TTU134: Katy Kaminski, Chief Research Strategist at AlphaSimplex Group

[00:00:06] Katy

People ask me all the time, “What’s going to happen to the market?” And I say, “We don’t do what the market should do, we do what the market is doing.” So therefore, when there’s a crisis, we don’t sit there and ask ourselves the question like, “Oh, I don’t know if this is a crisis.” Our strategies move and then we answer the questions later. We figure, “Oh my gosh, did you see what happened to oil?” But during the actual move, it’s not about trying to value oil, it’s about figuring out what’s happening, where is it going, and get on the train.

[00:00:38] 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.

[00:01:34] Niels

Hey everyone and welcome to another edition of Top Traders Unplugged, where today, Alan Dunne and I are joined by Kathryn Kaminski, Chief Research Strategist at AlphaSimplex Group, 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, Katy, it is great to have you back on the podcast. Thanks so much for joining us today. We really have been looking forward to our conversation. I hope you’re doing well.

[00:01:59] Katy

Yes, great. Nice to be here.

[00:02:02] Niels

Absolutely. Now, before we dive into all of the different topics we’re going to talk about today, I wanted to maybe set the stage for our conversation and give the audience a little bit of background to your firm. So perhaps you could share just a few highlights as to the type of strategies you focus on and also maybe where the business stands today as we have just entered 2023.

[00:02:25] Katy

Yes. AlphaSimplex is a quantitative investment manager located in Boston. We’ve been around for over 20 years and we focus on a range of quantitative strategies, including managed futures, which we’re going to talk about today, but also alternative risk premia and hedge fund replication and other strategies as well. Our largest strategy is managed futures and we’ve been in the trend following space since 2010. We manage a relatively large trend following program that is one of the members of the SG Trend Index.

[00:03:03] Niels

Absolutely. Now, Alan and I have come up with a number of different topics that we like to discuss with all of the managers. What we normally do is just to alternate a little bit in terms of bringing on a topic and then we can take it from there. So why don’t we do as we always do, Alan, and that is we’re going to let you kick off with the first topic.

[00:03:26] Alan

Great. Well, good to speak to you, Katy. It’s interesting. The range of strategies you run at AlphaSimplex is maybe not very typical. We’ve spoken to a number of managers here and they’re typically trend and quant macro or maybe trend and short term. But obviously, you guys are running trend and hedge fund replication and alternative risk premia. So what would you say is the investment philosophy that has brought the firm to the point of picking those particular strategies to focus on?

[00:03:58] Katy

Yes. So, what’s interesting about AlphaSimplex is we sort of came into the space from the other direction. Most CTAs in the space came in as hedge fund 2-and-20 type of vehicles where they were seeing trend following as like exotic alpha, in some sense, if you think about it. So what AlphaSimplex did, which is a really exciting way to think about it, is we came into the liquid alternative space wanting to disrupt and to provide good quality, alternative liquid alternative strategies to investors in the masses. So we tend to have the philosophy that we are a best ideas fund.

We want to give our best ideas to all investors. We want to provide returns that are alternative, that can help investors with diversification at multiple levels of the investment hemisphere. So what I would say is that we really care a lot about all of our investors; we want to give them the best strategies and we find ways to put our best ideas into everything that we do.

[00:05:00] Alan

When you say ‘bringing it to the masses’, does that mean then as an offshoot of that presumably focused on high-capacity strategies as opposed to more niche strategies?

[00:05:12] Katy

Yes, we are very focused on liquidity in most of our strategies; so that’s liquid alts – strategies that can be reached by a larger audience. In addition to that, if you think about it, when I say that we went backwards, it’s that we started off in the liquid alts space. Eventually, institutions and others started to realize that they liked what we were doing. So we started to move into the institutional space many years ago, and now we sort of work in both spaces; both in the retail and also in institutional. I think that has to do with our idea that we want to do the best we can with everything that we do to all clients.

[00:05:54] Alan

I know Andrew Lo is obviously a founder of AlphaSimplex Group and he has written his idea about the adaptive market hypothesis. Can you link that to the strategies you run? Is that very relevant in terms of thinking about why the strategies your run should make sense over time?

[00:06:15] Katy

Yes. The adaptive market hypothesis was a key part of the philosophy of the founding of this firm. The way we think about things is we think about markets adapting over time. What that means is that it’s definitely about constantly innovating and changing and finding new ways to deal with different and changing market environments.

So from an investment perspective, we’re always looking for models that will move and adapt with changing market environments, and that’s why trend following is one of the best examples of an adaptive strategy. If it’s designed properly, pure trend, at its purest form, is meant to adapt to changing environments. Hence, it’s been one of the cores of our business.

[00:07:01] Alan

Okay, interesting. It sounds like managed futures and trends are a big part of the portfolio. When we’ve spoken to other managers, there’s been this desire to diversify into different types of strategies within the managed futures universe, but it sounds like you’ve taken the view of sticking to that core trend following belief.

[00:07:23] Katy

Yeah. The way I think about it is that each investment product has a mandate, and our managed futures program has a mandate of pure trend. What it means is that we want to deliver to our clients the purest form of trend in a sense that we don’t want to add a bunch of other things. We want to focus on crisis alpha. We want to focus on being able to capture difficult environments, adapting to volatility, and that is really what we want to deliver. We’re not trying to maximize Sharpe ratio, we’re trying to maximize the trend experience and make it the most robust and consistent with capturing those key global market trends.

[00:08:04] Niels

Yeah. You kind of already dived into the things I wanted to talk to you about, Katy, because one of the things that I have often talked about on the podcast, and I always am delighted to give credit where credit’s due, which is of course, you when it comes to the term crisis alpha. So let me be very frank about my own experience, because I say to people that I was so excited when I heard the term because it made so much sense. You could go into an IC committee saying we’re going to add this crisis alpha strategy, everybody would know it.

But my own personal experience has also been that I’ve had to discuss with people, so many times, what a crisis is every time trend following didn’t deliver and people thought there was a crisis. But be that as it may, where I want to go with this first and foremost, and you’ve kind of touched upon it a little bit so maybe we need to broaden it out (not just purely from your perspective in terms of AlphaSimplex but maybe the industry as a whole), because one of the topics we brought up with people is this paper that came from Cliff Asness.

He basically says the industry of trend followers has two mandates. We want to create absolute returns and we want to create returns when equities are down (or when there is a crisis). But the other thing he mentioned, I think, is that there is a lot of focus on Sharpe. You obviously referenced that just before. So my question to you is do you think the industry as a whole has become too concerned about Sharpe? Let’s start with that.

[00:09:35] Katy

Yes, that’s a good question, because I do agree with him that there are sort of two mandates and it depends on the investment objective and the preferences of the investor. We have been more in the camp (and I think there’s several peers of ours as well) that pure trend, at its purest form, is the best diversifier over the long run. So that’s really about maximizing total portfolio Sharpe as opposed to maximizing individual strategy Sharpe. It’s really going to depend on the mandate for the following reasons. It depends on which of those matters to the investor. If the investor is thinking about the big picture and actually measuring their success on the big picture, then they want pure trend.

That’s what we see with a lot of institutions that come to us and say, “We don’t want a bunch of other stuff. We want to know exactly what we’re adding to our portfolio, and pure trend is one of the few things that in very difficult environments does well. So we want to distract to try and improve the individual Sharpe.” But then we also meet investors who come to us and say, “I care about P&L returns in a line item way, that I’m comparing apples and oranges and I’m really seeing this as an individual investment.” And that’s where you start to see people want to have a more diversified trend approach.

So for us, it depends on what the investor is looking for. We have products that are like that as well. So, I think for everyone out there who’s looking at the space, they have to ask themselves this question: Am I trying to improve the overall Sharpe ratio or am I trying to have the best Sharpe ratio for that one individual investment?

[00:11:20] Niels

Okay. I really like that. I like the term total portfolio Sharpe as opposed to individual line item Sharpe. I really like that. I think we should have much more focus on that. But my follow-up question would be, so how do we have that conversation successfully? I find it so hard, in dealing with investors, for them to get away from the individual line item Sharpe, because they may not even really know the impact of the specific strategy that it has on the portfolio in terms of the Sharpe. Of course, as you also know, lots of people have such a small allocation to trend that it doesn’t really move the needle on the portfolio Sharpe anyway.

I know you’re not only a great strategist and researcher, but you write amazingly, so how does that narrative sound like when you talk about or think about that?

[00:12:14] Katy

That’s a really good question because in all honesty, it’s always that people will say one thing and sometimes behave differently. So, you really have to talk with them. I think the most successful trend following investors, that look at pure trend, are ones that have created a segregated mandate and have labeled it and explained it to their boards or explained it to themselves if it’s an individual, that this is something that is either risk mitigating or something that’s supposed to be there based on my defense mechanism. It’s something that will react in difficult environments and it may not work as well in others. So the challenge is, when you talk to investors, they often say that they want to maximize the total Sharpe, but don’t.

In practice, in a bad year, as you know, the phone rings. They’re calling you and say, “Why are you underperforming equities?” And that’s where we have to tell them the story again. But I think you hit one of the biggest roles of why education and working with your clients is so important, because they need to understand the volatility in such a space. Really, there is a lot of volatility and there’s a lot of dispersion so they need to be prepared for this. It’s easy to say that prior, but when that actually happens, it’s the understanding the education that helps them through understanding longer term moves in markets and correlations are not the same as returns.

[00:13:43] Niels

Now, if I understood you correctly, Katy, you mentioned that you cater to both. You have your flagship, which is probably focused on pure trend, but you have other versions of it that people can get if they want something that is maybe a little bit easier to hold, which by the way, we hear from a lot of managers that they’ve gone down that route because they say it’s no use for them to own trend following if they can’t hold it. So that’s an argument which we fully appreciate.

I’m curious to know if you can talk a little bit about if you start with your pure trend, what kind of stuff do you add to make it more palatable and come in the other category where people can hold it a little bit more? What are the tricks you can put in where it changes the characters enough for people to be able to look at it, maybe more as an individual line item as well?

[00:14:35] Katy

That’s a good question. If you take trend, there are many different directions you can go. Starting just even with pure trend, there are things that you can do to diversify that investment. So the pure, classic, highly liquid pure trend strategy that we talk about, you can expand that by adding more markets; either moving into alternative markets, but then you can also expand that by moving into other strategies. So, other strategies such as carry, roll down, many different ARP strategies, which can complement trend (maybe not always negatively correlated, but maybe zero correlation to trend), which creates more of a diversified return stream.

The only challenge with that, of course, is it depends on the client. If a client is coming in with a line item view, then basically, they might want that diversification to smooth the ride over longer term. But if they’re coming in to us and saying, “Look, we have so much equity, we have all these things that are very classic fundamental approaches, we want trend to be the one odd man out, something different in the portfolio.” So I think it really depends on the objective of the client, and sometimes, they don’t always know so you have to talk to them and really say, “What are you trying to do? How are you going to defend this when it’s difficult? How are you going to explain when equity markets rally and it doesn’t?”

Those kinds of questions are very important for investors; to ask them those questions and figure out how can we help you find the right solution.

[00:16:10] Niels

Yeah. Now, before I turn back to Alan, I do have one or two follow up questions on the term crisis alpha that I have to ask you. From memory, I seem to recall that your co-author of your great book Trend Following with Managed Futures, Alex, that he once did a paper where he showed that one of the most consistent, if not the most consistent asset class during a crisis period is commodities. So that’s just one thing I just want to put out there. I’d love to hear your thoughts on that.

But also, when we talk about crisis alpha, do you think that trend following as a strategy, do you think it is just (I don’t know what the English word is) a feature of the strategy that it turns out to generally make money when there is an equity crisis or is there something that managers do, or can do, specifically in the design of their strategy that will more ensure that it will do well when there is an equity crisis? How do you think of these things?

[00:17:13] Katy

That’s like three questions. Okay, so let’s start with number one. Why don’t we go back to the original conception of crisis alpha and at least give some context, because I think you’re right, people throw terms around. They throw vocabulary around just for fun. Sometimes, if you think about where something actually comes from, it gives you a better idea of why that name is there. So the original story with crisis alpha, back after 2008, I was working in this space in Sweden and I was asked a question by one of the big pension funds to explain why managed futures did well during this crisis, because they said to me, “I think it’s fantastic that it does well during crisis, but if I don’t understand why I don’t care.” And I always laughed, because I was like, “Oh, this is like a charge.” I was a young, fresh academic so I was ready to go.

Andrew Lo, who we discussed earlier, was my original PhD thesis advisor and so I was indoctrinated in the adaptive markets hypothesis. So what I was very interested in, for crisis alpha, was really thinking about what is it that makes a strategy succeed during a period of stress?

So, the definition of crisis alpha is potential opportunities during periods of crisis. It’s a much more generalistic term than just trend. It’s associated with trends sometimes, but you’ll understand why in a second. So what I started thinking about when I was thinking about crisis alpha was, what is it that makes a strategy succeed during stress? Well, there’s a couple of key features. So number one, liquidity; number two, opportunistic, so being able to find many different things; and number three, no bias, so not having a specific bias that you’re stuck with.

If you take those three characteristics, we can walk through them and you can come up with lots of things that actually work as crisis alpha. Liquidity is important because if you have liquid strategies, when things are difficult, you can move, number one. Number two, if you have opportunistic, meaning that you can be long and short a bunch of different things because every crisis is very unique so the opportunity set is very different. Let’s take an example. During COVID, the best trade was to be short energy and long bonds. During the Ukraine event, guess what? It was the opposite. It was being short bonds and long energies.

You can’t predict how difficult a crisis is and where it’s going to go. So you have to be opportunistic, in some sense, whatever strategy you have, and then finally, the bias is important. I talked a little bit as well about this long-short, is that if you have a long bias or a long biased equities or bonds, which we found out last year is that you can be stuck and that you just can’t move. I can’t tell you how many conferences I went to last year and I said, “How many of you think rates are going up?” Every person in the room raised their hands. And then I said, “Who is short bonds?” I raise my hand. Nobody. So what’s interesting with that is that those are the three key principles of crisis alpha: liquidity, opportunistic, and also non-biased.

If you think about that, what happens with trend following is it just happens to have some of those key characteristics that help it to be more adaptable during a period of stress. What that means is that when you have this crisis, with most strategies people either, because they’re stuck thinking that things are always going to keep working (that’s the bias part), or they’re stuck in the wrong asset class, or they can’t go short or long and they don’t have commodities even in their portfolio, that means that they are just stuck in that crisis waiting for it to end. Whereas with certain strategies, trend following being one they are potentially able to do that, they are able to adapt to what is an unexpected environment.

And this is where I have a paradigm I often say about trend (where it kind of fits), is people ask me all the time, “What’s going to happen in the market?” And I say, “We don’t do what the market should do, we do what the market is doing.” So therefore, when there’s a crisis, we don’t sit there and ask ourselves the question like, “Oh, I don’t know if this is a crisis.” Our strategies move and then we answer the questions later. We figure, “Oh my gosh, did you see what happened to oil?” But during the actual move, it’s not about trying to value oil, it’s about figuring out what’s happening, where is it going, and get on the train.

So I think that’s where crisis alpha comes from. It’s this idea of understanding which strategies do well during stress and what are the key characteristics of strategies that help you to be successful during stress. So that’s one of the questions. Sorry, that was a long-winded answer.

[00:22:12] Niels

That was just one of them. The only other one…

First of all, I love that and you’re now swaying me back in the crisis alpha camp so I appreciate that. Because when you describe it like that, it makes a ton of sense. So well done.

Secondly, I do want to ask you a little bit about this notion about the commodity, what role they play in a crisis. Because I think it is quite interesting and I think this is one of the other things that we, as a diversified manager, bring to the table is access to these markets that a lot of investors will never have access to. So I’d love to hear your thoughts.

[00:22:50] Katy

Yes, that’s a good question. That’s a good point. I actually want to highlight a paper I wrote a couple of years ago that is one of my favorites that I’ll have to recreate at some point. It’s called Crisis Alpha Everywhere. I think I published in 2016 in PI Online. It was just an interesting discussion. What we did in this paper is we defined crisis in a much more pluralistic manner, where we define crisis as a drawdown in any of the four major asset classes. So that could be commodities, currencies, bonds or equities. What we found is we defined a crisis depending on how many markets were in extreme events. What we showed is that when there were more and more crises, that was an environment where there were big, big moves; that was an environment where trend did better.

So the more crisis there is, the better the strategy does, which makes a lot of sense. But it defined crisis in a much more pluralistic manner. Because, to be honest with you, the reason why we focus so much on equity crises is that those have been the major crises over the last 20 years. But guess what? Last year, we had a bond crisis and an equity crisis at the same time, and in 2014 we had an energy crisis also. So I think the reason investors focus on equities, that’s what they hold, and most of the major crises, that we have all experienced and hurt from and felt difficult times in our investments, have been equity-focused. So I think there’s that lens that tilts everyone in that direction.

I think last year might change that, because you’re seeing an environment where bond crises have come up and that has been very rarely the case. I actually have an interesting paper we have to talk about later on this as well. So the way to think about the commodities part of it (that you asked in the beginning) is, of course, think about this concept of opportunistic. Having those extra levers within your portfolio, aka things like currencies and commodities last year, in addition to equities and bonds, allowed you to capture that massive rally in the dollar. It allowed you to capture that massive rally in energy and metals that we saw.

So I think the key thing is alternatives are meant to add alternative sources of opportunity to your investment set diversification, and a key component of being able to capture these opportunities during stress is having more tools in your toolkit, aka more asset classes. And that’s why I’m not surprised. I haven’t seen Alex’s paper, I’ll have to ask him. But basically, it’s not surprising to me that commodities play a key role. But fixed income has played a key role too; even equity shorts from time to time. In 2008, the equity shorts helped. They didn’t help in COVID, let me tell you that, but they did help in some periods. So that’s why this idea of opportunistic is important because you link back to (during crisis) that you’ve got to have all your hands on deck.

What happens is going to be very different depending on what is driving the crisis, and commodities are a key asset class that a lot of investors have forgotten about because they had several lost decades of returns. So that provides new opportunities is how I would frame it.

[00:26:24] Alan

I’m curious, you’ve talked a lot about crisis alpha. How much then does that inform that this is in your mind, this importance of the program having that crisis alpha characteristic in terms of the development of the program, and specifically then in relation to a few factors, one being speed of system? Is it better to be faster to have a greater likelihood of delivering performance in a crisis? That’s one thing.

Secondly, a topic that comes up frequently here is vol sizing or not. The argument of the people who don’t like to vol size is often that you will get better skew in these crisis periods because you’re not reducing positions that are working, and then more generally, risk variation; allowing the vol of the program across the whole portfolio to be higher in those risk periods.

I wanted to specifically think about, we say managed features and trend following can have crisis alpha, but it’s not a guarantee. February 2018 is a good example of a risk reversal and a big down month for managed futures. Obviously, it could have been a lot worse if that equity reversal had kept going. So, to protect against those reversals, how important is that crisis alpha consideration in terms of those particular aspects of developing a trend program?

[00:27:56] Katy

Oh, yeah, let’s talk about building a program first and the philosophy of pure trend and crisis alpha. If you look at this problem from my perspective thinking about crisis alpha, those three key characteristics, liquidity, opportunistic, reactivity, and no bias, you need to spend a lot of time thinking about what is the right strategy for clients that are looking for that potential reaction. So you hit on several of them that are very important. The first I’ll talk about is speed. Having a program that’s able to adapt quickly to changing market environments is very crucial. So having a sizable enough allocation to short-term, windows and short-term approaches.

Now, some things that you can do that we think about as well is that you can also have nonlinear approaches. Let’s put this in simple terms. You want your strategy to move when it’s necessary, but you also don’t want it to move when it’s not necessary. So how do you balance that reactivity with capturing the long-term average alpha or potential for trend? That requires some finesse in terms of thinking about adding enough short-term strategies and also adding strategies that can change, that can adapt to market environments and capture a faster approach. So we saw this.

Let me give you an example. If you look at COVID, that was a great way to think about that. Things moved super quickly. It was unbelievable. I’m sure you guys all felt the same. We wrote a paper where we studied this after the fact called The Coronavirus Crisis: What is the same? What’s different? We highlighted a couple of key attributes. One of those was speed, the other was pure trend versus diversified trend (which were the key aspects), and we also looked a little bit at volatility and volatility management as well. So there are a couple key things.

If you’re thinking about a pure trend strategy, one of the key components is to size your positions as a function of opportunity sets, which is very consistent with time-varying volatility. Which means that you want your volatility of your program to be conviction scaled, aka when the opportunities are bigger, you want to take more risk, when the opportunities are worse, you want to consolidate. So if you vol target a strategy like that, you’re actually adding mean reversion to the approach. Because basically, if your signals are strong and you want the same risk, you lever down, and then when your signals are weak, you lever up.

So if you’re a pure trend follower, you believe in volatility flexibility within reason. Of course, because there’s always an art to doing this. It’s not just about wild volatility, it’s really about managing the adjustments as a function of your signal strength. So that type of strategy worked very well in an environment like last year where you had some very big trends that then went very volatile at the end. What happens is you see the signals growing, you increase your positions. As you see volatility spike, eventually, that sort of normalizes and captures the main part of the trend. So you want to capture the center of the trend and be able to at least slowly realize that trend is dissolving after the volatility at the top becomes higher.

So I think for us (going back to your question), finding ways to incorporate speed without losing too much of the costs, because faster signals do not work as well in trend, but they’re very important to have a strategic allocation to them. Secondly, allowing your volatility to fluctuate but managing it. Thirdly, we also talked about pure trend versus diversified trend. Having a pure trend approach is going to react the most consistently with very extreme moves, and that’s exactly what we saw during COVID. Those are the three characteristics that differentiated one manager from another in terms of which ones were able to actually adjust to the big trends that we saw happen so quickly. I think it was only a little bit over a month, which felt like five months, but that’s fine.

[00:32:22] Alan

The other idea that comes into the mix when people think about this whole debate as well is the idea of capping the equity beta so that you don’t get caught with a large equity beta at a turning point such as in a February 18 scenario. What’s your thoughts on that as part of the mix in terms of the crisis have a discussion?

[00:32:44] Katy

So this is also a good question, because it’s a trade-off. If you take a bunch of people who are running on a team, have you ever watched somebody play that sack race where they have to have their legs in the sack? With any strategy, there’s always a trade-off to putting constraints, so you can’t run as fast when you’re foot is in a potato bag. So there’s a trade-off between the constraints of constraining your portfolio so it can’t be as opportunistic, but the advantage of understanding the real objective of the client. This is where it goes back always to the objective of the client.

If a client is looking at trend following as crisis alpha specifically to equities only, and they’re very direct and clear about it, there are many ways where you can think about making this particular approach palpable for them. So, we have many different solutions that we’ve studied and designed in this area where you make what I would call a trend system equity aware. So an equity-aware trend system is a system that either avoids equity to some degree or even filters equity signals to some degree to prepare it for those difficult environments for equities.

Now, when you look over time, what’s interesting is you end up with a lower Sharpe ratio on average for this strategy, but it can occasionally have a little bit more punch when there is an equity-type crisis move. So, when we design these strategies, we think about the concept that there’s a volatility mismatch between equities and trend. So trend, as systematic managers we manage vol; we’re always looking at vol and we’re adjusting. When vol goes up, what do we do? Delever. Whereas equity strategies, and most equity investments that people have, have widely time-varying volatility. So when equity vol goes up, and we delever, we’re actually now mismatched in our portfolios.

So if you really, really care about the global optimal solution, you actually might want an equity-aware strategy. The other challenge with that too though is now your new benchmark is how do you perform compared to other trends strategies, because now you’ve also created some deviation from trend as a whole and you’ve tied the strategy a little bit in terms of its ability to adapt to equity markets as one of the four key asset classes. So, these are small trade-offs, but they do create return dispersion. We actually monitor how they compare in certain years.

When equity is a positive contributor like 2021, those strategies underperform. But in a year where there’s a big equity crisis, sometimes they’re less exposed and they can perform a little better. So it’s really which return stream are you looking for and what is your objective as an investor.

[00:35:41] Alan

Just a general question. We don’t want to kill crisis alpha completely, beat it to death here. Obviously, you coined the phrase so you must think it’s a good thing. But is there a risk with overegging the crisis alpha characteristic do you think in the eyes of the investor from the perspective? Obviously, when you get a crisis move, we don’t know what the shape of that move is. It could be any given crisis. You could have lots of reversals in lots of different markets from currencies to commodities. So can people get too enamored with the crisis alpha concept to the detriment of being aware of the scope for reversals in a crisis?

[00:36:26] Katy

Yeah. This is why this is a great question. I’m so glad to talk about this with you guys because if you talk to me, somebody who came up with this concept of crisis alpha, I see the two things as separate. I see crisis alpha as this thing that we all want. We all want positive returns during stress, whatever stress it is, but we’re trying to find what strategies might get it, and when, and what type of crisis can we capture. So, when you have that segregation, then it’s very clear. What you’re pointing out is that the challenge is that people love to label stuff. So they think, “Okay, this is crisis alpha.” And then they give you a call because they’re like, “Isn’t this a crisis? I’m sure this is a crisis, Katy. Why don’t you have positive returns?” So that’s where the challenge comes in.

I’ll tell you a funny story about this as well. Back in 2018, we did a lot of backpedaling. We did a lot of talking about crisis alpha because everyone said, “Oh, my gosh, there’s a crisis. It hurt me. I’m upset. Where are you? You’re down? What’s happening?” Trend was down. So what was interesting then, we wrote a paper called Crisis or Correction, because we were trying to also explain that not all events where returns are down are crises. There is crisis and there is correction. And then this year, we had a ton of corrections, not crises.

The reason this was exciting to me is I had one particular CIO of a consulting firm and he came to me and he said, “These are the slides. I showed them to the board. When I could give somebody a new term, suddenly, they understood.” So I said, “Okay, this is a success.” That’s why our field is so fun, because education is important and understanding when something works, when it doesn’t, understanding the segregation between crisis alpha and trend following is very important, because they’re not the same. Trend just happens to be one of those strategies that sometimes captures crisis alpha, but guess what? There are others too, and sometimes, cash can give you crisis alpha, just having money and being liquid during something difficult.

I always thought about the example of Warren Buffett. He did super well during the global financial crisis. Did he time it? Did he do trend following? No, no, no. He just had cash and so he went in when things were undervalued. So I think the point is crisis alpha is a term that is segregated from trend, but trend is a strategy that sometimes captures it. So if you can explain that to investors, I think they start to think about it differently.

Some of the pensions that we talk to, that’s exactly what they’ve done. They’ve created buckets of investments that they think might do well in stress. They like to call them risk mitigating, which I’m totally okay, I think that’s a great word. They’re looking for stuff that’s going to do well in difficult times, and that is a bunch of different things. They tend to like trend, but they like other things as well. So I think that’s where the distinction is.

[00:39:30] Alan

Very good. Before we move on to research, Niels, did you want to come back in on this or any other follow-ups?

[00:39:37] Niels

I don’t think I want to do more on that, but I can squeeze in maybe a smaller topic, and then you can dive into more researcher Alan. That is you mentioned yourself, Katy, CTA replication. I don’t know. I didn’t fully understand whether that’s another thing you do or whether you look at what you do generally in the bigger fund as a kind of CTA replication, but be that as it may, it’s been around for a while. It has had new life blown into it last year because there is now a replicator of the SocGen CTA Index that grew a lot, and now there’s a replicator of that replicator that even adds twice the leverage. What could possibly go wrong with that I’m thinking?

But I’d love to hear your view because if you’re doing “CTA replication”, I’m sure you’re not doing it as a linear regression of trying to figure out what people’s positions are. So can you talk about, from your point of view, the pros and the cons a little bit about different types of CTA replication and where you sit on this topic?

[00:40:42] Katy

Oh, that’s a great topic for me because we’ve been doing replication of multiple forms within our firm for quite some time. We launched one of the original hedge fund replication strategies at the onset of the buzz about liquid alts. We run hedge fund replication as well as CTA replication strategies in another program, not our managed futures program. We do believe that there are some positive characteristics to capturing some of the key dynamics of certain strategies in a simple and pure form. But the one thing I want to highlight here is that a lot of people in our space, they really get confused by this concept of correlation.

So it’s very, very easy to replicate correlation to trend following, correlation to hedge funds. It’s not always as easy to replicate exact returns. So, people will get very excited because they say, “Oh, I can do 90% correlation. Oh, my gosh. I replicated it.” There are even books out there of friends of mine and people I know who have published and said, “I can replicate CTAs.” I agree, you can, but at the end of the day, the devil is always in the details. When we talk to institutions and even retail investors, there’s a difference between a replicator (and it has a role in certain environments), and there’s a diversified program that has multiple 90 markets.

That’s why you see the ecosystem developing, that you have just a range of products, they have different goals, different audiences, and I think that’s a good sign because it means that we have this ecosystem. The trends strategies that are trying to move into more exotic alpha and all this type of stuff in exotic markets, all the way down to the other end of the spectrum which is, “Let’s just get some of the key macro exposures of trend because it’s easy to use an ETF, let’s do it.” So, we don’t have a view that one is right and one is wrong. We believe that the ecosystem is diverse and that those clients or investors that want pure trend or non-pure trend can be different.

The same with those that want an ETF. Because let’s think about it, a lot of people use ETFs today, and the retail space likes the idea of the ETF, and they find it’s easy to trade and include. So it’s a way for trend to get into someone’s program who may not use a mutual fund. So I think that’s an exciting area, but I think there’s an ecosystem and we believe that they have different goals. The one thing you’re going to notice, with an ETF versus a regular trend program, is the number of markets, and daily rebalancing and exposure.

In a very diverse trend program, you’re going to see 90 to 100 markets. So, you’re going to get exposure to the Indian rupee or Singapore dollar, and many different things, wheat, corn, coffee, all of the above. Whereas when you’re talking about an ETF, you are going to capture some of the core macro exposures and that’s going to be the focus. It’s going to be much more concentrated. So it’s going to be dollar versus euro, it’s going to be US-focused often as well. So the nuance may not be there, but the big picture could still be there. I think that’s how I see it. It really depends on the investor and what they want and what they’re looking for. Some are looking for a wide global exposure in an easy package. Others are looking for a diversified set.

So I think last year was a good example for the ETF world because the trends were very macro. And so big macro trends work very well some of the time, and sometimes the idiosyncratic trends are helpful. Actually, there’s diversification across those two as well so you can see. I see it as an ecosystem and I think it’s exciting that we have such a wide range of different things that we can do and cater to such a wide range of different trend following investors.

[00:44:55] Alan

Just to get a sense on research from the perspective of a pure trend follower. Obviously, one of the things that has been very topical in the last while has been machine learning. Going back a few years, everybody was really excited about the potential for machine learning when applied to financial markets and maybe that excitement has waned a little bit. You’ve mentioned the importance of adaptability and machine learning could potentially give you that, being able to pick up on shifts in markets.

What’s been the AlphaSimplex experience in terms of success with machine learning? I guess more generally, for the benefit of an outsider thinking about trend, if you’re a pure trend follower and the system is fairly stable, there’s probably a sense that not a whole lot changes over time. What are the big things that you can focus on as a researcher that can add value in a fairly stable pure trend system?

[00:45:57] Katy

Yes. So talking about machine learning first, machine learning is something we’ve been applying for many years in our program, and it has been a very positive contribution within our program. But we use machine learning with a sense of skepticism in the sense that we prefer simple machine learning models and approaches that are interpretable. So we prefer things that allow us to create a nonlinear response to trends. That’s the best way I like to think about it is that machine learning is… What is trend? Trend is that you have a filter. When things go up, how much position should you take?

So, what machine learning allows us to do is to have a more nonlinear filter instead of a linear response curve to markets, and it allows us to react at a speed that’s nonlinear; that can be either faster or slower in different environments. So that’s the way we think about machine learning. We think about it as another tool to allow us to be a little more precise in how we can react to different market moves by learning with past data and different techniques. This is exciting because we have seen that machine learning has helped us capture trends a little faster from time to time and even stay slower from time to time in different markets.

The way to think about that is if you just take a very simple trend system, we talked about replication, you can get a pretty good representation of trend. But if you want to do just a little bit better on the margin to something that’s a well-known strategy, you have to really be thoughtful about how could I be a little bit faster, a little slower, how could I react in a slightly different way that kind of tilts my system to better perform in trend environments. That is both at the signal level, and going to your next question, also at the risk management level.

So having a system that is adjusting its volatility in a way that captures opportunity sets in a concerted measured and organized fashion, but with attention to detail across the board. I think that’s where (going back to what you were asking me about replication) the devil is always in the details for these types of strategies. What makes a very, very sophisticated trend strategy is something that really pays attention to all of those factors and how they integrate to each other and thinks about some of the nonlinearities and some of the complexities of these types of systems.

[00:48:32] Alan

Interesting. Would you be able to say, can you quantify what’s the benefit of a sophisticated trend follower over a more simple trend following system? What kind of order of magnitude do you expect to be able to achieve those more sophisticated improvements?

[00:48:54] Katy

Remember, these strategies are not high Sharpe. But if you can add 0.1 Sharpe or if you can increase your Sharpe by a small amount, over a long run, it shows. So, that’s where the point of a sophisticated product is still desirable to institutions who have very long windows because they get it. They understand that in one year or another, it’s not going to be noticeable. But if you’re actually paying attention and concerted effort to really take as much extra information and process it in a good way, that you will, over longer time horizons, outperform.

So I think that’s where the sophisticated group of investors are really focused on that and see the value of having a diversified program or having a more complex program like the type of programs you see out there.

[00:49:00] Niels

Yeah. We may have some other topics we want to discuss, but we certainly also wanted to make space for some of the topics that you mentioned, Katy, and I will, in the show notes, have a link to the page where all of your insights are published. But you mentioned one thing in our conversation already, which is something you’re working on so I don’t think it’s even published yet. I don’t know if you want to start with that and give us a little bit of a teaser for what’s coming.

[00:50:16] Katy

Yes. Thank you, Niels. You know me for quite some time. Also, Alan as well. I’m a big fan of CTA style factors, and factors that help us to understand tilts in trend following systems. So the first time I wrote about these style factors was in my book in 2014. We talked about the CTA style factors, it’s in chapter 13. There, what we were trying to do is look at different tilts that people might choose within their systems. One was speed, another was equity bias, and the third one was size (so small markets versus big markets). Since then, of course, I’ve expanded my network of many different style factors that we study and we’ve written about them a lot at AlphaSimplex.

We designed a correlation factor, we also have a co-movement factor, and several other factors that we study. So this year, a new factor came into the play (which is very exciting), and that factor is the long bond bias factor. The reason this is important is, if you look at trend following over time (we talked about running with your leg in a sack), it’s the same thing with equity bias because equities tend to go up. We studied equity bias in systems to understand if strategies have a long bias to equities. The reason this mattered is during crises, that’s bad.

So you want to know if a strategy has an equity long bias if you’re thinking about adding it because you already have equity long bias so it’s one thing to kind of measure when you look at a trend program. This year, with the miraculous move in bonds, many people don’t know that it’s been 40 years since bonds really had a serious bear market. We actually wrote another paper called The Short on Shorting Bonds, we can talk about that later, where we looked at trend signals in fixed income over different horizons. What you find is that over the last 40 years, long signals are always better.

On average, it never paid to be short bonds, hence, the advent of an idea of this long bond bias factor. The truth is long bond bias didn’t matter for the last 20 or 30 years because you actually wanted to have it in general. But when you got to this last year where fixed income’s volatility doubled and we saw the real downside in fixed income, if you have a long bias to bonds, it would have been good for you but it would really hurt this year.

So what we did was we actually looked at (and this paper is very interesting), we looked at this long bond bias factor and we examined the impact of a long bond bias factor during 2022. But we also examined: how is it possible that a systematic manager, who’s supposed to be unbiased, has this bias?

There are three ways. One is you can easily add constraints and they can either be asymmetric constraints, like I won’t take a position on the short side more than x, y, z. Another is that you could add non-trend. We found that it didn’t explain it. So, you can have lots of strategies that are different. We found that actually didn’t explain the bias, so that wasn’t an issue. And then finally, we also examined machine learning. It turns out that if you have machine learning models (we showed a simple example in some of our work) that it’s very easy to learn a long bond bias in data just like it is easy to learn a long bond bias and equities.

So actually, the advantage of having machine learning is that you learn these good patterns. But when the patterns change, the question is, are your machine learning models adaptable enough to actually see that there’s a change in the data? So we found that this is an interesting year to talk about that because most of us haven’t thought about long bond bias, but it’s very clear, once this actually happened that we saw bonds down for a year, that it gives us a great time to talk about that and talk about long bond bias.

[00:54:37] Alan

Is that something that you were finding was prevalent across the industry?

[00:54:42] Katy

Yes. In this research, what we found was that there was a huge range in exposure to short bonds last year. If you think about a pure trend follower, you can kind of map what the desired positioning would be for a very simple (we talked about replication), a simple trend system. We were finding that there were two camps. There were some managers that had very large short exposure, and there’s some that had very muted short exposure. That had us scratching our heads like, “Wow, this is a really big trend.” Why is there only half a position, so five of the managers in this set of data that we looked at? We started asking ourselves the question, “What caused somebody to do that? Let’s think about it ourselves. Do we have this bias? Could we think about it?”

So we started spending a lot of time talking to clients about those positionings, because our positioning was very much consistent with a trend, very short bonds. There was such a diverse group. There were some that were very short and some that weren’t quite so much. And that made us question, is it the pure trend versus non pure trend? Is it just constraints? Could there be an explanation for this? So we designed this asymmetric long bond bias factor and we found that that could explain a good portion of the relative performance last year, because last year was really massive. The best trend last year was short bonds. Energies was good, so was the dollar, but it was really the year of the short bond trade.

[00:56:17] Niels

Yeah. Staying with bonds, I remember a few years ago that at least one, maybe two, shorter term managers came out suggesting that trend followers basically made all their money in bonds and once the interest rates would start to go up, they would not make any money from that. I think 2022 probably disproved that. But my question is, do we need to revisit that argument again or do you think that argument has been put to rest?

[00:56:45] Katy

I love that argument, because it was basically that people would say we only make money in long bonds. I just said, you know what the greatest trend for the last 40 years is? Long bonds. So what you’re saying is we’re following a trend. So I was confused. That’s what we’re supposed to do. I always said, what’s going to be interesting is when that trend is over, what happens next. That’s why looking at bond bias actually matters now more than before, because now, when we see this massive opportunity in the other direction, in a direction that’s very uncomfortable for a lot of investors. Our trend following strategy is following those. If so, if they are pure trend, they shouldn’t be. They shouldn’t have a bias long or short to either asset class and that’s why it was such an interesting year to talk about bond bias for me, and also to see how systems reacted.

I think the interesting part for me is that if you take a wide range of different trend models with multiple different signal response functions, most of them were very short bonds. So that’s why I was scratching my head because a pure trend strategy should follow the trend and it is short bonds and short bonds in spades last year. That’s where it’s sort of an interesting environment for us as pure trend that shows the differentiation between a pure trend and an approach that adds other things or tries to do different things or focuses on Sharpe, because Sharpe would have been higher if you had a long bond bias prior to this year as an example.

[00:58:25] Niels

True. The final thing it also showed I think last year was that if you look at some of the attributions and you look at some of the short-term interest rates, which were really difficult tor impossible to trade for a few years when they were basically pegged at zero or minus something. But we’re trend followers, we have this belief we shouldn’t just give up on a market just because it doesn’t perform for a period of time. And of course, last year, we got the payoff because a lot of the profits came from these short positions in the short-term interest rate space for sure. So another lesson that we were reminded of.

The final topic I wanted to bring up of the ones you came with Katy, and as I said, I’ll link to all of these articles in the show notes and then Alan and I will have some final topics, but it’s a topic that actually comes up a lot and we’ve discussed it on the podcast. I think people are aware of this more so than before, and that is the world has become a very uncertain place. You’re not aware of all that uncertainty. I think you’ve written about uncertainty in relation to managed futures, trend following if I remember correctly. Can you share some thoughts on that?

[00:59:43] Katy

Yeah, we have a great paper that we published last year called Managed Futures and Macro Uncertainty, and this was a fun one because if I create a synopsis of that paper, the one thing I like to say is managed futures and trend following is long macro uncertainty. What that means is that we like it. Anytime there’s stuff that’s really difficult or there’s change and the world is sort of in flux, that’s actually a very good environment for us because it means things move, things change, and unexpected stuff happens.

In this paper, what we tried to do is examine different inflationary environments, different macro environments. We looked at low and high macro uncertainty, we looked at rising or falling macro uncertainty, and of course, we find that high macro uncertainty and rising macro uncertainty is the most exciting for the strategy. But we also looked at how other asset classes performed during these periods. I think the key message that we were thinking about with this research in this discussion was this idea that when there is macro uncertainty, when things are changing, you don’t know how some of the core asset classes that you invest in are going to move and change. So it is actually very important to find strategies that like it, because most asset classes don’t.

Let’s take the example of bonds and commodities. People have forgotten about commodities because commodities struggle in a low inflation environment. In a higher inflation environment, suddenly, they become very interesting. On the other hand, bonds, which love low inflationary environments and we’ve seen it, struggle in a higher inflation environment and a rising rate environment. So really some of the things that are tried and true investments get in trouble when there’s macro uncertainty, when things change. So you want to think about what kind of strategies and approaches and which asset classes are going to be the most amenable to positive return contribution and diversification during a changing macro environment. There’s another buzzword instead of crisis alpha.

I like that view, because crisis is macro uncertainty. So they’re kind of similar. But macro uncertainty is a little broader way of defining it. Times where things are very, very uncertain. Crisis is one of those times, but as a broader tool, macro uncertainty is probably a way that you can think about trend following likes that type of environment as well. It kind of makes it a little bit more pluralistic instead of just equity-focused.

[01:02:18] Niels

I think to some extent, last year was a little bit of an example of that, because it didn’t feel like there was a massive crisis in equities. It was quite orderly sell-off. We know that obviously volatility strategies didn’t work because there were no spikes in volatility. So you’re absolutely right. It’s another term we need to talk about.

[01:02:40] Alan

Maybe to follow-up on that, it sounds intuitively appealing. Taking the other side of it, maybe playing devil’s advocate, when do we ever not have macro uncertainty, you might say? Maybe the more general point is trend in a multi asset portfolio or allocating to trend, the Holy Grail is around the timing and nobody’s been able to crack that one yet. But when you’re dealing with investors, is there anything you can give them to say in these types of environments, you obviously will expect trend not to perform as well? If you were looking for some potential signposts to say, okay, maybe the environment might not be getting as favorable for trend, what would you be looking for as possible signposts for that?

[01:03:32] Katy

I think anytime you have change and stress, it’s a good environment for us. I think 2020 was perfect. It basically changed the world. Everything has changed now from where it was before. So I think what’s interesting is most investors are constantly looking at how we can get back to where we were before, and you and I all know that it never happens. Whenever there is a transition, that’s a period that’s very interesting, because these transitions are stressful and you don’t know how things are going to react.

Actually, in my book with Alex, we looked at inflation over 800 years of data and we were also looking at trend following and just thinking about trend following as a philosophy. So buying things that are going up as things move over time more as a philosophical question than a strategy question. But we also did study inflation and what I never forgot was there’s a very clear pattern in high inflation or rising inflation that strategies tend to do better, and this is very, very simple. When things move a lot, when things are inflating, there’s going to be overinflation and underinflation, and then also when there’s a rising inflation, so things are moving at a much faster pace in terms of their rate of change.

Inflation is just a good proxy for things changing a lot, high macro uncertainty. So in an environment where you have high inflation or even changes in inflation, like deflation can even be interesting, because you end up in a situation where change and change is generally difficult and it takes time to understand the ramifications of change. So I think for us, understanding trend following as a strategy that does well when there’s a lot of change when things are difficult.

[01:05:26] Alan

Fair enough. So more stability of inflation, which is what we had, obviously, in the last decade is the obvious environment that would be more difficult.

[01:05:36] Katy

Honestly, the last few decades, all you had to do was buy equities, buy a 60/40 and everything was fabulous. I think that’s what’s scary for a lot of investors today is that was a pretty good way to go about things. If you could just buy the 60/40 and do really well, that’s nice, because a lot of investors really profited from that environment. The challenge is now, they don’t know what to do, because a year like last year has left a lot of people scratching their heads. “Where are my bonds? Should I hold bonds? Wait, oh, look at the yield curve. Wait, I get 3.5% for the 10-Year and 4.5% for three months. What does this mean?” So I think it’s a harder world right now that we’re in and difficulty creates opportunity.

[01:06:25] Niels

Yeah. I wanted to, and we do this with everyone. It’s a little bit of a trick question. But it’s not really a trick question, and that is, I’d love to hear the one thing you hear about trend following that you disagree with the most.

[01:06:43] Katy

I guess it goes back to what you said, when people say it’s going to work in crisis. I hate that because it means that they made the narrative too simple. So that’s what makes me nervous is when people count on it as a hedge. That’s when I react. They say it’s a hedge for equities. I say, “It’s not really a hedge, it’s a tool that might help you.” So I think that word “hedge” or “protection”sounds too promising to me. I think that’s where I like to think about things as a tool in your toolkit, something that might be able to help you that’s different, something that has a philosophically different view.

That’s why, especially when I speak to retail investors, one of the things I love to say to them is that example of we do what markets are doing, not what they should do, and most investors sit around thinking about what the value of the S&P is. They try and find the level. We don’t do that. We’re just trying to figure out where markets are going and move with them as information is coming in. That means that we’re going to react very differently to environments, which is diversification. So it’s philosophical diversification.

When we see things that are uncomfortable, we don’t ask those questions and we don’t have to re-adjust all of our prior assumptions. So that makes us just philosophically different. I think that’s the way I like to think about it is not thinking about I’m putting this in because it’s a guarantee. I don’t like that. I don’t like the word hedge. I don’t like the word protection. I don’t like promises with things that have a lot of risk. I think I’m more into thinking about a tool, seeing investments as a tool in a toolkit.

[01:08:30] Niels

I like the fact that you chose that Katy, and I also like the fact that you touched upon something which I don’t know if there’s written enough about this. This is maybe something for you Katy to do, and that is the benefit of the diversification of the investment process that we bring. We often talk about diversification in terms of return streams, but actually, the investment process is really what is also part of that power that we can bring to a portfolio not just the markets, not just the returns, but just the whole process. But that we’ll leave for next time we have you back once you’ve written that paper, Katy.

I do want to end up with my final question and that is just simply, what are you most excited about as you look into 2023 and maybe also if there’s any concerns that you have on the radar?

[01:09:18] Katy

So the things I’m the most excited about are that the world has changed and that inflation is higher, and that tactical strategies and tactical investments might have a chance to be interesting for the next few years. It’s been a very challenging time with globalization, sort of everything kind of harmoniously working. It’s been a great time to live, but I think for an investor and for investing, it has been less exciting. Since 2020, the world has changed and there’s opportunities and so I think as a trend follower, what I’m excited about is what are the next trends and what potential areas are we going to find interesting opportunities?

I think it’s exciting that commodities are definitely something that people are following and thinking about. You’ve also seen currencies being an important trend recently, which is also diversification. And then just the fact that we’re in a rising rate environment, and rising rate environments provide a very, very different opportunity set and I think that’s exciting. As one last point, I’ve kind of plugged that one paper that I really like, the Short on Shorting Bonds, we just highlight the results to give people an idea. During rising rate environments, short signals worked a lot of the time, especially in inverted yield curves, and we’re already in an inverted yield curve environment.

So I think we’re going see some really interesting patterns of opportunities that haven’t worked for a long time. Hence, it’s going to be an interesting world to invest in.

[01:10:53] Niels

I couldn’t agree more. What a great way to wrap up our conversation today. It’s been fascinating, as always, Katy,. Thank you so much for being on the podcast, again, and sharing your thoughts and your insights with us. We hope, of course, that we can do this again sometime in the future.

To all of you listening today, I hope you were able to take something from today’s conversation onto your own investment journey. If you did, please share these episodes with your friends and colleagues.

From Alan and me, thanks so much for listening. We look forward to being back with you on 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 the other resources that you can find on the website. Not least, take care of yourself and take care of each other.

[01:11:39] Ending

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