TTU141: Douglas Greenig, CEO of Florin Court

[00:00:07] Douglas

Obviously, we had entered a world where central banks were applying huge amounts of liquidity to the global economic system. Liquidity kind of fixes everything until it doesn’t, until it causes inflation, until it increases imbalances that ultimately end up breaking things. But I think we’re returning to a more normal world. People can’t get past their anchoring bias. Also, the notion that there’s a burst of volatility when trends reverse and change direction, that’s universal.

The Minsky moments and the anchoring bias, they’re here to stay. I don’t think that trend following is in any sense obsolete. I think that certainly when you apply it in relatively green pastures, relatively fresh places, there’s quite a lot left for the future.

[00:01:11] 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.

[00:02:06] Niels

Hey everyone, and welcome to another edition of Top Traders Unplugged, where today, Alan Dunne and I are joined by Douglas Greenig, CEO and CIO at Florin Court Capital 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, Doug, it is great to have you back on the podcast after a few years. Thank you so much for joining us today. We have very much been looking forward to our conversation because I know it’s going to be a little bit different to some of the other ones we have in the series. I hope you’re doing well where you are.

[00:02:39] Douglas

Very well, very well. Thank you very much for having me on. Hello from Abu Dhabi.

[00:02:47] Niels

Hello to you. Now, before we dive into the different topics that we’re going to be covering today, as we do with all the guests, we would like to just set the stage a little bit. So if you don’t mind, Doug, can you give us a brief highlight, summary, or whatever you call it, to Florin Court and where you stand today in terms of the business?

[00:03:11] Douglas

Absolutely. We’re now approaching the sixth anniversary of the Florin Court Capital program which is a systematic trend following program focused very tightly and exclusively on alternative markets. We’re very proud of our results over the last six years. You mentioned an excellent year for CTAs in 2022. We had that, but we also had an even better year in 2021. We’re approaching now I guess about $2 billion. We’re on our way to 2 billion in AUM and things are going very, very well.

[00:03:53] Niels

Glad to hear that. Now, Doug, I want to do something a little bit different with you as the first topic because although we normally don’t give much room for outlook and macro views, and that’s purely because we are systematic in nature of course, I do want to ask you about this because I know you have a deep background in macro and you follow this, but also because I know you have some opinions and ideas about how this might relate to trend following. So do you mind talking about this before we kick off our usual topics?

[00:04:28] Douglas

I’m glad to. You see, allocators, of course, are very interested in the kind of environment in which they’re allocating. They’re trying to make decisions. How much trend should I have? How much should I have in quant equity long-short or other strategies? Trend is particularly suitable for an environment that will be characterized by instability, regime shifts, and major changes.

If you think back to some of the great years and trend following, those were years where big things happened, for example, 2008 or last year with the fight against inflation that we’ve seen across the world. I just want to point out to people that I think I have never seen a more difficult, unstable, fundamentally unstable environment than we’re seeing today.

This matter came up in a great interview you did with Nigol and Michael Harris, the point is, we have an extremely unstable situation now. We have very high debt burdens across the developed economies. We have a situation where we’re attempting to decarbonize. The reality is that carbonization played such a crucial role in the creation of modernity.

In fact, our prosperity has a great deal to do with the fact that we have, I don’t know, five times more usable energy per person than we did a couple of centuries ago, and we want to jam that in reverse, because we have to, in a couple of decades. We’re creating a situation across many dimensions: political, economic, energy; look at these different things where there’s a huge amount of instability. So I think allocators need to be thinking really hard about how they want to own the tails instead of getting owned by the tails. I think trend fits into that.

If anybody thinks this is a really stable, nice environment that’s going to settle down, I’d like them to call me and explain to me why and how, because I’m not seeing that. Instead, I see an outlook full of a great deal of uncertainty and instability, as we have been seeing in the last couple of years.

[00:06:58] Niels

Yeah, I completely agree with that, Doug. I’m sure Alan does as well. We, of course, in our other Global Macro Series, we’ve talked a lot on these different topics and I think you make a compelling case, as we generally do, for why trend following should be a part of the portfolio.

Now, let’s get back to our regular programming here. What we normally do, of course, is that we have Alan kick off the first topic and then we just see how the conversation goes. So Alan, good to see you. Where are we heading?

[00:07:31] Alan

Thanks, Niels, and good to speak to you, Doug. You outlined the nature of the Florin Court Capital program with that focus on systematic trend following and a focus on alternative markets. So I guess the question is, why trend following and why alternative markets?

[00:07:51] Douglas

Well, trend following is a kind of evergreen strategy that has worked very, very well over the years. There are folks who have gone back and looked at a century of data, even two centuries of data, and of course, we have the direct experience (in recent decades) of systematic trend followers. It’s a strategy that works well for a good reason, and that is, trends tend to reverse with a burst of volatility. That interplay of volatility and trend is actually key to the process. Think about, for example, a Minsky model.

Charles Kindleberger in his book Manias, Panics and Crashes presented a narrative model for how bubbles rise, get big, and then burst. But the same thing actually happens at a smaller level. A trade will appear appealing, there’ll be a good idea behind it, it develops momentum, more people pile into that particular trade (whether it’s a big one or a small one), it goes to a certain point, it gets overextended, and then there’s a bit of distress and increased volatility as a general rule, and then it reverses.

Capturing that trend and then getting out when you get that burst of volatility is the essence of a good trend following program. That’s why rapid vol scaling is so important. So trend is a wonderful strategy that depends largely on the behavioral bias of anchoring. People have trouble interpreting new information without reference to the past. They probably should look at the past. But it means that when novel things show up or there are big dislocations in the macro environment (such as the environment we’re in now), things don’t necessarily move where they need to go as quickly as they should. No one is actually sure where they need to go. There’s a process of price discovery. You get that trend.

So trend is basically a pretty wonderful strategy. I don’t think I need to convince you guys or your listeners. You know why it’s good. Although the role of volatility around trend reversals, that I just highlighted, is underappreciated for sure.

[00:10:19] Alan

Why take that philosophy and apply it specifically to alternative markets?

[00:10:25] Douglas

Well, as other guests have commented on and as you guys know (you’re super experts), trend following will often go through periods of (what should I say) quiescence, where you’re not making a lot of money. Sometimes, people have trouble hanging on to trend following in those periods. They have that tail protection and they’re sort of paying some money for insurance or it’s kind of flattish, and nothing’s really happening, and can you really wait for the next big thing, which, of course, no one ever really knows exactly when that will come along.

So there are a number of different solutions to this. One solution, that I don’t particularly like, is to reduce the convexity that you’re creating through your trend following trading. Because remember, when you’re trading trend, if you’re doing it in a pretty pure way and you’re doing it fast enough, you’re synthesizing convexity. So one idea is to sort of collect risk premia, to sort of sell some convexity (in certain places), and earn some extra carry to try to ride out those periods. I think it’s a bad idea because I think it dilutes the great benefits of the trend following program; the positive skew; the so-called crisis alpha and all that.

But there’s another approach, and that’s to increase diversification. The way you increase diversification is you add new markets that are genuinely diversifying. When you add a market like regional carbon emissions in the US, that’s genuinely diversifying to the kinds of things that you are likely to have. If you add Malaysian palm oil; when you talk about emerging market interest rates, Turkish interest rates, Colombia, these tend to be pretty different from the standard CTA markets.

As a consequence, you end up with a sufficient number of relatively independent bets and ideas. There’s always a trend going on somewhere, and as a consequence, the returns are better. In addition, things are less crowded and less kurtotic in the world of these alternative markets. So you have better diversification, better trends. Following Papa John’s slogan, that makes better pizza. There you are. That’s why we do what we do.

[00:13:08] Alan

With managers who focus on alternative markets, and obviously, I guess you have two types of managers. People who trade the major markets and add alternative markets and other people who maybe focus on the alternative markets. One of the arguments for the alternative markets is, as you say, maybe they’re less crowded, maybe they’re less efficient, not as many people trading them. So maybe they trend better.

Is that a big part of the opportunity there or is it just that they trade about as well as the major markets but adding them gives you that diversification?

[00:13:44] Douglas

The diversification argument is certainly correct. That’s indisputable, really. However, the better trends argument is probably true, but it is harder to demonstrate. The diversification is just straightforward. Either way, if you do pure trend following across a big set of alternative markets with roughly double the Sharpe ratio over the past decade or so versus standard markets trend following, you retain the nice skew, the nice tail characteristics.

It’s a good way to do things because you don’t want to become less like a CTA by having risk premia strategies and junk and filler in your program. Instead, if you just expand out the diversification, you’re going to get a lot of benefit and you probably get some better trends too.

[00:14:46] Alan

Just for the benefit of our listeners, within your program, your focus, is it purely on the alternative markets and you’re not trading the major markets or are you trading both with a heavy emphasis on the alternatives?

[00:15:00] Douglas

We’re about as pure as you can get in the alternative markets. We will trade something like New Zealand interest rate swaps, but we’re staying away from US and G3, IRS and bonds. The focus is very purely on alternative markets and there’s good reason for this too.

If you’re talking to us about potentially allocating to us, the odds are extremely high that you’re already an experienced CTA investor, you already have that exposure to developed markets, and you don’t need more, you don’t need overlap. So the point is, we offer the orthogonal alternative markets pure play that will be very additive, we hope, to what you’re doing.

[00:15:55] Alan

Great. Niels?

[00:15:56] Niels

I want to stay a little bit on this and maybe kind of mix some of the topics up that we have because you open obviously an interesting set of areas where we can go and it comes down to the fact that you are focused on these alternative markets, as you say, Doug. You do two things that I find interesting.

On one hand, you say, “We are very, very pure trend.” But then at the same time, you reference the Sharpe ratio, which is something that normally pure trend doesn’t do so well. In fact, as we know from Cliff Asness’ paper last year, he’s arguing or he’s questioning whether we, as CTAs, even should care too much about the Sharpe ratio per se because if we do, we may lose some of the things that people (those of us who love trend following) actually see as a benefit.

So I’m curious about your view on Sharpe. Is that something that you really pay a lot of attention to or is it just something where you say, well, if I compare what we do and what a traditional trend follower will do in the liquid market space or traditional market space, we think there is a benefit of Sharpe purely from the diversification “if the trend side is more or less similar?”

[00:17:21] Douglas

Sharpe, in itself, is a very incomplete measure. That is a completely correct point. You need to care about skew, you need to care about kurtosis. You need to care about drawdowns and not just a daily or weekly Sharpe ratio. But my point is that you can take trend following, keep it pure, own the tails, focus on crisis alpha, not dilute it one bit and get a much better Sharpe ratio because you’re willing to do the heavy operational lift to trade a much bigger set of diversifying markets.

It’s not about adding more line items, it’s about having really diversifying different things in there. But by trading them with trend, you’re getting good Sharpe. You’re not getting, shall we say, a sort of diluted, crappy Sharpe where your skew is reduced or where you’ve gotten yourself more kurtosis.

[00:18:33] Niels

Now, you mentioned another term that, of course, is also certainly associated with CTAs and trend following. That’s the crisis alpha term, which I think also Cliff Asness referenced in his paper where he talked about do we have this dual mandate of absolute return as well as producing crisis alpha?

But actually, during this series of conversations Alan and I have had, it certainly has become clear to us, I think, that the term crisis alpha has kind of gotten lost in translation since it was originally invented and to what people think of it today. How do you view it? What do you associate with crisis alpha, Doug?

[00:19:14] Douglas

Well, it is a slippery term. You have to define what you mean by a crisis, and to some extent, the term was invented by CTAs who don’t have very good day-to-day risk-adjusted returns but occasionally make a lot of money when there’s a major dislocation. But I don’t want to use crisis alpha as some kind of an excuse for poor day-to-day returns because you can actually have them both. You can have reasonably good day-to-day returns and have performance in large dislocations. But basically, the notion is that when there is a major sustained move in markets, it needs to be major and it needs to be sustained a bit. You want to be able to perform. That’s usually associated with moving from one kind of regime to another.

For example, moving from the Great Moderation, where inflation was under control, or the Great Liquidity (I don’t know, maybe not the best term but it’s the term that I can use for the post-great financial crisis period when central banks sprayed the world with so much liquidity), moving from that to an inflationary environment is a big, big regime shift. It will involve a big, sustained move.

By the way, anchoring bias was very much in evidence because people just couldn’t quite believe where interest rates were going, so it had to get there step by step. Capturing that, that’s an example of the sort of regime shift alpha. Another example was how there’s been a regime shift in terms of energy security.

Returning to my macro comments for one moment, we had it very nice in the post-World War II period. Relatively speaking, the world was unipolar. There was, in general, low energy costs. There were a lot of things like globalization. You had a lot of things working for you. Now, so many of those things are in question or are crumbling. We’re probably moving to a multipolar world. The era of cheap energy is probably kind of behind us. We’re running into various resource constraints. There are a lot of things going on.

Now, those things represent regime shifts. That is precisely why I tend to think that we’re going to see some major sustained moves in markets as they look for a new equilibrium for this new environment. So maybe we should call it regime shift alpha instead of crisis alpha. But oftentimes, regime shifts and crises coincide. A crisis is a regime shift that happens very quickly perhaps, but it sometimes can be other things.

[00:22:29] Alan

I think it’d be good to delve into some of the issues around alternative markets and the philosophy of focusing on that. It opens up a lot of issues. The obvious thing is liquidity. Obviously, you have to satisfy yourself when you’re moving into these less traded markets that the liquidity is there. So that’s one thing. How do you get comfort around that?

But the second thing is, are the nature of the markets themselves stable and continuous enough to be able to trade confidently as well? Say if you take something like, I don’t know if you trade the VIX, but the nature of the VIX, the return distribution is very different from say the S&P 500. You’ve got much fatter tails, you’ve got potentially discontinuous moves like we saw in vol-mageddon.

When you’re assessing individual markets, how do you get comfortable that they will be stable enough to trade and that liquidity is there to execute?

[00:23:34] Douglas

Well, you study them carefully. You study the distributional properties of the markets, you do the work needed for that operational lift, you understand the details of trading those markets. It’s a process we’re super, super familiar with. We add 50 new markets a year, 50 to 70 new markets a year, like, for example, those regional carbon emissions and all sorts of stuff.

So we’re sort of specialists in this process, which is precisely why you probably don’t want to go with folks that don’t do this for a living. This is all we do. That’s it. You mentioned something like the VIX, you will notice that it has very different distributional properties. By the way, why would you expect the VIX to trend?

The one case where it used to be arguable that the VIX can trend is simply because there was a term structure to the VIX that was excessively upward sloping and so you’d roll down, you get vol roll down, and that would impart a small trend. That’s probably true.

But as we saw in vol-mageddon, the tails are huge there. In general, we like markets that don’t have extreme kurtosis. With volatility scaling, you can manage your vol. You can manage skew with choosing the right trend models. You can manage it to a degree. Kurtosis is something that’s very difficult to manage. The only thing you can do is be very small there are ignore it entirely.

It’s not necessary to trade every market in the world. Let’s trade the ones that are suitable for trend following and have nice distributional properties or are orthogonal, more or less, to the things that we do, and there are a lot of markets around the world like that. It’s not impossible to find them at all.

[00:25:40] Alan

Maybe just on that point, if you could give us a sense, as you say, there’s so many markets you could trade. Obviously, everybody’s talking about carbon emissions, European power and gas markets, etc. But once you move beyond the standard 50 or 80 markets, futures markets, there’s ETFs, there are single stocks, there’s sectors of stocks, there’s synthetic spreads.

So how do you look at that whole universe and determine, okay, this is a suitable market to trade, it could be diversifying, it’s going to be valuable enough for us in our portfolio?

[00:26:19] Douglas

Well, first off, we very much like interest rate markets, interest rate swap markets around the world. They’re very interesting. They tend to be markets where you can make money. We trade dozens of markets and interest rate swaps, and it’s been a very productive sector for us. Obviously, we try to get as much exposure to power markets everywhere, not just Europe. We’re involved globally in power markets. So those are very good things that are sort of orthogonal to other stuff.

We tend to not emphasize equities very much. It’s our experience, it’s our view, that CTAs who delve deeply into equities don’t usually do as well as specialized equity managers. There’s a very advanced game in developed market equities, and by and large, CTAs aren’t playing it. However, emerging market equities are potentially interesting and simpler things can work there.

Then we have credit markets. The main challenge in credit is there tends to be a bit of an asymmetric distribution, things widen faster than they tighten. But there are things you can do with the modeling to try to take that into account, and we do that. Commodities are, again, very interesting.

We’re obviously very involved with the Chinese commodities markets, we have been for years. They’re liquid, they’re big, and there’s a bit of an operational lift to get involved as in these other markets. That’s the distinguishing feature, not low liquidity. It’s the operational lift and also just doing your homework on talking to the market participants and making sure that the liquidity you think is there is there. So it requires specialized attention to do this stuff, and that’s what we do.

But liquidity, the markets that you don’t like (let me make one more observation on liquidity, what I don’t like is some crappy, ignored market that nobody cares about; some futures contract that no one’s interested in and it’s illiquid all the time. What’s more common is a market like Turkish interest rates, where most of the time, it’s reasonably liquid, and occasionally (during a crisis) it sort of becomes illiquid, but it’s usually moving your way.

Because as a trend follower, as things start to break apart, for example, you will be getting short. So it will be moving your way and it results in an exaggerated move in the direction that you’re already trading in. So most of the time when an emerging market has a problem (I’d say about 80% of the time), we end up doing pretty well as a consequence.

[00:29:22] Niels

Can I just jump in here with a question? (Sorry, Alan, to interrupt your flow here.) You mentioned a few things that I highly agree with, but it also makes me a little bit curious in terms of your view on it. You mentioned regime change. I agree with that. You mentioned that the world is going from a globalized world, since the Second World War, into a deglobalizing world. I completely agree with that.

But here’s the question then. I can fully understand that in a globalized world where everybody is friends, we all trade together, it’s not a problem trading with the Chinese. But in a deglobalizing world where we already now see a war with Russia, we don’t exactly know where China stands on this (will they get more involved or less involved), there might be other countries that we’re not as friendly with as we were a year ago.

We have already seen banks go down, so counterparty risk has come in. We’ve been reminded that there’s something called counterparty risk. Of course, CTAs have always been known for being on exchange yet when you have to trade alternative markets, you have to go off exchange.

Is there anything, in your view, Doug, that may suggest that there are some new risks in being off exchange in alternative markets in countries that are no longer our great trading partners, etc., that might make you a little bit more cautious or maybe do things differently, operationally perhaps, to how you were doing it when everything was great and hunky-dory?

[00:]31:05 Douglas

You bet. That’s a great question. First off, you should always, as a CTA, be thinking very, very carefully about counterparty risk and bad situations. Because a lot of the times, our best profit opportunities, we do the best in some bad situation, and you don’t want to be hobbled by some counterparty problem in exactly the situation when people who’ve invested in you are expecting to do well, and maybe your positions are doing well but there’s some issue. So we think about that stuff all the time.

So first off, we absolutely minimize bilateral kind of counterparty risk in a lot of the stuff that we trade. Even if the trade was done off exchange, it is cleared through the exchange. That takes counterparty risk off the table. In many cases, we’re able to novate what we do so we’re only facing the most credit-worthy counterparties. We’ve thought about this issue very much in trying to figure out how onshore we want to be with China. Because we do a lot of trading in Chinese commodities, and then the question is, how onshore do you want that to be?

We were a pioneer in doing this offshore through swap structures. We were one of the very early, early people in all of this. The advantage of that is you don’t end up with a situation where money gets trapped onshore if a dispute arises between the US and China. Just to be clear, I have a pretty positive view of China and I think China has been playing nice on the international scene, at least it has been doing so in recent years. But the problem can arise also from the US end.

There’s a lot of political momentum behind getting tough on China, sanctioning China, giving people a hard time if they’re too engaged in the wrong way. You saw the semiconductor sanctions, which were, in my opinion, a very aggressive act on the part of the US. So you have to be thinking about these things and make sure that the way you do business is going to be robust to the kinds of problems that are likely to arise as we move to a multipolar world and as the US-Chinese frictions probably increase. I hope they don’t, but they’re likely to.

[00:33:41] Alan

Maybe just picking up on a couple of things that were mentioned earlier. Doug mentioned 2022 was a good year, but 2021 was an even better year. Obviously, when you trade a lot of the alternative markets, I’m guessing you’re getting exposure to lots of idiosyncratic risks in those markets, whereas 2022 was more of, I suppose, a macro dislocation, and obviously a big move in traditional markets in bonds.

So I’m just curious, do you think that that kind of crisis (well, I’m not going to call it a crisis alpha characteristic)… but that ability to make returns in equity downturns, is that as stable, do you think, as the alternative markets given that maybe they’re not as linked to micro factors maybe as being a driver of those markets?

[00:34:44] Douglas

Well, that’s a really interesting question. I thought about this, and the answer is not clear. Because alternative markets are very linked to macro stuff. It’s just a more global view of what’s macro, a more inclusive view of what’s macro. For example, 2021, we did very, very well in commodities and that was a macro reopening story, in large part, and not so micro. We did quite decently in fixed income because 2021 is when we started to see emerging market central banks take the lead. They were moving first before the developed market central banks were really focusing on inflation.

Then, of course, there were the power markets in 2021 where we saw some big trends. There were big trends in 2021 long before the Ukraine situation really blew up. So, there was a good mixture of stuff. Yes, we definitely can catch idiosyncratic trends. But I would say to be honest, we’re not making our big money from a big idiosyncratic trend in New Zealand milk. That’s not where the money comes from. It comes from big things like emerging market interest rates moving higher or a big regional shift like Latin American currencies or interest rates. It’s nice to make money on idiosyncratic things.

Of course, as I said, we’ve done very well in some of the emerging market countries who have regrettably made policy errors and have seen falling currencies and spiking interest rates. I’d say we’ve done pretty well in Turkey let’s say four times in the last five years, something like that, with those kinds of situations.

[00:36:42] Alan

I know a number of markets is a topic close to Niels’ heart, so we’ll go there. But maybe just on the whole topic of maybe alternative markets. You mentioned interest rate swaps being a very interesting market. Obviously, what you have in a lot of countries, you don’t have maybe a local bond future, but you have swap markets so now that facilitates trading interest rates in those markets.

Do you think in 5, 10 years’ time, those markets won’t be regarded as alternative from a trend following perspective and most CTAs will probably end up trading those ones as well?

[00:37:21] Douglas

It’s hard to know. Obviously, there is, over time, a tendency for markets to become more popular and commoditized. I would say there’s been some pretty decent CTA participation in the very basic European power markets, Felix and Nord Pool and stuff like that. Interestingly enough, it hasn’t hurt the returns. The last couple of years have been outstanding in the power markets. So it’s not clear that more CTA participation, up to a certain point, will be a bad thing.

It is probably clear that if you have only CTAs participating or mostly CTAs participating, which might be the case in some, I don’t know, some of the markets on the London metals exchange have some very heavy CTA participation, probably the Sharpe ratio has declined in those. But as I pointed out earlier, the key to our good risk-adjusted performance is first and foremost diversification. I think these markets will continue to be diversifying.

If you count the number of independent bets using statistical methods in a regular CTA portfolio versus the sort of portfolio we trade, the number of independent bets is up by something like a factor of 4. That roughly means risk-adjusted performance is up by a factor of 2, and that’s what the experience has been. So it is probably true that more CTAs will get into this, but it’s an awful lot of work in some cases, and that’s part of the reason we keep adding more markets.

Every year, we try to add 50 to 70, and we’re finding them and they’re often very interesting markets. Whether you’re adding, as we did a few years ago, wet freight from the Middle East to the China Gulf, which actually behaves quite differently from container freight. So there are so many markets and hopefully, by focusing on this one activity, you know, we can end up being the best or one of the very best at it.

[00:39:49] Niels

Well, maybe the LME is going to come out with this new market called stone because apparently when you expect nickel delivery, you get a bag of stones.

[00:40:00] Douglas

What a debacle that whole thing was. What a debacle! I’m very glad I wasn’t involved in that. But I can understand the consternation of those who were there.

[00:40:11] Niels

Okay. Well, we’ve talked a lot about markets, right? Let’s not forget about the trend part you do. So I’m kind of curious in terms of when you decide to go down the route of focusing on alternative markets, do you have to do the trend following part a little bit differently? Do you have to slow it down for example? I just don’t want us to not talk about the trend part of your strategy, because that is equally important as the alternative market part.

So can you talk about the trend part, how you approach it, whether you’ve changed it over the years? Obviously, you came from a big trend following shop, so just generally maybe how you do trend following, perhaps, a little bit different to a lot of the people we’ve been speaking to on the channel if at all.

[00:41:06] Douglas

What we try to do is take advantage of model diversification. So we have a whole range of smooth momentum and, shall we say, breakout or jump momentum models being applied at once. We don’t want to overfit. I’ve heard some of your other guests talk about it and most of the good people get it about right, which is to say, you adjust models a bit for liquidity and for some special market characteristics, but don’t go too crazy because otherwise, you’ll just be overfitting the models in a terrible way and you won’t have gone out of sample performance. You want robustness.

I would say one of the things that we have taken into account is that in some of the markets that can move far and fast, we use a bit more breakout-type systems so that you don’t stay on the wrong side of a big, fast move too long. That’s something we care a lot about. The other thing we care about is the measurement of volatility.

There are better and worse ways to measure volatility for volatility scaling and we think we do it in probably one of the very best ways, because we’re using range estimators of volatility as opposed to what we think are much cruder close to close measures, wherever we can use those range estimators.

I would say the big thing that we do is we allocate differently. We are trying to maximize the diversification benefits in our book. That means that our capacity is smaller than others and we allocate more to a broad range of markets. Essentially, we’re sort of aiming to allocate about as much risk to everything.

Now, you obviously have to take some clusters and correlations into account. But philosophically, we want each market to be capable of moving the needle and we want to allocate in a way that maximizes diversification. That’s very different from a strategy of trying to maximize capacity. That’s what separates us, I think, from some of our peers. We know we’re not trying to be a $10 billion fund. That’s not in the cards for this program.

This program is going to be a $3, $3.5 billion dollar program when it’s completely full, and that’s what it’s going to be. That keeps us nimble, that keeps us small, and it helps explain why our returns have been, I would say, class leading, because you need to be the right size and you need to be very well diversified to get the full benefit of this alternative market philosophy.

[00:44:09] Niels

I completely agree. I appreciate that. But just for me to fully then understand, you are not necessarily trading all markets using the same models. You have a market model type combination? Is that correctly understood, Doug?

[00:44:29] Douglas

Yes, but it doesn’t differ that much. For example, if you’re trading in a market that tends to have some negative skew, then you might want to include certain kinds of breakout models to protect you in the case that market starts to take off to the downside. But generally speaking, we are using very similar models across all the markets with an appropriate adjustment for liquidity and slightly different mixes depending on some special characteristics that a sector-like credit might have.

[00:45:06] Niels

Okay, fair. In terms of other parameters so to speak, do you generally tend to use the same timeframe across markets or is that also more tailored? I know you mentioned just before that you slow down a little bit, but more generally speaking.

[00:45:22] Douglas

Generally speaking, there are some differences. We trade FX relatively quickly. The way we trade FX, it acts as a risk buffer, if you will, against slower-moving markets that we can’t trade as quickly. The return to trading FX is not that brilliant but the marginal effect on the portfolio is very good. In a certain sense, it’s almost like the effect of a CTA in a regular portfolio. Do you see what I’m saying? You put the CTA in there and suddenly it has a magical effect on the overall process.

Well, we found that we tend to do very well in our FX program in exactly those moments when some of the slower-moving systems in interest rates or in the other markets are getting hurt a little bit. So we go a bit faster there, for example. There’s a bit of difference from sector to sector. We’re probably quicker in Chinese commodities than almost any of our competitors and I think it’s worked out well for us. But the models are very similar. I don’t have to tell you this, you guys are experts, and many of the people listening in will know this, of course.

You don’t want to be overfitting. So you allow yourself a little bit of room to maybe trade this sector a little faster than that sector, or to include maybe more breakout-type models in this place as opposed to that place. But you really want to be absolutely mindful that everything you’re doing, you’re doing for a good reason, and that you don’t become backtest junkies. That is a very bad way to proceed.

We’re very structural in that way. In many cases, we’ll specify certain aspects of our model as opposed to estimating it precisely to avoid that backtest bias, if you want to call it that.

[00:47:35] Niels

Alan, where are we heading next in terms of topic?

[00:47:37] Alan

Maybe if we delve into risk management a little, just to get a sense on is the risk management process different once you delve into the alternative markets. I guess one thing I’m thinking about is if you trade lots of different markets (and Doug mentioned that the number of independent bets is much higher), you’re very much harnessing that low correlation across all the different markets. So I guess then you lever up because you get that diversification benefit. But does that give you a risk, a correlation risk of a sudden sharp change in correlation? Does that have to be managed? I guess more generally, is the risk management framework any different because you’re applying trend to lots of alternative markets than in the more traditional programs?

[00:48:30] Douglas

Well, the first thing to realize is we end up having a lot of small positions because as I said, we tried to spread the risk out in order to maximize diversification. We’re not using some delicate covariance analysis where you’re pivoting this against that. It almost has a bit of a 1 over n-like quality after taking certain factors into account. So we end up with small positions, relatively small positions in a lot of things.

That keeps us manageable. It keeps us nimble. It allows us to trade relatively quickly and relatively easily, especially when you combine that with our capacity; our sort of low-capacity approach. So that is a key element in the risk management. The other thing is that we do not take on a significant amount of equity beta in our program.

Again, I don’t think that fits in with the alternative markets approach. In general, it’s not a good way for CTAs to make money, I think. Certainly, I will leave that to the developed market CTAs to do that. For us, we stay within reasonably tight bounds in terms of beta exposure, very seldom being more than 0.3 or minus 0.3 on the overall book. That’s another component of risk management.

We also measure, as we size things, the realized correlations among the different components of the model and gear things dynamically so that we’re moving toward our volatility target. One of the things that’s unusual about us is we actually hit our volatility targets pretty accurately. There are many CTAs that don’t really hit their vol targets. Since inception, we’ve had a volatility target of 10 and we’re incredibly close to that.

I think we were like 10.03 when I checked a few weeks ago. In over any six-month period, we seldom realize more than 11 or less than 8 or 9. We’re right around that 10 mark. That comes from our continuously measuring the correlation and the volatility of the return streams from the various models and dynamically adjusting.

[00:51:25] Alan

So it sounds like that daily adjustment of position sizing is key to that. I suppose just following up on my question, I’m just curious, would you say is the gross exposure level of a program like this higher than you would get in a traditional market trend following program?

[00:51:40] Douglas

Probably very slightly. Simply because we have a lot of commodities, we have a lot of power, they tend to be uncorrelated with things.

[00:51:50] Alan

I guess you have to vol-adjust that gross exposure too, adjusting for that. You’re saying you have lots of small positions, but you have lots of positions.

[00:52:00] Douglas

That’s right. So the multiplier from that is going to be a bit larger.

[00:52:09] Alan

Maybe just one more on this topic. Obviously, you started off with referencing the macro backdrop. Is that something that you think having that macro appreciation becomes more important in market selection?

Niels mentioned trading Chinese markets, how much of a concern from a geopolitical perspective that we had an issue with China and you can’t get your money out of capital controls, we’ve seen this in Malaysia in the past. Obviously, we’ve had challenging conditions in Turkey recently. So is that something you think is important or not when you move into these more alternative markets?

[00:52:53] Douglas

It’s important from two angles. One angle, obviously, is you have to be aware about the political risks and stuff, and that’s precisely why we have chosen to sidestep the problem of having money stuck in China. We’re avoiding that from the way we trade. We’re in general dealing with counterparties outside of China who then have subsidiaries and so forth inside and so we’re sidestepping the issue to a very large degree. But it also points you in a different way.

I don’t know if you’ve seen the work of Vaclav Smil or Mark Mills. Certainly, you might have seen Robert Friedland, of Ivanhoe, talking about the outlook for commodities and the fact that decarbonisation is going to be an incredibly commodity-intensive enterprise. We need to rebuild the power grid to be able to handle electric vehicles and renewable sources of energy. Electric vehicles themselves need a whole variety of minerals in their batteries.

A lot of the changes that are underway right now point you in the direction of saying this is a regime shift for the molecular economy. In some ways, we spend too much time thinking about the digital economy. The real bottleneck is a bunch of molecules like nickel, and lithium, and copper, stuff like that. So with that in mind, I think it is very, very worthwhile to make sure that you have the exposure to those kinds of markets because that’s where I think a big regime shift over the next decade is likely to occur.

There’s been huge under-investment, I might add, in traditional energy and in resource extraction. We’re not very well set up for the Green Revolution and decarbonization which is being mandated by governments. On one hand, you make a good point. In the multipolar world, be very careful about getting your money, about how you deal with countries that may be falling out with each other. Okay, agreed. Absolutely, and we are.

But it also tells you, you really want to be participating in markets like Chinese commodities, if you can, if you can do so in a safe and appropriate way because those markets are going to move over time. I think that’s something you can really bank on. People are just beginning to figure out that we don’t have the materials we need to achieve our goals in terms of sustainable and renewable energy and decarbonisation. So what’s going to happen as these forces collide? Reality and our goals.

[00:56:03] Niels

Yeah. I very much agree with the fact that I think commodities will play a very important role in investor portfolios, and of course, a great way of accessing those is through CTAs. Because sometimes we think these things will happen much quicker. I remember a year ago, people thought about oil at $200 or $300, and yet we find it at $65 a year later. So being long and short makes, I think, these markets even more attractive. But it opens another question that I’d love to hear your thoughts about.

You decide, Doug, how you want to respond. Given your trading in alternative markets, given your trading in venues that are a little bit further away from home, so to speak, do people raise the point about ESG with you guys more than maybe with other managers? How’s that area? How’s that topic discussed from your point of view?

[00:57:05] Douglas

No, it really hasn’t been raised with us more than with any other manager. We’re doing what we can to be responsible and to be reasonable. We made a decision to stop trading coal a few years ago. Now, you can argue whether or not it’s the right decision, because in reality, coal will be an important part of the energy mix for many developing countries for many years. But in the developed world, there are better ways.

There are better ways to generate energy than coal. It’s not even one of the nicer fossil fuels in general. So we took that step. We’re conscious of these issues, but it’s not particularly brought up with us in any unusual degree. I believe that we have taken some steps so that we’re carbon neutral as a firm.

[00:58:14] Niels

Yeah. I think that’s fine. The other little bit different question I wanted to ask you (we can’t ask many firms this question because they’re all based in New York and London, whatever), but you’ve decided (and I don’t exactly know when it happened) to kind of have offices, one in London, of course, but also in a different region compared to where we find CTAs (although there are lots of CTA investors where you are now in Abu Dhabi). Can you tell me a little bit about whether there’s any advantages or disadvantages to being in Abu Dhabi or whether it’s just a lifestyle choice?

[00:59:00] Douglas

If you’re trading markets around the world and around the clock, the way Florin Court Capital is, you need to have trading desks in multiple time zones. You certainly need two time zones. What are your choices for a more Eastern time zone than London? You could go to Hong Kong and Singapore, which are fine choices and great cities, or you could go to Dubai/Abu Dhabi. That’s another alternative. There aren’t a lot of other choices, I think. I’m not leaving very much off the list there.

The United Arab Emirates has a very, very beautiful time zone because it overlaps substantially with London, but it’s four hours ahead. That allows you to have two functioning offices that feel like one. But if you have London and you have Hong Kong, the hours are so divergent. There’s less overlap, there’s less interaction. You’re not going to make that feel like one office or even approximately one office.

In addition, at the time I was making this decision, both Hong Kong and Singapore had very, very strict travel restrictions. They were battling COVID in a rather draconian way. It just wasn’t even feasible, really, to consider them. So I ended up choosing Dubai slash Abu Dhabi.

So then the choice is, what do I think about Dubai? What do I think of Abu Dhabi? Well, I have friends in Abu Dhabi. It’s a lovely laid-back lifestyle. The Abu Dhabi ecosystem welcomed us. It’s an absolutely terrific place. It’s a very orderly society. It’s got beautiful weather for eight months of the year. So we’re glad we came. I have an office in London. We have about 10 people there, we have 10 people here, and we have people helping us in Sweden as well from Brummer.

[01:01:18] Niels

Fantastic. Yeah, of course, the connection with Brummer of course. Alan, do you want to do one more round of questions and then I’ll do the usual wrapping everything up at the end?

[01:01:28] Alan

Sure, maybe just one to wrap up. Obviously, the last decade was seen (certain parts of it at least) as tougher for traditional trend following and the alternative markets performed I think more strongly (trend following and alternative markets) in that period. People obviously tended to assign a narrative to that around less volatility in markets, central bank behavior, etc.

I’m just curious, in what kind of scenario might you get better performance in trend following in the major markets and when might alternative markets struggle? What kind of set of factors might lead to a more pronounced drawdown in trend following and alternative markets do you think?

[01:02:17] Douglas

It’s a good question. Most of the scenarios where traditional standard market CTAs do very well, for example, developed markets, equity crash or credit crisis, most of those scenarios would probably be pretty good for us, but not quite so good. Even if you take a look at last year, developed market CTAs were up 30%, let’s say, something like that. We were up 20%. In the previous year, we were up 30% and the developed market CTAs were considerably lower than that.

So I would imagine that a scenario where some sort of credit crisis, super hard landing happens, and it’s focused on the US or Europe, I would imagine the developed markets CTAs might make 30% or 40%, we’ll probably make something like 20%, because most of these trends spill over.

On the other hand, if the crisis ends up being a crisis in China or an emerging market, a Latin American crisis, or Turkey gets into trouble (I hope it doesn’t), or South Africa, we will make more money, probably, than a developed markets CTA. It really depends on where the crisis is focused.

We cast our net very, very widely. It tends to be a somewhat smoother profile year after year. If we were to enter a very placid environment without much going on, that’s a tough environment for any kind of trend follower. But I don’t really see that kind of environment in the cards. But who knows? I don’t have a crystal ball. But it seems to me that the sources of instability strongly outweigh the sources for stability.

So I think CTAs in general will do well, and I think we’ll continue to do well. I think the emerging markets, it’s a very complicated world. I think diversification (getting back to the multipolarity point), diversification may be improving as the world becomes a little bit deglobalized into some separate supply chains, and so forth. So we’ll have to see. But it’s not guaranteed that alternative market CTAs outperform every year. But we do have that edge of much superior diversification to the standard medium-speed trend followers.

[01:04:55] Niels

All right, Doug. We’ve touched a lot of topics. I’ve got two questions left that we tend to ask everyone. I don’t know if you’ve listened to them before, but one of the things we’re curious to know is to just find out generally speaking, what’s the one thing you hear about trend following that you disagree with the most?

Now, there’s been a few that have been sort of mentioning the same topic. But if you think about what you hear people sometimes talk about trend following, what are the things you tend to say, well, I definitely don’t agree with that?

[01:05:28] Douglas

Well, there’s one notion that it’s easy to do. There is this point that you can set up a basic trend following program in the developed markets and trade some futures without a huge amount of overhead, but there are a lot of things you have to get right. Then when you get off into the world of alternative markets, it is such a heavy operational lift that frankly, folks really have no idea. It’s a very, very big part of what we do. So this notion that trend following is so easy isn’t correct.

Then there are a lot of important decisions to be made about model design and allocations and so forth. Running a really tight, well-organized, precise, careful business is never easy. So I would say that would be one thing that I think people get wrong. I think people saw the decline in the performance of developed market trend following, after the great financial crisis, and I think maybe they read a little too much into that. Because obviously, we had entered a world where central banks were applying huge amounts of liquidity to the global economic system.

Liquidity kind of fixes everything until it doesn’t, until it causes inflation, until it increases imbalances that ultimately ends up breaking things. So yes, I think the trends in general were weaker, particularly in the developed markets over that post-great financial crisis period. But I think we’re returning to a more normal world. People can’t get past their anchoring bias. Also the notion that there’s a burst of volatility when trends reverse and change direction, that’s universal.

The Minsky moments and the anchoring bias, they’re here to stay. I don’t think that trend following is in any sense obsolete. I think that certainly when you apply it in relatively green pastures and relatively fresh places, there’s quite a lot left for the future.

[01:08:06] Niels

Yeah. I was just going to say, we certainly agree with your positive outlook on trend following and the fact that it’s been around for so long, and it’s most likely going to continue. So I’m not going to ask you to finish off what you’re most excited about looking into 2023 because I think you’ve articulated that very well.

So I’ll instead just ask you if there’s anything that you are concerned about, something that might, I wouldn’t say keep you up at night or awake at night, but is there something that you might think, well, I don’t really like the potential of what this, whatever it might be, may bring us in the rest of the year, so to speak?

[01:08:51] Douglas

Well, there are many things in the world that make me uneasy, but they don’t make me uneasy because of the investment program. As someone who is legitimately long volatility in my view, most of the things that upset me about the world might actually be good for the profitability of our trading program.

I’m very concerned in general, and it’s not a concern about my program really. But I’m very concerned with how the war in Ukraine plays out. I think that Russia regards the matter as an existential matter for them. It’s very, very important to Vladimir Putin and to the leadership over there. The Ukrainians, on the other hand, have been so traumatized by this terrible war and this invasion that it will be very difficult for them to reach any compromise.

The US is playing a role there that, if you listen to say Jeffrey Sachs or Mearshimer may not be… This is great power competition taking place on Ukrainian soil, not just the sovereignty issues of Ukraine. So it’s a very sad, complicated, tragic situation caused by, recently, the Russian invasion, and I don’t know how this thing gets resolved. It will have a tendency to escalate, and that concerns me a lot.

I don’t have a big concern that volatility is going to die out in my investment program and the markets are not going to move. That’s not a huge concern of mine, although maybe it’ll end up being choppy. But I am certainly concerned that there’s so much instability in the world and a tremendous example of that is this terrible situation that has happened.

[01:11:11] Niels

Exactly. I think we all share that, Doug. This is a good note, a good time for us to wrap up a fascinating conversation. Doug, we really appreciate you coming back on the podcast and sharing your thoughts and all of your insights especially to the world of alternative markets, which is somewhat different to some of the other guests we’ve had on recently. Of course, we hope we can do this again sometime in the future.

To all of you listening in today, I hope that you were able to take something from today’s conversation on to your own investment journey. If you did, please share these episodes with your friends and your 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 our website. Not least, as usual, take care of yourself and take care of each other.

[01:12:07] Ending

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