Why Investors Keep Getting Trend Following Wrong ft. Patrick Welton

[00:00:01] Pat

It’s the usual tragedy of managed money, to watch people, watch performance, wait for there to be enough confirmation and confidence, get in a little bit too late and put themselves on a right shift of time, off cycle.

[00:00:20] Intro

Welcome to Top Traders Unplugged. In markets success doesn’t come from predicting what happens next, it comes from being prepared for what you can’t predict.

In each episode we go deep with some of the world’s most thoughtful minds in investing, economics, and beyond to understand how they think, how they prepare, and how they decide, and the experiences that shaped how they see the world. No noise, no short-cuts, just real conversations to help you think better and invest with confidence.

[00:00:53] Niels

Hey, everyone, and welcome to another edition of Top Traders Unplugged, where today Alan Dunne and I are delighted to be joined by Pat Welton, founder and CEO of Welton Investment Partners, as part of our series focusing on the one investment strategy that we have dedicated pretty much all of our careers to, namely trend following and managed futures more broadly.

First off, Pat, it’s really great to have you on the podcast. Thanks so much for joining us today. We really have been looking forward to our conversation. I hope you’re doing well.

[00:01:23] Pat

I am doing well and thanks for inviting me.

[00:01:26] Niels

Absolutely.

[00:01:26] Pat

I’m actually, maybe more importantly, as I told you the other day, thank you for all you do for the trading community. You’ve probably built the single largest and best resource to help traders and investors that they could find anywhere.

[00:01:41] Niels

That’s very kind of you to say. Thank you so much. And of course, we do it because we have contributors like yourself, so that’s how we can do it.

Alan, it’s also great to see you. How are you doing? How is Dublin treating you?

[00:01:53] Alan

Dublin is very good, yeah. Great to be on and looking forward to speaking with yourself and Pat. I’m sure we’ll have a lot to delve into.

[00:02:01] Niels

Yes, absolutely.

Now, before we get into all of the different topics we’re going to be discussing, I would like to set the stage a little bit for our conversation so that the audience knows a little bit about your background, Pat. But instead of doing the usual list of places you worked and all of that stuff, I was hoping that maybe you could tell us about maybe 2, 3 pivotal points in your career where you experienced something profound that shaped how you think about investing and maybe also kind of led to where you are specifically today.

[00:02:36] Pat

Wow. Well, you know, when you’re 65 years old, there’s definitely been a few pivots, especially in this industry.

[00:02:42] Niels

Tell me about it.

[00:02:44] Pat

You know, I think for those who know me and know that I’m a physician and know that I started a hedge fund years ago, the usual three pivots that I get asked about are something like why medicine, why trading, and then when they hear those, then the most perplexing one is they say why both? So, we could delve into those.

Why medicine’s a pretty short story and mostly about working in a cancer laboratory. Why trading really is a life pivot because that really is also how fortunate I was to meet my wife and co-founder Annette. And why both, it’s a multi-legged story but the capstone of it was probably a very kind Paul Tudor Jones that Annette and I went to visit many, many, many years ago that gave us some resolve afterwards. So, would you like to delve into any of those?

[00:03:51] Niels

Yeah, actually, you know, because you have a very interesting background, and obviously it dates back to the Commodities Corp. days, many people don’t really know how important I think that company was. Not that I want to spend too much time on it, but I mean, of course, it could be fun and interesting maybe just to hear one or two short stories. You had mentors. You mentioned Paul Tudor Jones. I think you know, John Henry. There are others that are very well-known people from our industry. If you have a few things you can share that would, of course, make it very interesting.

[00:04:33] Pat

That will probably help condense 40 years into a smaller number. So, sort of spinning my way up. I ended up changing initial college studies into medicine, received a grant for a medical scientist training program, which led me to UCLA, which is also where I met Annette, the very first person I met at UCLA. So, I’ve warned young people for years, be very careful who you get into an elevator with. You might be there for a long time.

And that subsequently led to really, I think, to some degree, us trading personally to make some ends meet. But with Annette’s entrepreneurialism and sort of striving, we ended up getting discovered, if you will, when we were up in the Palo Alto area, when we since moved to Stanford. And one thing led to another and we were introduced to Commodities Corporation. So, we learned about them much like somebody today might.

If you roll back into the late 1980s Commodities Corporation I think could reasonably be thought of as the very first multi-strategy pod shop of traders. I think of them as much more dimensional than that though because they also were very explicitly in the business of developing trading talent. They had senior traders, they oftentimes mentored juniors, they had facilities that, you know, helped junior traders work. And one thing led to another and we were offered a contract to trade for them.

So, while we were trading for ourselves initially and thinking we might be saving up some money for some kind of opportunity to explore later in life, it turned out the trading itself became the opportunity when we turned professional and started trading for them. And that really sort of leads to the mentorship that we learned from many other traders.

And there are many others that we met. And we learned a lot from some of the very biggest names in the industry that you and I might know, some of which aren’t even in the industry today – for instance, like John Henry.

[00:06:52] Niels

True.

[00:06:53] Pat

But there was one episode. We were still thinking about medicine as a primary career, and trading was just on the side. It was just simply a profession for us. And we hadn’t really thought about developing a separate company.

But I do remember, in ‘89, we had sort of had a really good start with CC. We were allocated more money every quarter as we hit return targets. By 1990 or so, we were trading sort of more and more money and met more traders along the way. And it was about that time that Elaine Crocker, who was the head of Commodities Corp’s trading at the time, called ahead for us and said we should really meet Paul Tudor Jones.

And so, she brokered that. And though it was long ago, Paul was already very famous as a trader, even that many years ago. He is just a standout natural talent. So, we really looked forward to meeting him.

And I still remember that day because we arrived, and one of his colleagues, I think his name was Sean, met us, and he guided us in, and showed us about the office. We waited for a little while, and sort of in the distance, at one point, we could see Paul very sort of engaged, intensely engaged on a phone, screen, you know, looking at something, walking about. And we were delayed, and delayed, and delayed, and we were thinking we might be meeting him for a five minute handshake or something.

But after about 15 minutes, just this remarkable thing happened. He sort of came out of his office, all intensity was gone. He was fully gracious, and welcoming, and kind, and apologizing to us (as sort of trading nobodies from Commodities Corporation) for his being late. And then almost instantaneously, he offered us one of, I think, the greatest trading lessons we ever learned.

He said in this sort of marvelous Southern Memphis accent that he had at the time, which was much stronger then than I’ve heard him recently on interviews, but I still remember him saying, he says, Pat, Annette, he starts going on, one thing is that when you start trading size, you can’t only think about getting out when you want, you have to get out when the market lets you.

And from there forward, I could never sort of unsee the obvious, that markets weren’t math, that there’s somebody on the other side of every single trade who at that moment believes they also have an edge. And I’m sure as we wander on other topics, that theme is going to come up again and again. Market structure matters.

The second thing we did was we walked around his office, had this marvelous tour, his graciousness, humor, all everywhere, telling us one short story after another. And he’s pointing out the desks and pointing out the facilities. And then he said something like (which just from memory was something like), when you grow, you need more things, you need more people, you need more capital. He said, and then it starts getting funny.

And so now we have manuals for this, we have manuals for that, and now we have manuals for all the manuals. And of course, we’re all laughing at this point. But we left that meeting and the lesson that was really clear for us, was that trading was only one, one component of building a professional trading firm.

And we digested those lessons for years. And ultimately, after sort of processing them, we decided that if we built a small firm, even one that was a tenth or a twentieth the size of Tudor, that we might be able to fully separate the missions of medicine, whether they were practicing, or teaching, or research, or any combination from money. We could solve for them separately.

And so afterwards, we decided to build a small firm and we began taking in outside money. And that’s what Welton is today. And even in retrospect, it seems naive, but it’s exactly what became true, and it’s been a guiding principle for us since the start.

[00:11:17] Niels

Yeah, wonderful story. Thank you so much for sharing that. I have to say, I think these stories from around the time when I began as well, I think they’re so important. And there are some people in this industry that have, yeah, really got some amazing lessons that they have shared along the way. So, I appreciate that.

Now, Alan and I, and you, we spoke a few days ago because you brought along a lot of great ideas in terms of what we could be talking about. And what we have done since then is we’ve kind of tried to divide topics up into the usual headlines, if you like, that we normally talk about when we do this particular series. And so, what I will do, in the usual tradition, is I’m going to kick it over to you, Alan, to start off.

[00:12:12] Alan

Great. Well, maybe to pick up on that, and, I suppose, evolution that you talked about, Pat, in terms of medicine to trading. And then I suppose what came next was an asset management business. And obviously it was one of the themes you kind of touched on in your own notes, the transition from being a prop trader to running an asset management business, which you’ve mentioned again there. So just curious, maybe if you could delve into that a bit more.

Obviously, when you run an asset management business, there’s the whole business side that comes with that in terms of compliance, and sales, business development, etc. But I’m more interested in kind of the risk management and the trading. Does that differ when you’re just trading as a prop trader for yourself, with purely just yourself accountable, to then thinking about, okay, we’re going to get into the business of managing risk and generating returns for outside investors and how that evolved and how you’ve thought about that over the years.

[00:13:11] Pat

You know, I think that’s a question that doesn’t receive enough attention. Or if it does receive attention, it’s the mechanisms of building the firm, kind of the lessons we introduced, the compliance, the operations, the regulations, etc. But that’s not really the big difference.

I think the real big difference is a moral difference. When you’re a proprietary trader, and to make it easy for yourself, you would have one set of goals, and hopefully they’ve been sharply defined because if they’re not, that’s going to be a principal weakness, and we could talk about that separately. But I think the minute you take in outside money, you really take in the moral obligation that it’s their goals that are most important, for what you do with that money, which shapes everything.

It shapes the very heart of the question you just asked. How is risk managed? In their particular world they’re more like an allocator than an investor, they might want something that is more consistently exposed, and more constant and targeted volatility as it would be known today. If they were more of an investor, they might want more exposure when there’s a better value or when there’s a better forward return profile and less exposure when it’s weaker, because there is a sense of wanting to have your investment size proportionate to return.

But I think it all stems from really that moral difference that the day you take somebody’s outside money is the day you make their goals the number one goal. If you were turning it into any kind of a formula, the formula is probably different because most prop traders for themselves are probably thinking something on the order of a RA ROT, a risk adjusted rate of return on capital. So, they think in dollars more than they think in percents.

[00:15:14] Alan

I mean with that in mind then, obviously, does that presumably inform you of the kinds of programs you offer and the blends and the levels of volatility and everything that goes with that, presumably?

[00:15:26] Pat

Absolutely, and it has over the years. You know, when we first began trading outside money, we traded what would be classified today as more or less a diversified medium-term trend following program with a few shorter-term elements in it that was not traded at a fixed volatility. The volatility would ebb and flow within a range though its average volatility would be in, approximately, probably about a 15 vol in the ‘90s, but that might be 10 vol when there’s less opportunity, and 20 when there’s more, something like that amplitude range.

Later on, in the early 2000s, I still remember, actually, a very pivotal meeting. I was speaking for one of the French bank circuits that were popular at the time. And after my speech we were gathered in one of the restaurants in the hotel outside of Florence with three pretty well-known people in the industry, maybe even people who’ve been on the podcast at one point in time. I remember us all being at the table and them asking a really serious question. Why, when I have an account with some professional traders, do I seem to lose money three or four times faster than I make money?

And I, of course, thought it was an observation, a feeling, maybe some griping. But when I left, went back and looked at track records, other than ours, and looked at what would be likely in different products, it was exceptionally true. And the early industry at the time I don’t think was as sensitive to some professional allocators’ needs for the fact that when, once they took positions, when there was rising volatility (which oftentimes was accompanied by rising correlation), that the overall net exposure was rising and that it wasn’t poor timing, but that a reversal, in some cases, was approximately three or four times faster in equity P&L.

I don’t think you see that in track records today because in the early 2000s many people, including ourselves, began volatility targeting the portfolio or volatility targeting segments of the portfolio to mute those kinds of responses, to make it more compatible with professional allocators dedicating exposure.

[00:18:08] Alan

Interesting. I mean it is a topic that we’ve had on in different guises over the years, vol targeting or not, or should even the kind of the idea of pure trend versus more diversified systems. It sounds like, from your perspective, that you do really have to solve for investor needs more so than shooting for the maximum RA ROC.

[00:18:34] Pat

I think it’s the only way you can go. I mean, I’ve had investors, savvy investors who… I remember getting a call when they would call and double the size of their account. I was almost certain that was the end of any industry drawdown, they were so good at it. Or when they took half off the table that, you know, essentially it was time that the current party of the day was over.

There were others that could never find that sense of value in investing. It’s the usual tragedy of managed money, to watch people watch performance, wait for there to be enough confirmation and confidence, get in a little bit too late, and put themselves on a right shift of time, off cycle. It doesn’t really matter if you’re taking outside money. I still think you just have to do the best job for every single allocation that you have. But, by no means do I think you group them all in the same bucket. They really, I think, have idiosyncratic and important differences in their organizations for how they’ve designed their portfolio, how they consider your contribution, how they even capitalize that contribution, things that I know you both are very expert at.

[00:19:53] Niels

Can I jump in here in this particular topic? Sorry to do that, Alan, but here’s something interesting. I think we’ve heard from many industries, and I certainly remember from conversations that I’ve had with our colleagues in the industry, that I think people would question that customers or clients actually know what product is best, if I can define it like that.

And so, I think I know what you’re referring to, Pat, and I think, from a purely business perspective, clearly if you only have products nobody wants to buy, there’s no use in that. On the other hand, I think our industry, as trend followers, it’s probably not the most liked investment strategy out there, but it offers tremendous value.

But I think part of that value actually comes from us doing it the way we think is the right way to do it. And then the data will support investors making allocation to it. So, I don’t know if I misunderstood what you were saying or whether you agree with that, certainly, if we’re just talking about pure trend, we can get to how you can diversify away from trend in a second. But certainly, if you think about pure trend, it’s probably not going to have the profile that most investors say, yeah, I love that shape of the return stream. But on the other hand, it’s an incredibly useful property to have in a traditional portfolio. Do you know what I mean?

[00:21:40] Pat

I not only know what you mean but let me take it a little further and see if you agree. When I say there’s a moral difference of understanding the client’s goals, I use those words on purpose because what the client exactly wants isn’t necessarily always what their goals are. And I think there’s a listening phase there.

And one of the most pernicious and damaging things I think traders have done to themselves is to respond to marketing feedback. In the hopes of growing their business they end up changing what they do.

And if we rolled back the clock 30 or 40 years, there would not be 20-page pitch decks. If you were interviewing a trader, the four seminal questions were always: What’s your edge in the marketplace? How and where are you going to exploit that edge? What is your risk management or position sizing? And just when you thought you were done with the interview, the last question was: And how do you protect your tails?

And the minute… And trend followers have done it, hedge funds have done it, it’s pervasive, private equity groups have done it. They get into the marketplace, they hear some feedback, and they start to try to change what they do. And a trend follower has a very… I think the way you use the term a ‘pure’ trend follower has a very specific edge from agnosticism. And there are nuances along the way but, for the most part, the setup, the signal, the position sizing, the asymmetry of positions, all of those things rely upon multi asset class, multidirectional participation.

You offer the client the ability for them, as they’re invested in singular asset classes long, you offer them the possibility as capital moves from one asset class to another, from one sub asset group to another, from long to short, from long to flat, from selling one to buying another (which inherently of course is obviously a synthetic short and long), you are picking up return as that capital moves over months and quarters. It brings the convexity that is so valuable, it brings the skew that’s so valuable, at least on the timeframe of quarterly and semiannually, which is another discussion of how those terms are sometimes confused.

And if there’s a reflexivity in the marketplace in pricing, which is strong and there is, there’s still a reflexivity in the managed money business of managers conforming to what they think clients need and then clients changing what they want based on what they think they heard managers evolving to. And I think the true north compass needs to always come back to: Is there a market edge? Because if it starts to drift from that edge, results are just going to get worse.

[00:24:47] Niels

Yeah, you mentioned a few S’s there. I think we probably should dive down maybe a little bit further into those S’s, because I think one of the things that I hope we’re going to do today is also to kind of get your take on the narrative side. I think this is something we’ve talked about for years, how difficult it has been for our industry to really maybe explain well enough the benefits, and so on, and so forth. We know narrative is incredibly important, but maybe we could just start with the kind of the four S’s that you referred to and take it from there.

[00:25:33] Pat

Well, you know, the four S’s are helpful. It’s not a complete framework, but it’s a helpful starting framework for anyone who wishes to trade in that it’s part of the mechanism. It’s not really part of, I think, of a grander narrative, we probably should park that for a separate question. But if somebody’s trying to set up a successful trading approach, and it probably works for discretionary, systematic, or both, but let’s just confine it to systematic for now. Normally the four S’s would need to be satisfied.

You simply have to ask yourself, what is the setup for your trades? Are you trading continuously or is there some form of a setup you’re looking for that raises your probability, in a Bayesian sense, for when you wish to exploit your edge?

Two, second S: What’s your signal? What makes you get in? What makes you get out?

Three: What’s your sizing? This is sort of synonymous with risk management, but sizing now includes forward opportunity and risk.

And then [four]: What’s your symmetry? Have you entered a trade with an equal win to loss balance, or have you entered a trade, either directly or synthetically, where you have an asymmetric advantage?

And that’s what I really meant by the four S’s. I think those are more of a practice, a discipline of understanding how to put together a trading system that has well-defined steps and there’s an infinite number of those solutions perhaps, but the better defined they are, and I think if a trader or an investor soul searches their answer to each one and understands why they’re doing it, they will also stick with it. Which maybe gets back to another one of the early trading meetings I had.

I remember when Annette and I drove down the coast. We lived up in Palo Alto at the time. We drove down and met John Henry in his early office. Back then, back in those days, he was in Newport Beach right next to PIMCO. And we had met him once. Then we met him a second time.

And I still remember him saying something to the effect of, Pat, the difference between our success and other people’s is that we actually follow our system. And then the other thing I remember him saying was that we could print our system on a billboard on Highway 101 and not have to worry about anything because no one will ever follow it because it’s not theirs and they’ll have no confidence in it.

Which really means you have to… The trader or the investor and the methodology, they have to pair themselves with a degree of confidence or there’s really no way to exploit that edge through time. They can’t navigate the seas when they’re rough or even when they’re calm. But the four S’s help there.

I don’t think it sells the narrative, though. I think there’s a little hook in the narrative part because there are a lot of managers and a lot of analysts for allocators who dive into the mechanism almost right away. But because it’s, I think, a relatively… It’s both unemotional and unattached to any rationale for success. It’s more just facts and not reason. I don’t think that, over time, there’s been very many compelling matches between an investor and a manager based strictly on what do I do every single day, what math do I invoke, what formulas do I use? I think, for the most part, they’re either unappreciated, unmoved, or quickly forgotten.

[00:29:36] Niels

I want to bring Alan in a second here because I also think it’s relevant to talk maybe about regime shift, and so on, and so forth. But just staying on this topic for a little bit longer. You describe the four S’s. There’s more to it. And then you also talked about, well, if it’s not kind of your system, people probably wouldn’t do it even if you told them the rules.

Now, this is a bit of a stretch, and I might get into trouble with some people, that we know well, when I say, replication comes to mind in a sense that, well, they probably solved the narrative, let’s start there. But it’s not really their system because they are not using the underlying rules.

However, some of them, at least, have been pretty good at mimicking the returns, depending on how you define that, of course, or at least the correlation, maybe, they’ve been able to mimic. So, I’m curious about your thoughts on replication.

[00:30:53] Pat

Well, I think I would separate replication from the mechanism of replicating versus the productizing of replication. I think one of those is a valid mathematical way of formulating a systematic approach and it’s something that almost every trader does one way or another. Even a trend follower, for instance, does not trade primary cash bonds or primary cash commodities, mano a mano, with other counterparties, when they’re really waiting for price, smoothing price and deciding some formulaic way of deciding whether to say there’s an uptrend or a downtrend. That’s really replicating the actions of others, through the reflection of the information of the price signal, which is then typically smoothed and brought in.

There’s not much of a different step to then say the P&L of another trader is now just a price signal that then is used to replicate, usually by some form of regression technique where it’s done, and it’s been done in many areas. I don’t think any of your sophisticated audience would be surprised to learn that an S&P 500 index fund doesn’t have to own all 500 stocks at any given point in time to replicate the S&P 500.

So, I just separate that because we’ve actually done some very specific work to replicate some of the replicators, mainly to ask our own questions. We wanted to see what are some of the reduced minimal market sizes that replicate, say, the trend following industry. Is it similar, for instance, in some of the popular ETFs that are used?

Some of those ETFs have changed their market set over time. If they hadn’t, would there have been much of a change? There would not have been, by the way.

If we do replicate the replicators, we actually end up with better performance. But that’s probably not too surprising because we end up with a better smoothing coefficient, and we probably end up with less churn for rebalances at the end of the day. And if it were fully funded, you’d have probably lower fees and better cash management.

So, if an institution wants to do US$500 million, they don’t necessarily have to go into a retail product and they could get the same idea. The other part of replication, of course, is sort of the less savory part. It’s the narrative story. It’s the hero’s journey, if you will. Somebody has to come along and, you know, solve the problem. The rapacious managers are charging too much money, they’re too opaque, and we’re going to beat them at their own game, and we’re going to sell this much lower, etc., etc.

And, you know, it certainly worked for Jack Bogle. He wasn’t in the hedge fund world, he was trying to give consumers a better deal. It starts to stretch though, as you get more and more into the very, very active ETFs. At some point that gets to be a fuzzy margin of extracting cost, which is clearly true when you have a three or five basis point product or whether or not you’re simply trying to carve another narrative niche out and finding a sensitivity point.

And some allocators, the overall cost or the manager selection risk, those are two failure points for some of the professional allocation staffs that exist in the world. So, solving for those two would definitely appeal to a large number of people.

[00:34:39] Niels

Sure, Alan, sorry, I hijacked the conversation there.

[00:34:44] Alan

Yeah, I’m just curious, you know, you’ve obviously been in the markets many years and, you know, you’ve started off trading in college, I think you said, and you know, then had a big focus on trend following…

[00:34:58] Pat

The Hunt Brothers silver trade, my first trade.

[00:34:59] Alan

Okay, so there you go. But you’ve had programs in kind of macro type program, short-term, equity. You know, I’m just curious where your philosophy around markets and investing came from. Was it an observation on behavior, or just an observation on what works, or something that has just evolved in markets? What underpins that to give you confidence that these types of strategies will continue to work going forward?

[00:35:32] Pat

Yeah, I think that goes back to Niels’ question of, if we were to want to improve our narrative, at least for some classes of investors, would we stay with the true statement that trends are behavioral, but then be willing to defend the fact that the non-trending periods are also behavioral and the periods of high liquidity are behavioral and the periods of low liquidity are behavioral because the markets are the sum of the participant behaviors – all true.

I think sometimes those kinds of explanations just simply aren’t enough for the types of people who are listening who either, if they’ve had sort of CFA and securities training, they’re listening one way, If they’ve been entrepreneurs or it’s family office wealth, they’re listening from a different point of view. Perhaps if they’ve had technical or engineering type backgrounds, they’re listening from yet another point of view.

And I think that it took 10 or 20 years of a lot of disciplined work and especially, as we began trading for individual clients, a volatility arb program. We traded a stat arb program, thousands of trades per day for a while. We’ve traded trend following. Really to come back and say, I think the best narrative, after some form of a story, of a character overcoming a challenge, that’s the thin layer. The next layer I think comes with, can you really tell me where the returns source from? I’m a student of the markets. Where do these returns come from?

And I think from trend following, we’ve been quite successful decomposing trend returns into true counterparts. I think that there are four. If we stick truly with trend following, which I’m going to define now, holding positions through time for a profit.

I didn’t say long or short, I didn’t say one. I just said holding positions through time. With one more feature, some form of buying strength and selling weakness, that’s what the following part means. We’re not predicting. I think one can decompose returns into the components of economic trend, into financial carry, into information diffusion, and then into some form of reflexivity in a Sorosian term or in an academic term, or just a feedback loop, buying begets buying.

Each of those, it’s different powers in different sectors. They have different time frames and clocks. And when I talk to investors and they need a natural metaphor, it’s not a stretch for them to say, look, if you had a boat in the ocean, there isn’t one source. The boat will move because it’s in a current. The boat will also move because it’s in a tide. The boat will move because a wind is applied to it. A boat may also move because someone starts an engine. Now all those could all be in the same direction, they could be in the opposite direction.

If you could have a positive economic carry, for instance, in equity indices, which is extremely strong, but face, for most of the time, a negative financial carry and still come out ahead. In something that has very little influence of a long-term economic carry but a strong financial carry, one could look at say roll premium and fixed income contracts.

If one does a pretty careful decomposition of trend, one will find that the majority, and in some cases the vast majority of returns, will be accumulated term structure premia, not so true in other markets. But those four components, I think way beyond the scope of our one-hour podcast we could spend the entire time decomposing returns and showing those return decompositions, and why a trend follower picks them up, and why a trend follower picks them up agnostically. Because they do flex, they do change, and they can have unexpected directionality.

There’s a great story of 2013. I remember 2013 is not unlike a little bit today in that everyone, everyone was writing how much bonds will go up and how much interest rates will go up. And to get ready. And of course, what happened in 2014? Interest rates went down the entire year, and trend followers made 20% or 30%, and almost everybody else missed on their predictions, but they were still happy because if they owned bonds, they went up.

So, trend following has a very powerful meta cognition of all these returns. But I think if you’re trying to explain it and the person has an economics or investment background, showing the return attributions plainly that they could even derive on their own, or they can see how they are derived independently from the opinion of the trader, I’ve seen light bulbs go off in people’s heads, like why didn’t somebody just show me this years ago? Now I get it. And they get everything. They get why the correlation is zero. They get why it’s positively convex, all kinds of things happen positively.

[00:41:02] Alan

And that kind of high-level justification, you think that’s the same to different degrees? I mean, you might weigh those four factors differently for say short-term trend following or systematic macro signals?

[00:41:15] Pat

I think the answer is true in both cases. So, almost by definition something that is some form of a carry, like an economic carry or a financial carry, I’m essentially saying something that those positions benefit by time. Your ownership through time is what accrues profits. So, if I make something short term, I’m essentially taking those out of the equation.

Back to a water analogy. If I’m swimming downstream in a river, I can swim faster with the carry than I’m swimming upstream against the carry. That will matter if I’m swimming for 20 hours. If I’m swimming for three seconds, the carry doesn’t matter very much.

So, short-term definitely spends more time not only in the information diffusion and reflexivity, but it also begins to pick up other terms I didn’t include in trend following because the impact of flows, accelerating flows, periodic flows, rebalancing flows, these kinds of more market mechanistic I think are far more useful in the time frames of say less than 10 day holding periods. As a matter of fact, there have been very few instances except for very large contracts, large dollar volatility of the contracts, oftentimes with large point values in those contracts, where you can parameterize any type of a traditional trend following mechanistic approach and make money with very short-term holding periods – three days, four days, five days.

Even in academic studies, when they look at short-term trend following, usually the holding periods are closer to a month on average. There’s just a very narrow window by the time you buy strength and sell weakness, what’s left in the middle is your potential profit. And if you’re only in the market for three days or six or five, other techniques work better.

And we’ve learned that and experienced that, but we’ve also focused a lot on it. We love trend following, it works. We love systematic macro trading because it works. And what I mean by that, in this case, definitionally, is a full separation. Trend uses price, the macro trading uses only cross asset signals, fundamental signals, government reports, alternative data. The short-term models are all principally focused on flows with holding periods far less than 10 days typically.

And in our particular firm we also would include things like relative value trading where we are very specifically trying to create neutralized baskets that are really helpful to our main portfolio, a main portfolio and macro or in managed futures, some will pick up large scale thematic risks, direction of US interest rates, direction of US equities, direction of energies. And there’s a natural construction where you can build, say, a dollar neutral currency basket. Now you’re not stacking on top of your dollar risk. You can pick a rate neutral interest rate basket and you’re not stacking on your DV01 or commodity neutral basket. And you’re not just landing on top of broad based. So, that adds diversification.

And I guess, as long as I’m actually addressing it, the fifth thing that we do in our multi-strategy is a dedicated risk-off sleeve which is only designed to sell equities when there’s a rapid rise in flow data that shows us to have hedging and mispricing activities. When people are willing, as an edge, to give us money to neutralize the risk, our edge rises and it helps our clients.

[00:45:21] Niels

Now Pat, you mentioned yourself there the word multi strat. And of course, we can see the rise of multi-strategy funds in the past, call it 20 years, maybe even shorter than that. And I was wondering, because obviously my personal bias, is trend following, have you noticed… And I guess maybe it goes into some of the great work that Alan has been talking about in terms of regimes, but do you think that multi strat funds at large, and how they trade (and I’m not an expert in that, but it’s not trend following, at least not all of it), do you think that has had an impact on, let’s call it, microstructure that, in some ways, is reflected on trend following, or does trend following actually, by being adaptive in itself, kind of find ways to compensate for it even though for short periods of time it may get affected? How do you see that?

[00:46:37] Pat

Yeah, this is the kind of subject matter that forms the basis of financial journalism. And then when one wants to really dive into it, it’s harder to substantiate the information.

What do I think of multi strats? I think, for the right clients, they’re a wonderful idea. I think many clients don’t have the skill, or the time, or the budget yet they have the desire to have a real alternative allocation and vigorous sort of multi-strategy product providers are there to provide it, for good or for bad, expensive or cheap.

We’re not really in that realm because we now only focus on futures and foreign exchange. So, our multi-strategy approach is still at the more macro and individual derivative level. But I would say that’s bullish for investors overall because, I think, all investors, if we looked at US$100 trillion in allocatable capital around the world, are massively under allocated to alternatives, not over. So, that’s been going on for awhile…

[00:47:47] Niels

Sorry to interrupt here, Pat. Sorry to interrupt. My question was a little bit different, I think. I was looking for, with your experience, the way you look at say being a trend follower for part of what you do, whether you think the size of these funds and the way they trade has actually made it more difficult to be a trend follower. Meaning…

[00:48:13] Pat

No.

[00:48:14] Niels

Okay.

[00:48:15] Pat

No, not at all. I think the majority of trend following returns have been driven by accumulated economic and financial carries and information diffusion over months, if not semiannual, to years. None of which… It’s definitely affected when you go into a ZIRP environment. It’s definitely affected when spreads in G7 environments all become extremely narrow and there’s virtually no difference. These are massive differences for trend following.

Not the type of trading… I think a lot of the trading at the high leverage, shorter-term, more arbitrage level is more in the concave surfaces of markets that exist not just at the microstructure, which might be more market making, high frequency, or the medium microstructure like, say, stat arb. If anything, for most trend followers it’s either not seen or it may even be providing a liquidity pool.

[00:49:20] Niels

True. Now before Alan jumps in, just one other thing. And of course, I know you sense my distinct bias for trend following here, but I’m curious again, is there something you have heard being said about trend following that you really, I mean, what’s the thing you disagree with the most when people kind of describe trend following?

[00:49:52] Pat

Oh boy, I’d love to give a clean answer, but I think it’ll be a slightly nuanced answer because it depends who’s providing the criticism. So, for instance, you know, I served with a wonderful man. So, I served on a board with Bill Sharpe for many years. And someone like Bill Sharpe, he wouldn’t necessarily have had a criticism of trend following. It would have been more like, why bother?

If you’re going to invest for 20 years, you’re going to invest in broad assets, own everything in the right proportion with the right growth because everything else at some point is noise. And that simplified answer, that’s not even a criticism. But that doesn’t reflect the reality as you know it.

If you go meet the allocation staff of a pension fund, if you go to a family office, if you’re on the other side of an endowment and their consultant has them in a particular allocation and somebody does a Monte Carlo analysis, say, on their pension assets and they find out that a two sigma move on their pension plan might throw a $400 million liability onto a company that’s got US$60 million in P&L and earnings and their head explodes. They need to have a better allocation strategically and one that can cover tail exposures better.

And I think then, when you get to people who are living in a world where very adverse moves that occur over quarters or years matter to them, trend following becomes this invaluable tool if they use it right. Again, how one allocates capital to it, what’s the opportunity cost to that capital? Is it for instance, more like portable alpha? Is it fully allocated to at what volatility? These become all these mechanistic questions, but I don’t think those criticisms are there.

The one criticism that… not criticism but the one I remember I faced, it was again one of the popular financial press narratives. I was giving a speech, I think at Pension Bridge. I’m not even sure if it was the same year I was on a panel with Katy Kaminski, who is just such a wonderful joy and an ebullient mind to be on a panel with.

But it was one of those things where somebody in the audience asked me a question and they, at the time, it was are trend followers too big? Is there a capacity problem? And I said, well, I’d like to just… I do this a lot with my graduate students and post-docs. So, let’s try a thought experiment and then we’ll all decide at the end.

I said, what if, before speaking here, I had gone to the private equity shops up in Embarcadero and others and I had arranged financing to do a roll up of all the trend followers and CTAs that I could. And I had billions of dollars to buy their businesses, and I went around, because I know them, and called them, and made them offers and the vast majority accepted. And I now own US$200 of the $250 billion worth of capacity. I bought them all and I specifically did so with no consolidation, no operational, nothing. I said, please do what you’re doing, you’re good at it.

I’d be a single trend follower with $200 billion under management and my performance would be exactly the same as if I didn’t. This whole narrative that a trend follower can get too big and somehow the returns will go away. No, not if they compensate for it by the same thought experiment – what if you just diversify the number of approaches you have?

Now, it wouldn’t be a criticism, it might even be a compliment for someone to say, but if you did that, you would no longer have an edge to the industry, you would be the industry, and they would be right in this particular case.

But that kind of gets back to, that’s another way to replicate if you will. You don’t just have to follow. You could end up running hundreds of different kinds of systematic approaches and at some point you will become average.

[00:54:16] Niels

Maybe as a little follow up question on that, if we then go to a company specific situation. And I think this is where (and you may not agree with this), I seem to feel that over the last three or four decades, from time to time we’ve seen companies that probably overstepped their capacity. And I was wondering, from your perspective, how do you know, as a manager, that you’ve reached capacity?

And again, let’s just keep it simple, let’s just stay with trend. You know, most people that listen to the show know what it is. How do we, as trend followers, really know when it’s time to stop trading more assets?

[00:55:09] Pat

Well, I think first of all, your premise is demonstrably true. There are managers that have overstepped their capacity, less so I think in long-term trend following than in other categories we could talk about that are more sensitive to capacity. So, it’s a real problem.

Confounding that problem is that reflexivity we talked about between manager and client. If a manager wanted to add or diversify their methodologies to accommodate more size and to have less of a footprint in the market, they would be fighting the impression of style drift or of changing what they’re doing in front of their clients. So, that would require a very trusting dialogue, probably one that can’t occur fast enough if they’re raising assets too fast, because those kinds of changes practically need to take place over years for client acceptance. Not if you have a good run of asset raising.

But I think the real question is how do you tell? And I think everyone who’s a listener pretty much understands that liquidity in the marketplace is the key question for any given market. And liquidity is dynamic. It’s not consistently present. It depends on time of day and the market, and it really gets back, again, to that there’s a participant on the other side of each trade.

In generic terms, a large volume of dollars trying to go into a smaller market, more rapidly, is going to press a market and cause a capacity issue, in this case, if we use that term, we’re just going to simply move the market, you’re going to have slippage, but a very small amount of money in a large market, slowly, and it won’t.

And so, I think if people are very diligent about seeing the fingerprint of their execution costs and their execution alpha, and they begin to see their execution costs rise, objectively measured and trend in a particular upward direction, they may have a capacity problem. And it very likely could occur, and it very likely could be noticed in a few markets long before it’s noticed in all markets.

It might be noticed in a few markets and then there are questions of whether that’s short-term or whether, you know, that’s just a phenomena that the particular country or the particular currency is less liquid and six months later it will return to its liquidity, or it could be because there’s just too much money there and it’s, you know, and it’s too tough. If you’re a metals trader, you know, you could trade that much in copper, but you can’t trade that much in tin. And you’re going to have to decide how to accommodate for that.

[00:58:06] Niels

Sure.

Alan, I know you have a hard cutoff today. We’ve had a few technical issues along the way. So, I’m going to give you the rest of our conversation. And you asked the last few questions that you want.

[00:58:21] Pat

You and I could talk anytime if you want.

[00:58:24] Niels

I think we will have to do a follow up anyways, that’s for sure.

[00:58:27] Alan

Just one theme. I mean, we have talked about this, we’ve talked about regime change, we’ve talked about new market participants, pod shops, microstructure changing. From a macro perspective, markets have changed since you started trading. The 2010s were very different than the 2000s. Now we’re into a new regime.

So, I guess the question is do you just try and design systems that are robust regardless of how microstructure and macro factors might change over time or do you take that into account and try and incorporate that into your research process? What do you see as a more kind of effective, robust way of having a research process?

[00:59:13] Pat

I guess the answers, I think, are all yes. I don’t think you can avoid not looking. In practice, if we were thinking of a trend following sleeve (and there’s a big question, why would you even want different strategies, for instance, but let’s just say you do), If you look at a trend following sleeve, and if holding periods are relatively long, and execution is extremely insensitive, meaning like for your listeners, if you had a trading approach that you could trade the next day or the next day and it would have the same results, you’d have one that’s relatively insensitive to market timing.

If you have one that if you delay by 15 minutes, if you lose 20% of your P&L, you have one that’s pretty time sensitive. And the ones that are more time sensitive and the ones that are… You know, their impact and microstructure obviously are a bigger research topic and a bigger capacity concern (to your earlier question), and, frankly, have, I think, less margin of error in forward application. You have to be humble enough to, you know, recognize, which is sort of the key aspect I think of all trading is objectivity, and objectivity… The emotional manifestation of that is humility. You have to be looking and then that fuels research.

I don’t know that’s the way I usually think of regime, it’s more a bias because I’m used to that term more from the macro perspective – are rates rising, rates falling, inflation up, inflation down? I think investors both benefit from those regime considerations, but I think they also are one of the things that ends up fooling early investors, especially early quants.

I think the first stage of somebody who comes to the market is somebody who thinks that when data changes in the market that somehow the market moves. And they’re constantly trying to model this sort of two body problem. And then they do all kinds of sensitivity analysis and they can’t figure out why sometimes this amount of unemployment report change had this big of a market move and other times they don’t.

And relatively rapidly one realizes there aren’t two bodies in the market, the data doesn’t, and data changes and surprises, don’t buy or sell anything. People see those signals, people see those surprises, people see those changes and then people buy. And there are entire regimes where some data is simply important and then later on it’s ignored because it’s felt to be…

When I first started trading, the M1, M2 and M3 money supply used to be on the front page of the Wall Street Journal because everybody followed money supply. I think if I hired a new young person today and they hadn’t necessarily had specific training in macroeconomics, specifically, but were brilliant, the topic would never even occur to them unless it was brought up. Because today it’s muted.

And so, regimes are also what information is important, I think, to the trading community and the investing community at the time. And that fluxes over time. I think it always will be an imperfect process. And I know you’ve done some, I think, great work in regime shifting and I know I’ve read your opinion. It is an imperfect process. It’s a shift. It’s not a precise prediction, but it falls into that category.

What I said earlier is the setup, you know, markets. You might want to trade differently in a high inflation, rising interest rate, supply constrained world than you might want to do in a demand constrained, low interest rate, low inflation world. And, in fact, I would even assert that you should.

But other people will find their own answer and then they’ll have to get convicted by it. And if they stay with it, steady handedness. Somebody asked me what’s the biggest input to compounding and once I said, well, it’s actually how much your hand shakes.

Steady handedness compounds well. The return gap, the negative investor alpha that occurs from people switching on performance is usually the biggest cost that they face in putting their portfolios together.

[01:03:53] Niels

Probably a good way to end our conversation today. I feel there’s definitely enough to talk about in a follow up conversation.

Pat, this was really wonderful, you know, we’ve done a lot of these conversations, and I think today, again, we learned something new. You spoke about things even though it’s a well-known topic but in a different way and it really benefits everyone listening. So, I really appreciate your time and your insights. And as I said, I hope we will be doing this again in the not too distant future.

And to all of you listening today, I hope you were also able to take something away from today’s conversation onto your own investment journey. And if you did, please share this episode along with the others with your friends and colleagues.

From Pat, Alan and me, thanks ever so much for listening. We look forward to being back with you as we continue our conversations on Top Traders Unplugged and we continue deep dives into the CTA industry and in the meantime, of course, check out the show notes for all these episodes where you also find links to Pat’s firm and to Alan’s resources as well.

So anyways, as usual, let me finish up by saying, take care of yourself and take care of each other.

[01:05:14] Ending

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