What makes an Alternative Investment Truly Valuable? ft. Moritz Seibert

[00:00:01] Intro

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

[00:00:23] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Moritz Siebert and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor. And let me also say a warm welcome if today is the first time you’re joining us, and if someone who cares about you and your portfolio recommended that you tune into the podcast, I want to say a big thank you for sharing this episode with your friends and colleagues. It really does mean a lot to us. Moritz, it’s great to be back with you this week.

It’s been a little while since we’ve done one of these systematic investor conversations. You were one of the founding co-hosts of this particular series many, many moons ago. So, I’ve been looking forward to this. How are you doing?

[00:01:03] Moritz

Likewise, Niels. Thank you very much for inviting me. It’s great to be back as a guest. I’m still one of your co-hosts with the Open Interest series. I’m really looking forward to chatting about all things you and I both find interesting.

[00:01:18] Niels

Yes, exactly. We’re going to talk about some, you know, usual wide-ranging topics relating to trend following. We’re going to be talking about a paper that the company I work with, the company Dunn Capital, put out last week. So, there’s going to be a little bit for everyone, I think. But of course, what I always like to start out with is something completely different and that’s just to see what’s going on when you don’t look at markets and you’re not looking at what the algos are doing. What else has been on your radar lately?

[00:01:48] Moritz

Yeah, we’re on vacation at the moment, so we’re pretty much dialed back from things. But the one thing that I’m following is the US Open. I’m in love with tennis. I love playing tennis. And it’s one of the four Grand Slams.
We’re in the final week now, quarterfinals. It’s just fantastic tennis. And, by the way, the male and female tennis, it just, every year it improves. I think it does. It’s a faster game, it’s a more aggressive game. You can see it. This game is moving forward and it’s incredibly tough now, incredibly fast.

[00:02:25] Niels

Now I have to ask you, who’s your favorite?

[00:02:27] Moritz

I think Sinner is going to win this.

[00:02:30] Niels

He won last year, right?

[00:02:32] Moritz

He did win last year. So, this could be his first repetition of a Grand Slam victory. He missed out on the French Open, but he did win Wimbledon, and he did win the Australian Open. So, he’s just an incredibly fast moving, fast hitting player – tough to beat. He just, you know, beat Bublik 6/1, 6/1, 6/1.

I mean Bublik is kind of like on and off, and volatile, but he’s a great tennis player, very talented. Last night he won against his countryman, Musetti, in three sets. He’s winning in three sets pretty much all the time. So yeah, he’s going to be tough to beat.

[00:03:11] Niels

Yeah, absolutely. And I did see there was an interesting other semifinal with Djokovic and Alcaraz lined up for tomorrow. Yeah, very interesting, and also, I did notice there was a little bit of an upset, I think, on the women’s side where the lady who lost, I think, she lost 6/0, 6/0, 6/0 in the Wimbledon final. She came back with a nice upset yesterday, as far as I recall.

[00:03:37] Moritz

Yeah, that is true. The women’s tennis is also getting so much better every year. So much faster. It’s great to watch. I watch both. It’s just good fun, when I can, time differences permitting.

[00:03:51] Niels

Sure, of course. Well, I’ll mention what’s been on my radar and there are two things that I found interesting this week.

One is, if I have to stay in the sports world, I’m probably more interested in the cycling. The Vuelta a Espana, at the moment there’s a Danish rider in the lead and that’s obviously very, you know, for a country with no mountains, I find it extraordinary that we have a rider that can actually compete in these races.

But the other thing, more seriously, that I have found quite interesting is actually what’s going on in the bond markets. I noticed that, earlier this week, UK bonds, 30-year bonds hit the highest yield in 27 years. Even higher than the so-called ‘Liz Truss moment’ which was a bit of a scare not long ago.

And I think since you obviously are based in Germany, I think even German long yields have sort of been ticking up and hitting some, maybe not 27 year highs, but certainly highs over a long period of time. And this is at a time where the ECB, I think, has cut eight times since 2024, about 200 basis points. And of course, the US bonds are flirting with 5% again. So, I find it interesting also because it’s happening at a time where the economy and the labor markets are not super strong. So, maybe there is a 2022 lying ahead of us, Moritz, which would be good for trend following.

[00:05:21] Moritz

Yeah, and it seems that, you know, the gold market is sniffing out the issues, potentially, because what we see is really a steepening of the yield curve. You know, we see the long end rising. You’ve mentioned the Gilts, the 10-year and the 30-year, and also the Buxl, which is the 30-year point in Germany, these parts of the yield curve, they’re clearly rising steadily. I don’t know. But yeah, they’re moving up.

And I think there is a concern that the fiscal positions of these countries, the countries we live in, they’re no longer strong. In fact, they are weak. I mean, every country is kind of like in big debt. And it’s obviously a relative definition of what is a large amount of debt relative to GDP, and what isn’t. You know, when you think about Japan, they have, I think more than 200% of their GDP is in debt. So, I don’t know.

But overall, this probably isn’t a healthy position. And market participants are demanding more of a yield to buy these bonds, which, you know, it’s understandable.

[00:06:26] Niels

Yeah. Well, turning to trend following, not much yield, except for a few managers, I guess, this year have created positive returns. But you know, the industry is coming back. We’ve had a couple of months now where the footing seemed a little bit firmer under the trend following space. I know you guys have been doing well and there seems to be a few of the longer-term trends that have kind of reestablished like equities, obviously things like some of the commodities like livestock – live cattle is quite a fantastic trend for a couple of years now. And of course gold, as you mentioned, has been really good and obviously a market where even big managers can take reasonably sized positions, and so has had a positive impact.

And it’s kind of classic, right, because only a few months ago there were articles coming out, very disappointed with the returns of our beloved industry. And then we see a bit of a turnaround, and I mean, who knows, it might even end up as a positive year for the industry if it continues.

But curious to know a little bit about sort of your experience, in terms of interesting contributions maybe, interesting changes in exposure. When I look at it from my vantage point, a lot of the financial sectors, which are generally obviously the powerhouse for certainly the larger managers, have been quite difficult for various reasons.

I mean fixed income has been trading in a huge range, up and down for a couple of years now. Equities, yes, they’ve been going up, but they’ve had these pretty quick nasty corrections, mostly politically driven, that has made it difficult to hold onto your long positions. And currencies have been also a little bit all over the place to some extent. At least that’s how I have experienced it.

Are you seeing the same or anything else of interest? And you trade, by the way, some markets that I don’t follow.

[00:08:31] Moritz

Yes, for us it’s really been a year of the commodities. They are driving our returns. You’ve mentioned the livestock markets. So that’s lean hogs livestock – lean hogs, live cattle and feeder cattle. All of these markets happen in strong uptrends, and I think these trends are, I mean as of right now, they’re still looking bullish. So, we have long positions in these markets. We’re long in the precious metal sector – this is platinum, silver, gold. All of that has worked really well and continues to work well as of right now.

In terms of contribution, actually we’ve lost most this year from currencies, equities and bonds. And that was around the Liberation Day period where all of a sudden we had these… We started the year, actually, with a positive profit contribution from currencies. And then you had these massive moves around the early April period where we got kicked out of our positions. Then it takes a long while to get back in, if you get back in.

So, we exited these with a loss and they’re still, year-to-date, we have losses in currencies, we have losses in bonds, and we have losses in equities even though, you know, when you look at the equity markets over the entire year (since the 1st of January this year), they’re up this year, but not for us because we’re trading long-term and we got kicked out in April. We made it back in.

We’re not fully exposed to all of the equity markets that we trade. There are some that we just don’t have any long exposure to right now. On net/net we do have long equity exposure and we’re also very much underexposed or not exposed to the fixed income markets. We do have some exposure there, but a lot of these markets, we got kicked out of them. Our systems determine them to be still trading range bound, so, we just don’t have a position. You know, the bubble is one example, the SHATS is one example.

Maybe that’ll change in a couple of weeks, but as of right now we just don’t have that. But yeah, we have these long-term positions in the livestock markets and the precious metal markets.

We’re still long cocoa even though, like six years even though this market has kind of like stopped moving higher. But it also, it hasn’t moved down enough yet, at least not for us to call it quits.

Coffee has been difficult, by the way. We’ve had this strong bull market in coffee which was great for us and then moved down. Now it’s moving up again. So, we kind of like reversed – going back in.

But yeah, overall, Niels, it’s a good year for us. So yeah, definitely not complaining, I never complain. It is what it is.

[00:11:17] Niels

It is what it is. That much we learned over the years, for sure. Yeah, it’s interesting that you also mentioned this fixed income because, although I said it’s been a difficult sector, actually I also think there’s a little bit of a “disagreement” among managers right now, or the models, as to whether you should be fully long or fully short or somewhere in between. When I look at the daily returns of the mutual funds, for example, where you can see daily moves. Yeah, it’s not actually moving in the same direction every day and it seems like it’s really driven by what bonds are doing. So, that would be interesting to follow.

But of course, this is also why, you know, investors have a choice to mix and match the managers, the timeframes, the speeds, and all of that stuff that they want. And not least of course, the markets traded, which is so important.

Let me quickly run through where we see performance now that we are in early September. So, not a lot of trading going on so far, but still a positive start.

BTOP 50 up 27 basis points, down 2.68% for the year. The SocGen CTA index up 22 basis points, still down 6% or so for the year. The SocGen Trend index up 36 basis points, down 7.25% for the year, thereabouts. And the maybe surprise this year for me, the SocGen Short-Term Traders Index, it’s flat so far this September, but It is down 6.46% for the year. And that is a big number relative to the volatility to that index. So, that is something we may discuss later on today actually.

Then in the traditional world, MSCI world is down 40 basis points as of last night, up 13.6% for the year. The US Aggregate Bond Index is up 6 basis points, but up almost 5% for the year. And the S&P 500 Total Return is down 16 basis points, up 10.61% so far this year.

Now, Moritz, we didn’t coordinate really our topics far in advance. I think that’s fair to say. A few hours ago, we kind of exchanged ideas. So, I’m going to kind of lead with some of the ideas you wanted to talk about. I think we’re going to weave it into some of the things that we had planned in terms of there is an article out from Transtrend, which touches on some of the same points. – surprise, surprise.

As I mentioned, Dunn Capital has made a paper that we can talk a little bit about, but more from maybe a benchmark or industry point of view. So, what are the things… Let’s dive into some of your things. What are the things that you find interesting and important about the space at the moment, some of the discussions that you’re having? Let’s dive into that.

[00:14:09] Moritz

Yeah. One of the topics which I really like is diversification in the number of markets that we trade. And not necessarily the number in terms of does it have to be 100, or 50, or 200. It is more the composition of the portfolio that one is creating. And some people distinguish between the traditional markets or alternative markets. I’m not necessarily a fan of that term. I think they’re all markets. But the way we approach the composition of our portfolio is to find as many independent moving items as we possibly can.

And with independent, that may be uncorrelated, but they really should be distinguished in and by themselves. So, cocoa and the S&P 500, or sugar and orange juice probably don’t relate to one another. They just have their own… They dance to their own drumbeat. And that is what we want. California carbon emissions don’t have anything to do with the 10-year note. That is what we want.

So, we’re building a portfolio of these constituents where, ideally, there’s just nothing that links between them. That’s akin to if you go to a casino and you play blackjack, you play many different independent tables and you always play a different hand. There’s a different set of cards there. They’re not correlated. And we have this small little edge with our trend following system.

So, if we can apply it to as many independent markets and return streams as we possibly can, then in expectation our return stream will be improving. So, I’m not saying that one needs to have 400 markets. I’m also not saying that 50 markets is wrong. And there is no wrong or right.

It’s just the way we do it is we’re building a portfolio of as many independent constituents as we possibly can. And we’ve set up our funds so that we can do this. So, we’re now adding some of the Chinese futures markets, which we found a very nice way of doing. And they’re just very diversifying. Canola is very diversifying. Lumber is very diversifying.

But obviously you cannot scale these markets into the billions, which is why we’ve made a decision to limit the size of our firm or our fund to US$500 million, which by the way is a moving target. That is just a best guesstimate as of the liquidity profile that we can see right now. It might actually be US$300 million, or US$450 million, or US$700 million, by the time we get there.

But we like it for these markets to continue to have a footprint, and a meaningful footprint inside our portfolio. This year is a good example.

Feeder cattle, and live cattle, and lean hogs, I know CTAs, most of them trade that, but they’re not the largest markets in the world. They’re definitely smaller than gold and the S&P 500 and the 10-year notes. So, if you run a multibillion-dollar fund, your footprint in any of these markets might become too large or you may not be able to efficiently trade them without a lot of market impact. But for us it’s important to have them.

[00:17:18] Niels

Yeah, a couple of things to kind of follow up on from what you just said. First of all, by the way, you mentioned carbon. I very much enjoyed your last conversation on the Open Interest series with Mike about carbon trading. I learned a lot. I don’t know much about carbons. There was a lot to learn. I thought it was very interesting.

You mentioned that now you trade California carbon, but I think actually the main carbon is still Europe, as far as I recall from the conversation. But these are not… Are they futures markets or are they…?

[00:17:50] Moritz

Yes. So, they’re all futures markets. The EUA, the European Union Allowances, this is the largest and the most liquid market with screen liquidity. So, you can go there right now. They trade on ICE, on ICE index and you can just bid offer a cent or two. So, you can just trade them very efficiently. The same is true with a smaller market, but also screen liquidity on UKAs, that’s the United Kingdom Allowances.

These two markets, the EUAs as in the UKAs, they’re relatively correlated to one another right now because there is a tendency for these markets to re-merge. They want to relink these two emission markets in the future. At least there’s an initiative to work toward that.

With Brexit, these markets decoupled, which also decoupled their correlation properties. Now a CO2 molecule is the same everywhere in the world but all of these markets are trading differently.

So, California is absolutely uncorrelated to EUAs. And the EUAs are uncorrelated to the Reggie market, which is the east coast of the US. It’s interesting.

So, by the way, CCAs also trade on ICE. It’s a futures contract but that is a brokered market. So, you don’t see screen liquidity or very rarely do you see screen liquidity. It really goes through specialist carbon brokers and then you trade with them. They’re your execution broker and you clear with your FCME, your clearing broker, at the end of the day, if they support that market.

And that is true for quite a few of the markets that we trade. We don’t necessarily think that as a disadvantage… Some people call it GRAB futures markets. I don’t agree with that. They’re just futures markets like all the other futures markets. It’s just maybe through history or the way market participants operate in these markets is using a brokered structure.

South African grain markets, they’re not the largest markets in the world but they tend to be brokered markets. There’s some screen liquidity there but really you go through broker. Yes, that costs a little bit extra, a penny here and there to get the execution done, but you’re probably getting a better execution than, you know, just going on screen and lifting offers and hitting bids.

[00:20:16] Niels

So, were you inspired by Mike’s idea which I actually have liked. I mean obviously they’re carbon specialists, but the fact that they take part of their performance fee and they buy these carbon credits and then they burn them so companies can’t use them to offset their emissions.

[00:20:34] Moritz

We don’t do that. I give a lot of kudos to Mike for doing that. But it’s more in line with their fund and their objective and the way they position themselves as they also want to have an impact. We need to be very clear and honest, we’re a hedge fund, we’re a commodity fund trading systematic trend strategy. So, we’re not really mixing this with a climate impact strategy. We can do this privately.

We’ve been, Niels, we’ve been trading these markets for quite some time. They’re not new to our portfolio. We’re not trading New Zealand, we’re not trading some of these very small, emerging carbon markets. But that is simply because we haven’t found a good way to access them.

I’m sure there is one. It requires some digging, it requires some setup. But you know, all of that is time intensive. It does have some operational complexity which we’re always cognizant of. We’re always cognizant of the risks when we access these markets. So, we don’t have exposure there.

But yeah, California is great, and the US and the UK is as well. They’re very diversifying.

[00:21:39] Niels

Yeah. That’s actually another thing I was inspired to ask you about when you started talking about this. This is also related to the paper we, I think, both briefly read that our friends over at Transtrend produced. They talked about, well, they didn’t talk about it directly I guess, but what you could say indirectly is this question about, yeah, we try to diversify through different markets, but actually, do we now, as managers, also have to think about where they’re traded, not just what we’re trading? Because I mean in the carbon market you’re clearly doing it, but they’re using this example with copper, which I think most managers will be aware of.

Copper had a very interesting couple of market days due to the tariff issue, but it was the US copper, not the European based LME copper. So, there you could see very different reaction patterns, certainly on the last announcement, maybe not the first announcement.

So do you think, as managers, I mean, first of all, should we encourage, say, European and Asian exchanges to list some markets that may be only traded right now in the US, given the fact that it seems like now policy can have an impact, or should we just think about it more generally to actually say, well, it’s fine to trade the same market if they’re traded in different places and we just divide up the total risk we want in that market?

[00:23:12] Moritz

Yeah, this is more akin to what we’re doing. The COMEX Copper, or the CME Copper market in the US, and the LME copper market, they tend to be very highly and persistently correlated. And now they’ve decoupled. Obviously, they’re now kind of like recoupling again, but with the risk of that correlation structure breaking again in the future if the tariff on/off dynamics continue.

You could make similar arguments about London sugar and New York sugar, and London coffee and New York coffee, cocoa Markets, they trade in different locations. The delivery mechanics, the warehouse locations, what can be delivered from where, they’re different.

They differ between these markets, which means they, at times, have different prices. They tend to be very highly correlated, but they’re really not the same. The grades may be slightly different, or the delivery mechanics are slightly different. That’s one of the reasons why we trade them. We trade them all.

And in the case of copper, nothing really much has happened with our LME copper position that was just, it didn’t have these gaps, these discontinuities, but the COMEX Copper position that we had on, we were long copper, and in the US. We enjoyed the spike that happened when, you know, the first tariff-on announcement came out. Yeah, boom, we were on the right side of that trade. And then we took it on the chin when the opposite happened.

I think what I wrote to you about is, this is one example where you have these massive violent moves. It does make a difference whether you have a resting stop in the order book, or you have a resting good-till-cancel order to sell out of your copper position, to close that copper position, or if you do not.

In our case, we do not have these resting stops in the order book for several reasons. You know, we don’t want these orders to be seen. But also, in the case of copper, we had big slippage because of how radical the exit was north of 5, 5.17 or something, and we got out at 4.6, so around there. So big slippage in this instance because we have a delayed exit. You know, we get the signal to exit the position, and we do it the next day. Sometimes that works for us and sometimes that works against us.

When we do it over all of our systems, all the markets that we trade, we find that there’s actually an improvement to have these delayed exits where we kind of like, you know, wait a bit and then get out of the position.

[00:25:55] Niels

Do you do it on the entry as well, that you wait for a day?

[00:25:59] Moritz

We also, like, we correct. So, we get a signal to take position based on the last available settlement price and then we would implement that signal usually on the next day settlement. So, we’re not immediately hitting the open. We don’t have stop-orders to get into positions.

[00:26:19] Niels

But you know, Moritz, even if you had stops, and of course we have this debate, and we’ll come to that a little bit later, in terms of how you manage risk through the trade and all of that stuff. But I mean even if you had a stop in the market, you probably wouldn’t have gotten a much better price, if at all, compared to waiting a day.

And I also remember, actually, one of the very first episodes I ever did with a manager. The manager doesn’t exist anymore, but I remember that this is back in 2014, they were very successful at the time and had a decent long track record. I think either they did it or they had found that delaying your actual execution by a whole week was better. Which sounds like crazy, but it was actually better in terms of overall returns, in the end, compared to just reacting straight away. Kind of interesting.

[00:27:13] Moritz

Yeah. I mean overall, just to maybe put this into perspective, it doesn’t make, at least for the way we trade, it doesn’t make a world of a difference. Like if we had the same systems run on a stop basis, with kind of like resting stops in the order book, or with our delayed entry/delayed exit type of methodology that we’re currently using, you overlay these two charts, they’re pretty much identical.

You’re not creating an all-too-different experience. The delayed entry exit rule, or it’s not a rule, it’s just a mechanic that we’re using that actually produces slightly better returns. So, we’re using it for that reason. We’re using it because we don’t want to have these stops being picked off in the order book.

And sometimes, and I think I also mentioned that to you, you have these spikes in the market. Transtrend, Harold de Boer, oftentimes reports about them, and I enjoy reading that – it’s just wild price moves caused by whatever, some market participants, a glitch, whatever it is.

So, two weeks ago you had a massive move in the South African rand, which is one of the markets that we trade against the dollar. And if you have a resting stop, you get hit, you lose your position, and you’re out of it. But it was just like one of these second events, you know where boom, boom, it just goes up a massive amount and then you’re back down to where you started. We just don’t want any of these like one-off random price events to kick us out of a position and interfere with our models.

[00:28:52] Niels

Yeah, yeah. You mentioned, in your email to me earlier today, something like simple derivative free indicator support resilience, and robustness, and remove unnecessary complexity. What did you have in mind when you wrote that?

[00:28:53] Moritz

Yeah. So, removing complexities from a trend system is a good thing. Like you have to stick to the system, you have to give it some time, we all know that in order to get the benefit of its workings. One of the ways to create robustness and increase resilience is to use relatively simple rules. Occam’s razor. Don’t overdo it.

Don’t get into the curve fitting trap or the over optimization trap where you put on yet another filter to this and another filter to that. And you know, all these parameters that you’re using, which are usually just a way to improve your backtest but not your future returns.

And what we find is that, in terms of indicators to get us into positions, for example, there are some which we put into the derivative free box, such as is the price today higher than the price 100 days ago? And that is a very simple, nothing else required than these two prices, and you compare one against the other.

Or has the price made a new 200 day high? All right, again, there’s no derivative. It’s just, is the price higher than the highest price 200 days ago, over the past 200 days?

A derivative based indicator is, for instance, a moving average. A simple moving average is already a derivative of price because you’re putting in 200 observations of past prices to come up with the latest calculation of your simple moving average. That doesn’t mean that a simple moving average doesn’t work, or any of these other indicators doesn’t work. In fact, they do work, but we try to stay away from them and just keep everything that we do as clean and free of complexities as we possibly can. That’s what I wanted to say with that.

[00:30:49] Niels

That makes a lot of sense when I hear it. But then I also think about all the conversations we’ve had, especially when Alan and I talked to the constituents of the SocGen CTA Index. And I would hazard to guess that certainly the Europeans, the large European firms, a lot of them actually started out using moving averages and are still using moving averages.

And it’s kind of interesting to me that, on one hand, your research might find that actually doing it in a simple way (and I think we all agree on that simplicity is good and you don’t want to overcomplicate it), but I also find it interesting, at the same time, that some of these large managers (which by definition have been very successful, even though they may not have produced the highest returns, but they’ve certainly done it for a long time), are maybe still using somewhat more complex (if we define complexity as using, say, second derivative information) in their methodology. Has this also something to do simply to, you know, size? Meaning that if you have large AUM, you need to do something that gradually moves risk, rather than say maybe a stop and reverse or using stops.

[00:32:14] Moritz

Well, you could also do this with the simple indicators. You could also smooth them out over time, and get into positions, over a period of time, if you’re doing different lookback windows. So, I’m not saying that the moving averages don’t work. In contrast, they do work when we research them. You know, you can make money trading off of a moving average. So, I guess it’s more of a philosophical quantity thing for us to stay away from them.

It’s kind of funny. The least important thing, for the way that we trade, the least important signal and also the most important signal, at the same time, is the entry. It’s the most important because if you don’t take the entry, you don’t have a position. That is also the least important because whether you’re getting in based on the moving average indicator, or a breakout, or whether you’re getting in today or three days from today, for a long-term trend following system it doesn’t move the needle that much. Obviously, you will see a difference, but the longer you hold the position, the more that difference goes into the background and it’s actually not that important.

So, when you think about this (and 70% of our trades are losing trades only 30% of them are winning trades), this signal has such a poor quality already that you kind of think like why are you doing this? So, why we make that money sometimes is because we’re just ruthless in keeping these losses small. That is one of the most important things. The way we size the initial position, the initial stop placement, like how much room do we give the position to develop, and how do we then exit the position? At the end of the trade which is on a reversal, on a give back, there’s some methodology to get us out of the position.

[00:34:02] Niels

So, if you had to rank, because I think a lot of people would be interested in finding what is the most important when you design the system? So, if you had to kind of rank it a little bit, if we say okay, actually the entry point, let’s obviously take it as an assumption that you do get into the markets. So, we’re not discussing taking the signal or not, but if the entry point is not super important…

Actually, I find that if you look at different types of trend following, I think more or less we get in more around the same time. Obviously, speed will determine how early, how late, but more or less the same time. What would you rank as being really kind of the key drivers of success, then, in designing a trend following system?

[00:34:49] Moritz

I think markets, the number of markets, the diversified property of your portfolio is really important – keeping losses small and letting these profits run, appropriately sizing trades. We know that, and from our research, but also Tom Basso, I think, has done this. You can actually use a random entry methodology. And if you randomly enter the market, and you have a rule to keep losses small and let profits run, you end up making money.

You can improve the random entry through signals such as a 200 day high or 100 day high. So, what we do, buying on a high, as silly as that may sound, because we’re buying something on a high point, which is kind of like counter to what most people like to do, but that improves a random entry signal. So, it is good.

If we could improve this even further, I mean, that would be fantastic because obviously if we have the lopsidedness of our return stream, we have a positive CAGR. But we are able to do this because we have the occasional outlier. But we’re doing this in the face of 70% losing trades.

Obviously if we could improve this and move from 70%, to 60%, to 50% losing trades, our returns would go through the roof. But it’s very difficult to find something that is statistically significant and better than buying a new high or, in the case of your maybe moving average, if there’s a crossover, use this as a signal. This is better than the randomness.

And this in combination with keeping losses small and letting winners run, in a diversified portfolio, with really independent bets, is a great system. And it’s very robust, very resilient, very protective to your capital, which is what many people sometimes forget. Because when we would trade with our volatility, you know, a single month can be a big down month, it can be a big up month. So, it kind of looks a little bit wild. But we’re really keeping losses small and we’re preventing these losses from deteriorating the portfolio where the compounding drag, the volatility drag really becomes such a big break where it’s very difficult to recover from the drawdown.

[00:37:08] Niels

Yeah, absolutely. I mean you did also mention actually the beloved topic of dynamic position sizing in your note to me. I don’t know if you want to go down that route. It’s been interesting to see. It’s been interesting to see.

I think that… I mean there are a few, we probably know all of them, that simply won’t adjust positions within a trade. Then there are few who would probably do it, but not necessarily in the way that most people who adjust positions do. I think you might be one of them. I think even Rich might be one of them. Or at least maybe not the position size but certainly the stops could be vol driven or whatever.

And then, of course, people like us at Dunn and many other people where we say, well actually we do want to recalibrate the position size on an ongoing basis, not necessarily based on vol. It could be based on risk and so on, and so forth. Whether it makes a big difference in the very long run, I don’t know because sometimes it can be hard to see the difference. And here, I mean really long-term performance of managers. They’ll be different along the way but that could also be driven by, as you say, market universe which is clearly very important in determining manager’s returns.

And I think even you sent me a link. I didn’t read it in detail, I don’t know if you did. But I think Man just published a paper, that I might discuss next week in more detail with Katy, about dispersion of managers and what they have found in that space. But clearly all of these small decisions that we take in our design makes a bit of a difference, of course.

[00:38:55] Moritz

Yeah, it’s the evergreen topic of dynamic position sizing. And there are so many variants of dynamic position sizing that it’s very difficult to really capture it.

But let’s just distinguish that there is kind of like this volatility based, or volatility and correlation based dynamic position sizing which some funds are using (we’re not one of them) where they respond to changing volatilities and changing correlation properties and they would adjust their positions because of that.

So, this is one form – volatility targeting. There’s a lot of QIS indices out there by banks that use these types of mechanisms. They create a more steady return stream, it’s smoother, you have less of a risk of a big loss. Obviously, it’s not without side effects. Something has to give, but this is one way of doing it.

And then there are other ways where people use valued risk or they use a risk-based metric. Maybe this is where you come in, where you have a heat component, or how much is the risk if we went to the stop of the position, how much are we therefore willing to lose on a portfolio or market basis if all our positions hit that stop?

It is also a form of dynamic position sizing because you would react and adjust the position post the initial trade. But it’s a different function. It’s not volatility and correlation based, it’s based on the risk that you observe in your portfolio in which you’re willing to trade.

No matter how you slice and dice it, and I’m not critiquing the risk-based stuff at all, I think risk management is an important part of portfolio managing inside a trend portfolio, the most important one is the initial trade sizing. But all of these trades tend to be profit taking trades when you think about when do you have a big volatility burst and you’re in the right position. It’s like this copper thing that I’ve just mentioned where oh yeah, we’re making all this money because of the initial tariff, tariff on discussion. And obviously, there’s a lot of volatility now in the copper market. You’d be reducing your size because of the volatility that you’re experiencing from that market or also from other components at the same time in your portfolio.

So, when you’re in a bidding position, you have this long copper position, the kind of very crude, very basic first rule is to cut losses short and let winning trades run on unconstrainted. So, you’re taking some of these profits early.

And the same would be true for risk-based or heat-based risk assessment where you say okay, the market has moved. Gold is now a good example. Gold has, in the past couple of days, really moved quite significantly to the upside. On a long-term trend following system, depending on how you set your exits, but the odds are that the distance between the last price and your stop or your exit has now increased. And there’s more of a gap between these two points which means there’s more of a portfolio risk, more of a give back risk. And if you’re calculating that and you say, I don’t want that much, I can go until here, but then no mass. You would now also be reducing your gold position in a long-term uptrend because of that calculation. So, that would also be a profit taking trade.

Now the more frequent you do this, if you do it based on volatility, these trades become kind of like mean reversion trades where you go on and off, and on and off, and all these types of dynamics that take place and they are not without consequence, I think. It’s obviously the implementation cost of these trades, that’s one component. You know, you’re paying commission, you’re paying bid/offer, you have implementation costs to do this in the first place. But getting rid of these big outlier trends when you’re in the position reduces the asymmetry of your trade distribution.

And it’s a question of taste really, how lopsided do you want your trades to be? Do you want to be a fund that really takes these trades and lets them run? And so like, you know, this year is going to be defined because of gold. This year is going to be defined because of the return that we made in livestock. In our case, we don’t mind that.

And there are other funds that don’t want that necessarily because when you trade that way, the give back potential, the drawdown potential is also much larger because you’re just taking these positions and they’re fully loaded, fully sized, and you just let them go into the lottery ticket, the left tail or right tail lottery ticket, where you’ve entered the draw and you see what happens. And obviously, if you interfere with these trades, you’re smoothing out your return stream. It’s kind of like a rebalancing process that takes place and you’re also reducing the risk of that major drawdown or that major loss because, at some point, these markets usually reverse. But you’re also cutting short that asymmetry and you’re also cutting short the potential massive year that you could have. So, it’s a question of what is it that you want?

And especially during times of like these big stress events in markets, I tend to think that what you want is really that punchiness. It’s something that you’ve mentioned that in your paper that is actually quite valuable, you know, to be there and then really have these punchy returns that help investors with other investments in their portfolio.

[00:44:31] Niels

Yeah, I mean, of course what you just said is absolutely true. And of course, this is often sort of the case that’s being made for that approach.

I will say though, I don’t agree with always the way it’s portrayed because I think, also, there are obviously, as you say, kind of single day or two day event risk where you can just get stopped out if you use that kind of approach. There’s also of course the very real situation whereby yeah, you may see that positions are being reduced at certain times even if the trend is still in place. But you may also see that if there is a correction or if there is a period, then, of volatility dying down or some other, whatever the factor is that drives the position size, that these positions get increased again. So, for me it’s just a little bit more of a nuance.

But what I do like about the different approach is when you blend them, so to speak, you actually diversify the investment process. And that kind of diversification is also very valuable because, as we talked about, yeah, sometimes one manager might stay in a position and other managers might get out and that actually helps, I think, overall.

Which is also why, even if people look at trend followers and they see that the correlation long-term is pretty high, they’re certainly not the same. And you should always find probably a few to blend together if you want to get the most out of it. Unless you just happen to pick the very best one.

[00:46:15] Moritz

Oh, it’s funny, one of our investors, and it may be a person that both you and I know at some point, told me, because we’ve been talking about this dynamic position sizing stuff now for two or three years, and especially you with some other participants on your show, and he kind of said, you guys have to stop talking about this. We as investors, we just do not care whether you DPS or you do not DPS. At the end of the day it’s about the performance that you make, how much money you make, what your Sharpe ratio is, whatever the definitions are. But whether you’ve used dynamic position sizing to get there or you didn’t use dynamic position size to get there, it just doesn’t matter to them. It seems to matter to us more from a kind of “who’s right, who’s wrong?”.

[00:46:58] Niels

I think it depends a little bit on investor type. I think that you’re right. I think sort of family offices, high-net-worth individuals, they probably don’t care, frankly, as you say. I think when you get to the institutional level where people kind of get paid for doing long reports on the managers they invest in and they kind of want to understand the details, it probably does mean something to them to be able to kind of clarify these points. But anyways, that’s a side issue.

By the way, just one thing before we move on. One thing that was interesting that I picked up from one little paragraph from the Transtrend paper. You may have seen it itself, but at one point they write, “It may sound a bit counterintuitive but we would argue that in a scenario like this (and they talked about the copper situation, what happened), an unprecedented large global event (and this is also the tariff in April, I think), more diversified programs will generally lose more than less diversified programs.”

I thought that was kind of interesting, which, they also explain why it is, and so people should go and read it. But I think it’s one of those things where people say well, hang on, how can that be? I thought trading hundreds of markets would always be less risky. But they’re saying well, not always.

[00:48:21] Moritz

You have more components in your portfolio and if these components have positions on (which by the way, we don’t necessarily force our systems to have a position in the market), there are many markets where we just don’t have a position. And to us that is the same as having a position, just the position is neutral. But I tend to agree with that paper. When you have these big, big, big events, you know there is a correlation event. There is a correlated behavior tendency of markets. And simply because of the fact that you have more markets on, that will probably make you experience a larger loss on that day.

[00:49:00] Niels

As I promised in the beginning, as we’re starting to slowly run out of time, but before we do so, although August was a pretty uneventful month for us at Dunn, it was an eventful month because we rarely, rarely publish any papers. But one of my colleagues found the time to put pen to paper, I should say, in the summer months. And we wanted to basically do something a little bit different because there have been so many papers published over the years.

I remember the first paper I came across was in 1987, about John Lintner arguing that if you combine non-correlated asset classes like managed futures (which I guess it was called back then) with say bonds and equities, you would be able to increase the overall portfolio returns and decrease the overall portfolio risk. That was kind of where it started. And we know, since then, there have been plenty of papers talking about this.

But one thing that we wanted to do maybe a little bit different, that I haven’t seen too many papers of, is actually comparing the universe of alternative investments to see well, what if you could have to pick one, maybe two. What would be called the most valuable alternative investment you could find? So, that would be kind of one question that we wanted to ask.

So, we looked at I think 14 different hedge fund strategies from private equity, to long /short equity, to global macro, and credit, and all that stuff. Then we also wanted to ask the question, and that is well, within the alternative strategy space, how about leverage? How about volatility? Does it actually have an impact – positive, negative – if you have something that is a little bit more high vol?

And one of the reasons why we wanted to ask that question is that we did a little study which is just simply taking the longest running CTA index, which is the Barclay’s CTA index, which goes back to 1987, I think. And we did a rolling three-year volatility assessment. So, what’s the rolling annualized volatility over three years?

And it’s very interesting because, back when I started in the industry, the volatility was usually somewhere between 20%, 25%. A number both you and I will recognize because that’s what our firms are kind of where we are still. But then the industry volatility really took a big dive in the 90s and then has continued. So, the rolling three-year annualized volatility of managers is not 20%, 25% anymore. It’s up 5% now.

You and I probably have an opinion about why that is. It’s the institutionalization, it’s maybe the flat fee asset gathering type approach that we see. Whatever it is, it has a real impact for investors who need to decide on where to put their money, how much money to put to work, and the efficiencies they get. So, those were the two things that we wanted to look at.

And before I forget, by the way, there is a way for people, if they want to follow along as they listen to this conversation, and there are two versions of the paper, but the one we can publish publicly, where we use the industry benchmark for trend (so it’s not representing Dunn’s numbers here), you can get a copy of that if you go to toptradersunplugged.com/highvoltrend. So, go to top toptradersunplugged.com/highvoltrend, and you can get a copy of that. So, I encourage you of course to do that.

Now I’m happy to talk a little bit about it. I would love to hear your thoughts. But not surprisingly, we start by just looking at these different strategies over the 25 years worth of data that we have for the SocGen Trend index. So, we looked at all the indices, at least those that were around for that long. A couple of them started after that time.

But we put them in and we see, okay, what’s the total return? What’s the CAGR? What’s the annualized volatility? What’s the Sharpe? What’s the max drawdown? And also, what is the max drawdown in relation to the volatility of the strategies?

And of course, as you and I know, most people would just say, well, let me just look at the Sharpe and let me find out whether this is a good investment or not. And of course, to no surprise for the people listening to this conversation and who have been regular listeners, the Sharpe ratio doesn’t make trend following look very good. It’s not bad, but it’s not great either. Certainly not in this company.

Now, there is one thing that I do find interesting in that simple table, and is also something that I gravitate more to talk about with people, at least make them aware of. And that is, well, what’s actually the max drawdown in relation to the volatility you trade?

Because a lot of people think of volatility as being the risk. I think, and I have a feeling you might agree that actually, it’s probably more the loss you can experience that is the real risk. So, what is that drawdown in relation to volatility? For us, that’s at least an interesting point. And of course, when you do it like that, trend following comes out on top of all of these strategies, including by the way, The S&P 500 and the World Government Bond Index, which we also include.

The next thing we do is we try and look at, well, you know, these returns are obviously, overall, important, but what about the timing of returns? Is timing of returns important for investors? So, we look at correlations, we look at convexity, we look at skew.

And, of course, this is where it starts becoming a little bit more interesting when you look at it from our vantage point because trend following starts to pick up a few places, to say the least, when we look at that. So, that was the next thing we started being interested in.

The third thing we said was, okay, well let’s look at what happens when you start putting it into a portfolio. Because although lots of people like to think about Sharpe, when they compare managers and strategies, of course Sharpe was never invented to use on single line items. It’s a portfolio tool.

So, it makes sense to maybe look at the impact of these alternative strategies when you include, in this case, we used a 20% allocation so instead of a 60/40, it became a 50/30/20. But again, we do it for all the various strategies.

And, of course, this is where we start seeing something really interesting happening both when you use the industry benchmark, so the SocGen Trend index, but also, this is where we start seeing the benefit of maybe adding leverage to the strategy. Maybe not as much as when you look at drawdowns (I’ll come to that in a second). But certainly overall returns of that portfolio increase a lot. The Sharpe is a little bit lower, but okay, that’s how it is. Of course, the max drawdown benefits also from having more of this non-correlated (or even negative correlated at times) strategy involved or invested in it.

And then finally we start looking at, okay, specifically, if we objectively say a crisis in equity markets is 25% or more drawdown in the S&P 500 (so, we’re not cherry picking as such, we’re just saying this is the criteria), you come up with four crises since 2000. And this is where, of course, trend following really starts to shine in terms of the reduction of drawdown to the portfolio relative to all the other strategies in terms of what they would have produced.

So, those are some of the highlights and people can go and read it, but of course I’m curious to hear your thoughts. I’m sure the conclusions are not a surprise to you, but I don’t know if you’ve ever, yourself, looked at all these other hedge fund strategies that we are compared to, and of course, that people often prefer because they look safer when you look at them on a stand-alone basis than what we do. They might even look better performing, in some cases. So, was there anything?

[00:57:48] Moritz

Nothing controversial. First of all, I do agree with you that volatility is not risk to us. Volatility is also opportunity to get into very interesting and potentially lucrative trades. We’ve done that research, Niels. We’ve selectively shared it. It’s not something that we can put out on social media.

But you know, we’ve not only analyzed the CTAs and trend following funds, but also other hedge fund categories with the data that we could find from databases. And very clearly what you can see, and some strategies, the deterioration and the decline in realized volatility has happened in the 90s. For some it has kind of like started 25 years ago, around the change of the millennium. But very clearly and now statistically significant, the rolling 12 month volatility, you can look at this and observe this, obviously, over different time frames. But I’m just using the 12 month volatility here. Rolling 12 month vol is really just downhill, downhill, downhill. Essentially the volatility has halved.

Hedge funds used to produce and generate a much greater or 2x times the volatility, on average, that they’re doing today. That, by the way, is also true for trend following funds. So, one of the questions, naturally, that comes out from this is, why has that volatility declined? Why has that happened? And obviously, I do not have the definitive answer, and nobody will have the definitive answer. It’s a decision that each of these funds has kind of like made for themselves.

But we can, at least, hypothesize about a couple of things. One easy one would be size. The larger you get, as a fund, you go from US$100 million, to US$1 billion, to US$10 billion. We’ve seen this with Winton at more than US$30 billion at some point. The greater that portfolio, the greater your AUM, the more difficult you will find it to implement these trades.

Forget about trading some of the smaller markets that we’ve mentioned at the beginning of this recording, like lumber and OJ. These have already dropped by the wayside then. But also in the traditional larger markets, if you want to get a US$30 billion portfolio to work, it just makes sense to trade smaller.

Trading smaller, or having a lower volatility target, if this is your objective, if we’re using volatility now as an objective function, then if you lower your volatility by 50%, it means you’re trading half the number of contracts. So, that means more scalability, less market impact, less slippage, all these types of things.

So that’s one thing. Size could be one thing, just the size of your own fund. The other reason for this, and this could be in combination with number one, is a response function to institutional investor demands. And this is also clearly, it can be seen over the past 25 years, the big tickets are written by institutional investors: the sovereign wealth funds, the pension funds, and so on. And most hedge funds are looking to get investments from these clients because they can be very large, sticky, lucrative, they can open other doors, because it kind of like it gives you a pedigree, if you will.

Now the willingness of these investors, on average, to experience large drawdowns or large monthly losses is much smaller relative to, say, a high-net-worth individual investor that has a diversified portfolio of things. That is because these allocators are usually paid, career risk. You’ve mentioned, at the beginning of the recording, there’s a board that oversees all of these types of things and assesses it at the end of the year or periodically. And you just don’t want to look stupid, as an allocator, to invest or allocate to a higher volatility investment that occasionally does go the wrong way, and then you’re kind of like responsible for that.

So also, in response to these institutional investor demands, the hedge funds could have lowered their volatility. I’m sure they will have. Now, the kind of weird outcome of this is that the fees really haven’t changed that much. I mean, over the past 10 years we could observe that the 2 and 20 model has kind of broken, and the average fee has declined. Now that has reversed with the multi-strat funds. The hedge fund fees are actually increasing again.

But what I find very weird is that the fees have not come down commensurate with the reduction in volatility. And some of these hedge funds, they’re kind of like now in the single digit per year return business. And I kind of ask myself, why are you in the hedge fund business (which is tough enough to begin with, with all the regulatory constraints that we have, all the things that we need to do) if you’re shooting for single digit returns? And investors, apparently, have put a blind eye to it. They’re just continuing to pay these high fees, especially management fees.

[01:02:50] Niels

Sorry to interrupt here, Moritz, but do you think that’s really true? Because I actually think fees have really come under pressure. I mean, just look at the CTA space. I mean, 10 years ago people, or maybe more they started to offer flat fees. I think there are a couple of indices with flat-fee managers that have been around for a while now. I thought that was a big change in our industry.

I don’t understand, frankly, personally, why people would not want to participate in the upside if you do a good job for your clients. That’s just my personal opinion. But anyway, flat-fee became much more common. And we know, in a sense, that that is something that institutions often gravitate to. And the other thing is, of course, with the ETF space, with replicators, non replicators, you see the fees now below 1% flat-fee. So, I actually feel that there has been a change. I can’t say whether it’s in proportion with the drop in volatility and all of that. I’ve never done that calculation, but I think there’s definitely a change in our industry happening.

[01:04:05] Moritz

Yeah. With ETFs, different dynamics, I do agree. And like I’ve said, fees have come down, but not commensurate with the decline in volatility that has been experienced. And for some hedge fund strategies (I’m excluding commodity trend following or our space in that regard), but for multi-strat funds the fees have been increasing.

[01:04:24] Niels

Sure. I agree with that.

[01:04:26] Moritz

Lockups have been increasing and all that.

[01:04:28] Niels

Yeah. And you know what? The other fun part, actually, is that this industry, to a large extent, probably most of the top 20 managers that we have today in size, they all had experience with sovereign wealth funds when they started out because there was one sovereign wealth fund in particular that was very early into this space and into this industry. Now of course they were not keen on paying too high of fees, but still.

But one thing that was very different back then was they didn’t mind the volatility. And this is kind of the interesting thing because today you could say, yeah, maybe it is sovereign wealth funds, maybe it’s pension funds that are driving down the volatility of our industry and other alternative investment strategies. But you would think, with funds that have really, really long investment horizons, that volatility wouldn’t be an issue.

And I don’t know if you read some of Dave Dredge’s stuff. I like his… (and I don’t want to sort of completely misrepresent what he says) but this idea that institutions today are really just optimizing for some kind of average return they don’t want to be too far away from instead of optimizing for how do we compound the best, over the next 40 years, not worrying too much about annual performance.

And that makes a big difference in the strategies you end up choosing because you kind of de-emphasize the true risk mitigators like trend, like maybe even long vol, which he’s obviously involved in. And then you end up picking a lot of the strategies that we put in our paper, the one that people love because they look safe but they’re just highly correlated during crisis to the underlying that they’re trying to diversify away from.

[01:06:31] Moritz

Yeah, I think Dave Dredge nails this, as always, quite well. And I do agree with him. The behaviors or the dynamics in this institutional space have changed. Above all, nobody wants to look stupid.

You’re kind of like, don’t go out Olympic, don’t put anything into a high volatility trend following system because you might just be looking silly at the end of the year. So, it’s become this composite thing of just, yeah, it’s kind of like an average, which is what they want to optimize for.

Also because of that, I mean in a way, this has been fantastic for the hedge funds in this game, catering to these investors who already have their allocation and the tickets from these pension funds. Because now with a lower volatility you just change the business dynamics where the management fee, the AUM based management fee is so much more valuable relative to the performance fee that you’re kind of like getting into this asset gathering mode where I fear that the alignment that previously was meant to exist between the hedge fund and the end investor kind of like deteriorates. It’s no longer as strong, which I think is a negative.

And it may also take away from the motivation to really produce the best returns because the average is good enough if you’ve gathered billions, and it’s sticky money. You’re just making so much money off that pool for management fees, they could just sit there.

So, this is one of the reasons I think your firm and mine were the only ones in that camp… Let me take ‘the only ones’ back… but at least I don’t know of any other ones. We’re not taking management fees that are based on assets. And I think that is incredibly fair. It is motivating. It aligns us with our investors. And, in a way, I think this is the way it should be.

If we’re holding ourselves out as a manager that can produce a return stream that is different, distinguished, uncorrelated, whatever your definition is, but it’s valuable and it doesn’t look like long-only buy and hold, or buy and hope of the S&P 500. So, you’re not something that is beta.

And beta is different than a strategy being commoditized, which trend following may be because a lot of people have read about the rules. But the return stream that we’re producing is not a beta return stream. And it can be very valuable at times, very punchy at times.

And because of that I think we deserve a performance fee if we’re doing our job right and we should be driven by that incentive fee and we should not be driven by asset gathering dynamics where we’re compensating based on management fees. In fact, in our case, because we’re limiting our size, the management fee would never really be possible to be the dominant driver anyways.

[01:09:24] Niels

Yeah, fair point. Now, of course we should always say that we have lots of friends, that we respect a lot in the industry, that have a different opinion about fees and all of that. And so, this is of course just the way we see things. And, of course, it gives investors more choice to decide what they really want to do.

This was fun, Moritz, this was great to have you back in this role in addition to all the episodes that you produce yourself. So that’s fantastic.

And if you want to show your appreciation for the efforts of Moritz, go to your favorite podcast platform, leave a rating and review, share the episodes so that more people can enjoy this type of content.

Next week I’m joined by Katy Kaminski. That will be fun. I think, as I said, we might get Katy to look more into the paper that just came out from Man Group about dispersion among managers. Maybe she’s produced another paper since I last spoke to her. You never know with her. So, if you have questions that you want Katy to tackle Info@toptradersunplugged.com is the email address.

From Moritz and me, thanks ever so much for listening. We look forward to being back with you next week. And until next time, as usual, take care of yourself and take care of each other.

[01:10:47] Ending

Thanks for listening to the Systematic Investor podcast series. If you enjoy this series, go on over to iTunes and leave an honest rating and review. And be sure to listen to all the other episodes from Top Traders Unplugged.

If you have questions about systematic investing, send us an email with the word ‘question’ in the subject line to info@ptoptradersunplugged.com and we’ll try to get it on the show.

And remember, all the discussion that we have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also, understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Thanks for spending some of your valuable time with us and we’ll see you on the next episode of the Systematic Investor.