based on their historical performance or is there any way that people can say on a forward-looking basis, you should expect a certain level of performance or a certain level of Sharpe or what in terms of the types of strategies that you run?

[01:06:16] Harold

This question is not related to ESG, is it?

[01:06:18] Alan

No, totally unrelated to ESG. Just in general.

[01:06:24] Harold

We just try to control our risk, that is what we do, and the return is the upside that we like to see. But we’re never going to predict an upside. We hope long-term to see an upside.

[01:06:41] Alan

If I’m an allocator and I’m looking at traditional investments, long only bonds and equities, credit, I’m looking at other hedge funds, I’m looking at private markets, etc., and I’m trying to feed all of this into some kind of asset allocation framework. I understand trend following and I like the properties and return profile. But I say on a forward-looking basis, five-year basis, I need to have some kind of sense on what the return profile might be. So I understand what you’re saying that you control the risk and you take the return. But from an allocation perspective, how would you guide somebody?

[01:07:18] Harold

If you do a long investment in stock markets, you could say, historically stocks have been rising by so much percentage, so they will do it again. But that’s a complete nonsense prediction.

[01:07:27] Alan

But I mean, say with equities, you can look at the equity yields, or with bonds you can look at the bond yield. Obviously, with trading markets, you have no intrinsic value to hang your hat on.

[01:07:40] Harold

The way currency markets or the stock market trades, you have no intrinsic value also that is linked to the performance that you see from year to year. I would not give any indication of what you can expect in absolute return type of yields. You can only tell in what kind of an environment you probably can make money and what kind of environments you probably will not make money, and how that return will be correlated with other types of investments.

We all know what kinds of investment types are sensitive to if the interest rates would rise further. We all know that if stock markets come down, many investors are losing money on them. So it’s nice if there are some investments that are different from that, and our CTA program is one of them that is different from that.

[01:08:37] Alan

So in terms of the role in a multi-asset portfolio, it’s an absolute return portfolio diversified, and that’s it. You take what the market gives you.

[01:08:45] Harold

That’s it, yeah.

[01:08:45] Alan

Fair enough. Okay. Just one follow up question. As people have increasingly used trend following within that as a diversifier and even for some people in terms of portfolio protection even to go that far, there’s been the suggestion that trend following would be better if you didn’t have so much equity exposure. There might be a suggestion, you’d be better off capping your equity beta. Have you come across that argument? What are your thoughts on that?

[01:09:17] Harold

I’ve heard that argument. As a matter of fact, if last year we wouldn’t have traded any equity markets, we would have done better. But that’s not very good proof of it. Let’s say this whole idea that stocks would be one area and completely not related to the other markets is of course wrong already. What happens in stocks and what happens in bonds is very related. So if you then would say I don’t want stocks, then you should not be wanting bonds either. But then many things are happening in commodity markets linked to that as well.

So better do it all and be aware that the way of investing (being long/short, finding different trends, how to work them together), is what we’re really after. By bringing down the area of markets that we are trading, we do not do well with diversification within our strategy since diversification is one of the main things for us to be carrying risk.

I think diversification is the only thing that is available for free. Taking out these markets is not a very wise thing, I believe.

[01:10:30] Niels

Well, let me just wrap up with the last couple of questions. Harold, we’ve taken up lots of your time and it’s a Friday afternoon here in Europe so we definitely want to make sure that we get you home in time. This is just like a little fun one, I think. But nevertheless, I’m curious about your answer. What’s the one thing you hear about trend following that you disagree with the most? What are the things people say about trend following where you say, no, that’s completely wrong?

[01:11:01] Harold

That it’s just a factor. That’s wrong. It’s not a factor.

[01:11:08] Niels

Nice and short. Finally, final question. Since we’re recording just in the first week of January 2023, what are you most excited about for the year and what are you most concerned about? It doesn’t have to be specifically about trend following. It could be anything really.

[01:11:26] Harold

Of course, we hope that the situation not so far away from our border, Ukraine and Russia, is going to be solved in not too much time. That is something coming out that will be giving more stability over time. I think that’s one of the most important areas.

Then of course, let’s hope that now this whole COVID thing is really passing away. In China, it is still a big issue. Many people are dying there. That’s not something to be welcomed. So let’s hope that this is now really moving in a good way. This is the last area in which the faculties are improved and there are no more victims.

[01:12:09] Niels

Okay, fair enough. Excellent.

On that note, let’s wrap up this fascinating conversation. Harold, thank you so much for being on the podcast and for sharing your thoughts and insights with us. We hope that we can do this again sometime in the future.

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

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

[01:12:53] Ending

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