Why Quants Might Be Your Best Bet ft. Nick Baltas

[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 Nick Baltas 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 would like to say a big thank you for sharing this episode with your friends and colleagues. It really means a lot to us.

Nick, it is great to be back with you. It’s been a while, actually. It feels like. How have you been?

[00:00:57] Nick

Hey Niels, I’m glad to be back. I think last time was the, I guess the group chat we had before Christmas with the rest of the crew. It’s been, well, it’s already February.

It’s been quite an eventful month, I should say. So, I’ve been doing well, primarily in London, spending time with kids and busy at work, flying off to Barcelona over the weekend for the EQD event.

And again, the travel season starts as I believe has already done for you.

[00:01:22] Niels

It has indeed, absolutely.

But good to hear that you’re well, we’ve got a very wide ranging lineup of topics today and it’s going to be a little bit loose because I know both of us have been having a very busy time, but I’m sure we’ll be able to tackle quite a few interesting topics nevertheless. But before we get into all of that, as always, I’d love to hear what’s been on your mind the last few weeks.

[00:01:50] Nick

I think that’s the easy bit in the sense that, look, this whole DeepSeek and AI has been quite fascinating. I mean, I’m not an expert in the field by any measure, but this whole DeepSeek, I guess announcement kind of made me a bit more curious to understand what’s going on. Why did that make such a fuss?

And obviously open source is important, but then this whole, I guess modeling of Gen AI that allows you to train the model in a much cheaper way can have a number of implications in the way that we think about those models going forward. So, I kind of spend a bit more time understanding how it works – like a chain of thought.

Basically, the machine speaks to itself up until it gets to the result. And it’s actually quite fascinating to go and play with DeepSeek, ask a question and then just basically tell it, or whatever the agenda is (there’s none, I guess), tell it to explain how you get to the conclusion and there’s some sort of nice riddles that you can ask and see how I guess this train of thought operates. That’s quite fascinating, I must say.

So, yeah, not too much free time, but in playing around with those technologies it’s quite a thing. I’ve spent my last week on. Look, if it’s going to have implications in the broader scale of AI, it remains to be seen.

My personal view is that we will still be using GPUs to train those models and maybe it’s become now cheaper, but maybe it’s now more open to a broader set of players.

So, it’s unclear to me how this is going to play out, but I think this is just yet another event of showing to us what the human brain can do to deliver an artificial brain. Anyway, that’s it.

[00:03:36] Niels

Yeah, no, I mean, I think it is an interesting topic. And of course, it all happened last Monday when all the hedge fund people, or at least a big part of them, 5,000 or so of them, were gathered together in, in Miami.

And of course, when you gather so many people from the industry, of course something like this will happen and suddenly volatility, you know, spikes up. But anyways, by the time the conference started on Wednesday, it was kind of down to normal level.

But yeah, anyways, I mean, for my part it’s going to be a little bit of a few different random topics I wanted to share with you, hear your thoughts.

The first one, of course, is that, you know, since we’re recording Thursday, part of the news flow this week, of course has been the tragic events that happened in Sweden a couple of days ago. And that’s obviously something that certainly has caught my eye and, and very sad to see that.

But of course, there are also some financial headlines that caught my eye. One of them it’s not directly linked to our industry, but it is linked to the ETF industry. And I don’t know if you notice, but Vanguard slashed the fees on lots of their mutual funds and Exchange Traded Funds, ETFs, which is interesting. I mean, it is this race to the bottom and it just almost gets to the point where it’s almost free to own these things.

Not sure what it means for our industry that has more recently moved into the ETF space because it’s not all of the CTA ETFs that are lowering prices, it turns out. I’ve seen a few that have now, actually, hiked the prices, at least in the quiet.

[00:05:18] Nick

A race to the top there.

[00:05:20] Niels

Right. So, we need to people… people should read the latest memorandum carefully, so anyways.

But the other thing that I did want to hear your thoughts about, and this I think, is relevant for us. So, I don’t know if you follow the crypto space. I don’t know if you trade it on your side, the cryptos. But on Sunday, which is the 2nd of February, we may have seen the largest crypto liquidation in history.

It’s estimated, from the news channels that I noticed it from, that about $10 billion or so of leverage longs were stopped out in kind of a mini crash they call it. So, Ether, for example, which is something that can also be traded on futures, although not over the weekend, fell by 20% or so on that day.

There were other things that fell even more. And for me, it opens the discussion about what I would call exit liquidity. So, what happens if, on a day, because a lot of people ask so are you trading crypto? Are you not? And one of the things that we, at least on our side, had done would always say well we need to be sure that the liquidity is really there.

Well, so, first of all, since it doesn’t trade 24/7 on a futures exchange, that would be difficult for us to do anyways. But exit liquidity also means that you don’t see the market that you’re trading dropping 20% or more in a single day.

That’s not how the futures markets we trade would behave. So, I’m just curious to know whether this is something you’ve noticed, if this is something that’s relevant for what you’re doing. Because I know a lot of our friends in the industry have embraced crypto. So, I’m just curious about this.

[00:07:08] Nick

I mean, specifically on crypto, it’s not something that myself or we can get active on. Surely the broad organization has teams that focus on this one.

The way I look into your comment more as to how it relates to systematically rebalancing portfolios and strategies is how we think of liquidity, and the fire sales, and more the synchronous impact that I guess orchestrated liquidation can have in the portfolio. And I think this is the primary danger of building big positions, levered positions across seemingly unrelated themes, or strategies, or investments. But ultimately some unrelated event, that could be the one that you mentioned, can have, I guess, a spillover effect, contagious effect.

I mean, when you were speaking, you reminded me of some nice, interesting piece of work that was done, I believe by Rama Cont, five, six years back, speaking about indirect contagion and how investors that are perhaps having similar utility function (let’s call it) in the pension community, that have similar portfolios but then act in a synchronous manner to a macro shock, can create a spillover effect in financial markets purely because there’s a vicious circle. That’s a classical fire sale and how we can hedge against it and so on and so forth.

So, it is certainly a topic that we spend a good amount of time on when we design systematic strategies. We always have to resort to some form of statistics and empirical analysis and historical observations. But we always try to err on, I guess, the side of caution and try to be even more conservative than what historical data suggests.

At the end of the day, what it’s hard to quantify is the externalities here. Like, if I’m buying a specific market for a specific systematic strategy, call it trend following, it’s not clear who are the other players that actually do the exact same thing with the exact same parameters. Not because the slippage in execution would be large, it can still be large. I think the biggest problem would be in a forced liquidation event. I think that’s the bigger danger here, which is more systemic, clearly.

And that’s precisely why, I guess, regulators over the last however many years, if not decades, have become much more focused in terms of regulating the market and making sure that financial institutions are capable of remaining solvent in those scenarios.

So yes, it is one of the risks that we have to be very, very careful, monitor, and when we design a systematic strategy, extremely cognizant of those externalities.

[00:10:02] Niels

Yeah. Now, of course most people would say, well, you should just trade Bitcoin because that is the most liquid market of them all. And that may be true. And I don’t even know exactly how much Bitcoin moved on Sunday. I haven’t looked it up.

But speaking about, you know, you said, who are the players and so on and so forth, I couldn’t help notice there was another yesterday, I think it was about MicroStrategy, which by the way, I think they’re changing the names. I’m not sure they’re still called MicroStrategy. I think everybody knows Michael Saylor as MicroStrategy.

But I noticed that when they reported their accounts they had basically doubled the number of Bitcoins they own in the fourth quarter to about 471,000 Bitcoins. So, they added about $20 billion worth of Bitcoin in the fourth quarter alone.

And I’m thinking, and they still have more to do, they say. I think they want to double that number again or whatever.

But I’m just thinking, okay, well if you have one player that just continues to buy regardless of price, then clearly that must have an impact on the price setting of that instrument. So, what happens when Bitcoin doesn’t have that continuous buyer anymore at some point when they finish whatever plan they have for Bitcoin?

So again, I don’t know. I just noticed the article. I thought it was kind of interesting.

[00:11:26] Nick

Yeah, you reminded me, now, of some academic work that tries to quantify crowding. And maybe I’m wrong, but I remember the outcome was that it’s more important to see how many investors own a specific stock or a specific, I don’t know, Bitcoin, in that case, instead of looking into the size of the position. And the number of owners has different implications to the size of the position.

So if it’s like a big size between 2, or smaller sizes between 10 but all 10 of them can operate in a synchronous manner, I cannot recall the exact outcome of the academic study, but one of the points that they were making is that a count is a different measure to the size and different implications arise depending on how you measure crowding and so on and so forth. So, apologies, I don’t remember the exact outcome, but I can look it up if anyone is interested and find the reference.

[00:12:29] Niels

And of course, usually I don’t really operate, necessarily, in the crypto world, but given that there was this article about this mini crash we saw, or some people may not have even have noticed it. They also talked about this interesting thing, which I don’t think about it very much. But it’s this thing about the dynamics of the crypto space.

So, in the equity space, for example, you’ve seen many, many large companies actually buy back shares. So essentially there are much fewer shares to buy today than there were 10 years ago. In the crypto space, it’s completely opposite.

I mean, there are so many more different cryptos being issued every week. And so, it’s quite an interesting dynamic once you start diving into it a little bit. And you see it a little bit, from above, how these are completely two different dynamics. So, I know, of course people would argue, well, there’s only 21 million Bitcoins that can ever be issued. Yeah, okay, sure.

But there are like thousands of other cryptos that are… So, yeah, anyway.

[00:13:29] Nick

That was the challenge that some people put forward in 2022 when, you know, Bitcoin was supposed to be the inflation hedge and it obviously did not move. Right. And I guess the point that we’re making is that maybe the supply is limited for this one, but the supply of coins, broadly speaking, is unlimited.

And I think that’s perhaps the challenge that was put forward at the time as the inflation hedge, because it didn’t play out as such at the time.

[00:13:53] Niels

You touched on a topic I’m going to raise with you later on in terms of the relationship between price, and narrative, and value, whatever. But anyways, when you say that, and I remember the conversation about inflation hedge – Bitcoin is an inflation hedge. Well, of course, I don’t really see that there is a strong relation between Bitcoin and inflation because the most recent rally, of course, has happened at a time where actually inflation is starting to come down, yet Bitcoin has doubled. So, I think it’s a much more narrative driven asset than anything else. But let’s leave that for a second.

The final thing that caught my eye was just kind of the first comments we’re getting from the new Treasury Secretary, Scott Bessent, when he talks about bonds that actually they should be more focused on the yield on bonds, getting that down, rather than the central bank or the Fed. And actually, I’m not sure if it’s related to those kind of comments, but we certainly have seen a bit of a drop in yields in the US in the past few weeks.

So, I thought it was interesting that if they’re going to have now a specific policy, it doesn’t mean it’s going to work, but it certainly shows their cards, I guess.

[00:15:02] Nick

I think the jury’s still out there as to where yields will go. I think what we saw recently was primarily driven by investor kind of increased risk aversion, at least that’s my reading.

Whereas, if we see the potential of tariffs and the rest of the, I guess, of the Trump policies playing out, somebody could argue that there’s more of an inflationary, I guess, spin into it. So, it is not clear to me so far. Suffice it to say that bonds have disappointed now for a prolonged period of time.

I know Andrew talks about five years of underperformance. We shall see. We shall see. Trend followers have not been that great, I guess timing those shifts. But, in reality, there hasn’t been any trend. So…

[00:15:43] Niels

No, exactly, exactly, yeah. And of course we don’t try to time it.

And you could say this, the “cycle”, just the way the price has moved in the last year or so has kind of hit, let’s call it kind of 90 to 120 day time frames pretty hard. You know, every time you get a long signal around that time frame, which a lot of our peers would get, the markets turn, and it flips, and so it’s been difficult.

So, let’s talk a little bit about so far this year, January and the beginning of February, so far. Speaking of bonds, we have seen, as we talked about, a resurgence in bond prices more recently, and that’s definitely hurt trend following a little bit. And that’s why, at least January, was a kind of a flattish month for the industry.

And February, we’re down so far this month, generally speaking. We’ve also had a little bit this month of softness in European equities. And that’s probably, as you already alluded to, Nick, the threat of trade war and other stuff that’s going around right now. So that’s also been a little bit of a headwind. The dollar has weakened a bit. That’s also been a difficult combination for trend followers.

And then on the positive side, you still see some markets shining more than others, such as gold and silver. And of course, coffee seems to be the new cocoa in 2025.

[00:17:09] Nick

Correct, correct.

[00:17:10] Niels

So, it’s been a mixed picture and there’s been, I would say, a continuous divergence in returns, although maybe last year’s was more divergence than we’ve seen so far this year. It’s hard to say. It’s still early days. My own trend barometer finished yesterday at 30, so that’s definitely suggesting a weak start to February.

And, and I can quickly run through the performance and then I’d love to hear your thoughts on this.

And by the way, for people who don’t follow the price of coffee, it’s actually making, I think it’s the 11th consecutive rise yesterday, which is the longest winning streak since 1970 or ‘70s. So, that’s pretty interesting. And it’s up by like 112% in the last 12 months. So, there’s been some really Interesting outliers moves in the soft commodities in the last couple of years for sure.

Anyways, before we get to Nick, BTOP50 down 35 basis points so far in February, still up 59 basis points for the year. SocGen CTA index down 91 basis points as of Tuesday, down 30 basis points year to date. The Trend index almost the same, down 92 basis points so far in February, down 77 basis points so far this year. And the Short-Term traders index down 1.19% and down 1.15% so far this year.

MSCI World, on the other hand, it’s up 31 basis points as of last night, up 3.8% so far this year. And the S&P US Treasury Bond Index for 20-year or longer maturity has a strong month again into that narrative of yields coming up, up 2.67% already in February, up 3% so far this year. And then we have the S&P 500 total return, it’s up 35 basis points and up 3.15% so far this year.

Rolling back a little bit, thinking about trend, what’s been your observations in terms of markets trends, opportunities, headwind, what’s it been like for you so far this year?

[00:19:35] Nick

So far trend following for us has been relatively flat to perhaps a bit positive. It obviously depends on the implementation, depends on the speed. We know we’ve discussed that quite at length and that’s, I guess, one of the key topics of this show historically.

Medium term is kind of wiggling around the positive, perhaps flat year to date. You are right in terms of pointing out which have been the contributors as well as the detractors. I think the dollar is one of the key detractors that we’ve seen, obviously significant reversion post elections or, I guess, delayed reversion post the initial rally that benefited us in Q4.

The things that we have found being much more interesting in the beginning of the year are things that I have been discussing for quite some time now and these are more cross sectional trades that actually play out quite nicely. And, in this particular way, looking into some carry dynamics, specifically in the commodity sector whereby, obviously, the significant backwardation dynamics we’ve seen in some of the markets (obviously NatGas is one of them) has helped to a good extent as well as reversion.

We’ve discussed about realized skewness and some of those measures that try to build cross sectional reversion dynamics within the universe of futures. It has had a very, very strong start of the year, across the board. You know, some of the emerging market currencies were key contributors there. Some of the precious metals, some of the AGs did help. So overall, I would say trend following is relatively okay.

But you know, when seen alongside some of those “enhancements” or maybe diversifiers (I can let you pick, I guess, the word that you like more) it’s a good start. It’s a good start of the year.

Now, how the market operates, and perhaps to the comments we made earlier on, it feels quite uncertain. I think, maybe a week ago, we were expecting tariffs and then a couple of days later, like, yeah, maybe in a month’s time now. Because obviously there have been some sort of discussions that took place between Trump and with respect to prime ministers.

Then you have this whole AI frenzy, maybe getting into a pose or maybe not. Again, to your point, significant reversions. But then, over the course of that week, we had some good earnings coming out for some of them, which I guess reversed the path that they took in the early part of the week.

What I’m sensing, from my conversations, is that this uncertainty builds up a bit of risk aversion. It seems to be a pivot from the more risk on, get the carry trades in place and generate return on the back end of those.

It feels that now there’s a bit more appetite or at least more conservatism in those trades and some defensive discussions have become more relevant or more frequent. And it’s no surprise that trend following is a part on this one.

Classically, is it the time to do trend? Is one of the questions. And classically the answer is you cannot time it. But I’ll pause here. This is like a quick overview of how I see the trend space in the beginning of the year.

[00:22:52] Niels

Yeah, I think that that’s well put. Now, obviously I know you didn’t come to Miami this year. I know you’re going to other conferences. But of course, part of the things we do when we go to these conferences is actually meet with investors and prospects and so on and so forth. And I certainly, from my side, feel that there is a bit more openness to have these conversations. For sure.

I felt that actually, you know, even last year I think there were more people wanting to talk about trend following, larger investors, maybe not to a point where they are ready to implement it just yet. And it’s going to tie into part of our other discussion that we’ll continue with and that is, you know, is there something to be said about not relying on bonds as your main diversifier away from equities? Is there something else you need to look at?

But I’d like to stay, before we jump into that, I’d like to stay a little bit with if you can maybe provide more color as to some of the arguments you hear or maybe some of the arguments you would use when you have these conversations. You talk about people wanting to be more defensive. So, okay, so what are their choices? What are their real choices in that regard? And also, if you suggest to them, well, have you heard about systematic trend following? What’s the reaction? Do they go completely white in the face or do they actually think, yeah, that might be interesting?

So, I’d love to hear a little bit more about that before we jump into this next paper that we both came across.

[00:24:28] Nick

Maybe I start from the last point you made. Do people react, I guess, in an unexpected way when we talk about trend following? Absolutely not.

I think there has been a lot of education, or maybe a lot of marketing, or maybe a lot of good performance, specifically in the recent years, in obviously 2022 was the stellar year. So, it is very clear that trend following, at least as a component of defensive overlays, is key. It’s key not only as an overlay, but I’m happy to basically share that there have been now a couple of discussions I’m having whereby what we have been discussing the last two, three years, whereby trend following could be seen now as a component of a strategic asset allocation, it starts becoming a reality. And this did not happen just with one or two investors. It’s now being discussed with a handful, more than a couple.

And it’s interesting to me to see this shift because it does showcase that bonds have been disappointing. Maybe there is no immediate or obvious reduction in this equity bond correlation, specifically if inflationary tensions continue or pick up, for whatever it’s worth, based on my earlier comments. So, yes, trend following is a component.

Now, obviously we get sometimes questions along the lines of, look, it’s not contractual. And the response is that, yes, it is not contractual. And clearly empirical evidence is enough, but perhaps not as enough as you being the client or the investor you’d want to have. But we cannot negate the fact that more contractual hedges cannot necessarily help in prolonged drawdowns. And this is now, I guess, starts going into more the first part of your question, what do we see and how we think that an asset owner should build an overlay for defensive purposes?

And in this Regard, my view has always been, and we’ve discussed it at times here in the last couple of years, there are systematic themes or there are derivative based structures that allow contractual hedging for flash corrections. And we can have a discussion as to how we can moderate the cost of those structures, buying some optionality, perhaps delta hedging it.

But there are some short delta, long volatility trades we can have both in the equity world as well as in the other asset classes. That does address the need for a sharp correction, but it does not address the need for an equity bond correlation shock.

And this is now when trend following comes into play. This is perhaps when dispersion comes into play, which was another interesting trade that, last week with AI moves, actually played out quite nicely. I personally see that more of a kind of longer-term correction component. But it is one of those components alongside trend following that can play out quite nicely in a correction.

And if you stretch it out and see how we can further finance, now, this combination of systematic themes. A good amount of investors talk about commodity curve, for instance.

This is a classical way of allocating into commodities on the back end of commodity curves, and then shorting the front to avoid having the negative roll yield, which is probably one of the more interesting, well understood, almost like vanilla ways of moving away from the beta world in commodities, into the alpha world, while at the same time achieving some good yield over the longer term. This allows you to be more defensive to, I guess, drawdowns that have no strong inflationary recession shock embedded in them.

To put it in layman’s words, if I am exposed in a commodity curve and I am effectively shorting the front part of the curve, equities falling, perhaps commodities falling would help me even if that is now a carry portfolio.

So, in combination we do see this complementarity between contractual hedges, statistical hedges, trend following and some carry oriented or market neutral oriented components. And I think commodity curve is one of those.

[00:28:52] Niels

Can I ask what’s the most favorite of those types of different ways that you come across in terms of “risk mitigating”? I hate the word hedging because you know…

[00:29:02] Nick

Exactly. But risk mitigation…

[00:29:03] Niels

…you never know. But risk mitigation, what’s most popular? What do people think, “Oh yeah, yeah, that’s easy. We can do that.”

I’m thinking it’s not we can do…

[00:29:13] Nick

Do that in house, or we can do it?

[00:29:14] Niels

No, no, we can implement that in our portfolio. And I’m thinking it’s not going to be trend following, I’m just curious.

[00:29:21] Nick

Trend following is one of them. Okay, for sure it is. Yeah, for sure it is.

Because sometimes, you know, obviously I’m sure you get this challenging question, so, oh, is it going to perform? What is the conviction that we have upon it? But at the same time, it’s like it’s a relatively simple “strategy” to have. You’re following past returns, using some horizon. It should be quite transparent what your positions are. It should be quite obvious what the market should do for you to benefit from it.

And yes, if you really want it to be more defensive, cut down your equity exposure in up moves. It’s pretty clear. So, the conversations are easy in this regard. Now, deployment is another topic, but I would say it’s one of the popular components.

Then moving away from trend following, I would say simple and basic option structures are well understood. So, people buy put options, right? Okay, fine. Then the question becomes, okay, how should you buy this put option and in what frequency? And can you do this thing every single day and split your notional? And how should you think about your trend or your strike, and what is cheaper and more expensive, and can you combine that in a way with some other option that is going to finance that hedge? So simple option structures are also something that we have seen relatively good, I guess, reception.

I think once you start putting more components into the mix, then it becomes a bit more of a convoluted discussion because it’s not only, now, a selection exercise, it’s also a sizing exercise between them, as well as vis-a-vis your asset allocation portfolio.

[00:30:55] Niels

Now, one of the things we talked about before recording was a paper.

I don’t know if we actually talked about it, but you sent a link to a paper that kind of deals with this issue, or this challenge of risk mitigation. Because obviously one of the big talking points that we’ve seen in the last couple of years at least, and that has favored trend following for sure is the breakdown of correlation, well, it’s not really the breakdown of correlation between stocks and bonds…

[00:31:24] Nick

It’s called the shift.

[00:31:25] Niels

It’s a shift, and it’s back to the norm because historically stocks and bonds are actually more often positively correlated than negatively correlated. Anyways, a lot of investors thought, because of two decades of negative correlation for the most part, that that was the norm.

Turned out and we’re now back to a normal, mostly positive correlation. Okay, so the paper talks about, well, maybe there’s another way, or there’s another thing you can do with the 40 if bonds are not going to help you as it has done in the past.

So, I don’t know if you’re able to, from a high level, because again, as I mentioned in the beginning, both of us have been a little bit pressed for time to do a real deep dive, but I think we know enough about the arguments to discuss it to some extent. So, do you want to talk a little bit about this alternative way of allocating away from bonds but actually into safe equities – “safe”.

[00:32:29] Nick

Yeah, yeah, so look, the paper is called (just for the interest of those that are listening), it’s called Safe Equities an Alternative Allocation to Bonds. It appeared in the last issue of the Financial Analysis Journal…

[00:32:44] Niels

And it’s by Stephen Penman and Julie Tsu.

[00:32:47] Nick

Correct, correct, exactly.

I mean, this alternative allocation to bonds is probably the most popular theme that we have seen in the last, I don’t know, couple of years. Right. And it’s this whole debate as to whether bonds will maintain their position in policy portfolios and asset allocation portfolios.

And as I have said in the past, the reason why equities and bonds, at least over the last two, three decades have actually done the job is for three reasons. The first two are that you are exposed to the two most fundamental risk premium out there – the equity risk premium and the term risk premium risk. That’s it.

Now the third reason is that they too have been diversifying each other, specifically in equity drawdowns, which basically suggests that inherently the portfolio is diversified and less risky and therefore allows you to maintain a more stable path across business cycles. Now this cannot be the case if the two become more positively correlated. And by the way, positive correlation can also happen if both go up.

But guess what? The positive correlation is more when they both go down. Primarily driven by inflation shocks and inflation news.

So, then the whole question is, because we are exposed to equities, how we should look on this 40 or 60 or whatever the remainder is if somebody were to look on the risk side. So, this paper is one of the many, I guess, that they try to bring an alternative to bonds.

I don’t necessarily think that it’s a problem of bonds per se. It’s just that, you know, nobody said that the term premium is not there anymore. It’s the inherent diversification that requires treatment. That’s the whole story here.

So, their point is that we should look into stocks that are less risky, whatever this is worth. And they talk about obviously fundamental valuation and how we can think of stocks which are less likely to face earning instability going forward. And these are the safer ones of the lot.

And they do some nice analysis showing the upside beta, the downside beta, and clearly showcasing that, you know, when the market is down – equity market is down more broadly, the safe element or the lower beta or the lower vol or the high quality names (I’m not going to go into the details how these are defined), but the point is that they become safer.

But are they really a replacement to bonds? In other words, can they produce absolute defensiveness? My response would be, not necessarily so. Yes, on a relative basis. Maybe the equity sleeve can be a bit more dynamically tilted towards the safe equities. But I don’t easily see how we can bring up this defensiveness I’ve been talking about.

You’re still exposed to equities, maybe with some tilt on a different risk premium, that being the low volume or I guess the low uncertainty to earnings, future earnings. But that doesn’t necessarily make the portfolio, in absolute returns, not safer, but I guess more stable, more robust.

I mean, I buy the argument that we should be more dynamic in the equity allocation within the equity sleeve. But that doesn’t mean that in absolute terms we’re going to outperform in a down market because there’s a beta which is still positive, maybe not one, but it’s like.08 in this regard.

So, there’s one point that says, in a down market of 2000, 2002, that’s a dot com, the average annual market return was -14.73. But that for the safe equities, I think that’s the top 30% by some measure of safety was -1.7%. So, significantly better.

But then there comes this single word which says insurance. And I’m like, that’s not really an insurance. On a relative basis you do make money, but on an absolute basis you’re still down. And in my mind, a defensive strategy should actually add an absolute positive return. The relative does matter. But you see my point, right?

[00:36:54] Niels

I completely agree with this.

And actually, this was one of the things when I kind of glanced through the article. It’s something that I’ve been thinking and talking to people about for a very long time actually. It’s this notion that people think that they are… They all say they want to diversify, they want to have a diversified portfolio, And I can’t remember it was the Makita paper a couple of years ago where they talked about first responders, second responders, but I don’t know if they started out the paper.

There is a paper out there where they start out by saying, well actually when you look at people who think they have a diversified portfolio, 85% to 90% of it is actually short vol. It’s just, it just called different things.

And so, I’ve always had a massive challenge to understand why people think that, if they want to diversify away from the equity portfolio, they can just invest in equities in a different way. Whether it’s long short equity, whether it’s private equity, whether it’s whatever, it’s still equity.

So, I’ve always had a challenge with really understanding why people would think that they were truly diversifying themselves if they were just going back into the same underlying asset that they were trying to get away from to some extent. So, the whole concept of safe equities, that’s something that I’m struggling with a lot.

Now the other thing, and this is a little bit wishy washy, I, I mentioned it to you too, so you were a little bit prepared for where I was going to go. But it’s interesting you mentioned this period, 2000, 2002 or whatever it was, the safer equities were just down a little bit more. But I think a lot of things have happened since 2002 and for me it’s kind of a breakdown between price and value.

I just don’t think there is much relationship left anymore as such. And it just comes from the fact that I think today prices are much more driven by narratives, by speculation, by manipulation for that matter. So, the old relationship that we kind of thought that there would be, to me, I just don’t think it’s there at the moment. It hasn’t been for a while.

And so, to a large extent, you have valuations that are more based on social sentiment rather than intrinsic, you know, worth of a company. And you see all parts of the industry, even into governments. I mean, I guess crypto is one way of expressing it. But then, when you have a president of the United States issuing a meme coin, I think, you know, that kind of encapsulates the whole thing in one way.

So, I know we’re not going to talk too much politics. But, for me, it’s just an expression of the fact that I think some of this analysis, when you go back in time and you say, oh look what happened here, I’m not sure it’s relevant anymore to the way financial markets work.

And of course in some way, and this was really not the intention of it, but in some way I think these changes speak into the fact that you should probably rely more on a strategy that only looks at price and actually cares about nothing else than price if you want something that is more “relevant” for the time we live in today.

And I can’t think of a better strategy than trend following, of course that does that. But I think it’s true that the way markets have changed and the participants and all of that, you could say that the trust in the system that this is how it works, I don’t think that trust is there anymore.

[00:40:41] Nick

A lot to unpack and, perhaps, quite a controversial way of putting that forward.

Look, I think my, my response would go as follows. To the extent that we have market efficiency, the price today reflects all information we need. But by having historical price movements giving us a bit of a hint as to where the price will go is in itself a soft, I guess, negation of the efficient market hypothesis.

That’s statement number one and perhaps to a good extent explaining why trend following works. And we know all those, behavioral bias and so on and so forth. That’s statement number one.

Statement number two, for prices to move to some extent, there has to be some change in the fundamental value of the firm or of the asset. And there has to be a reason why something is more expensive or cheaper in this regard and for the price to grow, clearly a narrative is important. But then, at the end of the day, unless there is enough demand for it, the price will naturally drop and demand will only be there if there is some form of anticipation of outperformance going forward.

I know I’m talking about theoretical concepts, but practically, trying to distill your points, that’s kind of my chain of thought maybe trying to play DeepSeek now. Now, is valuation important or is valuation completely detached from, from what we observe? And are we seeing like another dot com, perhaps?

It’s hard to tell.

The one thing I would flag is that, in the equities world, at the very least, over the last 10 years maybe, there has been a lot of work done as to what we mean by value. And once upon a time value was maybe how many dollars you pay for a dollar of participation in the earnings? Maybe now it’s not just that.

And there has been all this, all this focus on the intangibles, and the brand, and how different type of measures would be required in “what everyone used to call the new world”, right? So, is it that valuation itself is not informative of price movements, or we should take a step back and challenge our own definition of valuation?

So, is the model broken or the definition? And some of the claims that have been made, at least empirically, seem to bring some value is that maybe the definition was requiring a bit of an update?

Having said that, I cannot disagree with you that narratives are becoming progressively more, and more, and more ways that information goes from the source to the investor’s attention. And this is now happening also in packaged ways in the sense that one of the big themes in the investment world is to invest in themes.

And sorry for the pun, but this was actually quite intended. Instead of looking into single names, then we look into themes.

But, I guess, temporary outperformance, which is precisely what trend following tries to achieve by the way, is just a journey that takes you from some valuation level to the new valuation level but this doesn’t happen instantaneously. And as information goes from the source, to the end investor, to eventually have the supply demand meet (as we said earlier on), the themes at times help, but at times they create overconfidence and overreaction that some correction comes through.

I think what happened with Nvidia last week was precisely that, by the way. Something came out. I don’t know. DeepSeek was number one in the App Store over the weekend, 17% down. The rest of the week was partly a good recovery.

So, I do see from your perspective, I guess by the way that you kind of did the preamble in the conversation that narratives seem to be having a bigger role, or at least they play a bigger role. Now is there a role for them to play? That’s another discussion. But they certainly do play a bigger role.

I think the dimensionality reduction they produce is relevant for investors. Once upon a time we used to speak about momentum and quality and value. Now we speak about the AI and the aging population and whatever that might be the case.

So, it’s another way of dimensionality reduction. What is, however, unclear to me is that, or I guess I think I’m sure about it, there is no risk premium associated with the themes.

But what there is, is short term price movement and ability to foresee that price movement, whether that is driven by historical price movement or some sort of thematic grouping, does create opportunities for investors. And so, this is clear to me. I think, ultimately, it’s all driven by how we digest information.

And by not digesting information instantaneously, those price strengths or narrative shifts will exist. Now, would trend following (to kind of, I guess, conclude my chain of thought) be beneficial for trend followers? Or would trend followers just stay with their price and move on with their lives, as you suggested?

I would say, well, maybe, because if we take maybe 10 steps back, not even a single one, broader uncertainty about outcomes is the one that creates trends. Because broad uncertainty about how something should be valued suggests that price movements contain information. And if they contain information, we continuously learn from it. And by continuously learning from it, we somehow follow a path, and that path is becoming greater and greater and greater. And that is the price trend that we know we ultimately achieve at the times that there is no uncertainty. And clearly the Fed-put period that we had in the last 10 years, up until 2020 was the exact opposite.

Whichever narrative that would come out, if it was negative, the Fed will step in. So somehow there was this broad certainty that no matter what happens, it doesn’t really contain so much information. The price will bounce back.

And that was the whipsaw dynamic that in a rising equity market, trend followers did not manage to perform as well as they have historically done, or they have done post that regime. So, this is how it kind of perhaps wraps up. I’m not sure if I answered your question.

[00:46:55] Niels

I’m not even sure that this is a question that can be answered right now. For my part, these are observations. You mentioned the word information many times in what you just said. And that for me alone just begs the question, well, can we trust the information anymore? When I grew up and you watched the news, I would say, yeah, you could trust the news.

Today, I wouldn’t trust the news. And the information we get, to me, it has become very subjective. And I also feel that sometimes that if you just repeat the lie enough times, it becomes truth. And so, I guess I’m questioning the whole fundamental foundation of price.

But, what I’m saying at the same time is, well, for trend followers, the foundation of price actually doesn’t mean so much. It’s not a concern necessarily because we don’t need to know what made the price go to this level. We just need to know that that’s what it did. And so, we can analyze.

And this is what I mean by, in a sense. I like the prospects of trend following because of that rather than someone who has to justify the price of something based off a certain narrative.

I mean, the whole discussion about, and I’m just using this as an example. But two examples I can think of is just, one, the years long debate about the valuation of Tesla. What is the price and all of that. But another thing, and again, I’m not an equity guy, so I just take it for what it is. But I can be surprised when I see someone like a Danish company like Novo Nordisk, which has obviously had very much success, and six months ago the price was like twice the price now. What has happened in six months that makes the company worth half of what it was six months ago? So, I’m just questioning this idea, and I don’t have any answers.

All I can say is I think in a world where price is more subjective and where the price is determined more by speculation or the, you know, the convexity of returns, oh, I can make another thousand percent if I do this and whatever.

All this sort of very much what we see on social media type framing of things, and even to the point of manipulating or pumping stuff that we see, I just think that trend following might do pretty well compared to other strategies because it doesn’t concern itself about what makes the price, it just focuses on the price itself.

Do you want to do a quick thing on theme two before we start to wrap up, about sort of the impact of rebalancing – a paper that I think you mentioned came out only yesterday, which would make it very current, of course, for our audience to get a sense of? And I think it was tied into a headline that I noticed today on Bloomberg where they refer to actually a previous guest of ours, Cam Harvey, who talks about that there is a cost for investors who do rebalancing of their portfolios.

And just to read what was on Bloomberg, it says, “Now a group of academics claim they put a price tag on the resulting cost to pension funds and other market participants known for their rebalancing activity, and the price tag is $16 billion a year.”

Do you want to talk a little bit about it?

[00:50:40] Nick

Yeah, for sure. Maybe it has a tiny little link to the discussion we had earlier on because, if I’m allowed to make that link, part of the reason we always see trend following is obviously the sluggish way of digesting news. But there are some times whereby trends can at least be seen in the data by forced liquidation events, or can be seen by stop loss rules playing out.

So, there are those dynamics which are more like price based or more, I guess, endogenous in the investment process. And that kind of ties in quite well with this topic here. So, you’re right.

So, there was this Bloomberg article that came out yesterday referencing a very new paper by Cam Harvey, Michele Mazzoleni and Alessandro Melone (I hope I read the names well) that pretty much says that when you follow a fixed weight portfolio, and clearly the best example is a 60/40, you end up selling when something goes up and when they’re buying when something falls. So, if I have $100, I do $60 in equities, $40 in bonds, and my $60 in equities becomes $70, I need to get those extra $10 and split six and four, respectively. So, I need to sell four and buy the bond. Right?

So, it’s kind of equivalent to, if you like, to a value trade. But their point goes beyond this mechanical activity.

Their point is that when this rebalancing happens in a scheduled manner, let’s say another month or another quarter, which is typically how some of the large asset owners tend to operate, then it is obviously clear that there will be some expected price action. And therefore, those that are keen to front run this activity (some market speculators, some fast money speculators), their action will come at the expense of the asset owners.

And how do they come up with the $16 billion? They basically say that, you know, if the retirement US industry is not $20 trillion. Based on some modeling that they do, a conservative estimate of the impact of this “fast money” speculator activities is 8 basis points per year. So, 8 basis points multiplying $20 trillion, that’s the $16 billion they come up with, right?

So, I have to admit I haven’t yet managed to go through the paper because it literally just came out, but it did remind me some of the work that Cam had done a couple of years back with the Man Group on strategic rebalancing. And the point there was if you have a 60/40 portfolio, maybe you should consider looking into (surprise, surprise) some trend signals before you act upon your rebalancing.

And I think the point was if your equities are falling, as in the 60 becomes 50, then don’t yet buy if that negative trend continues because we know that trends exist and therefore buying at the 50 might get you exposed to a subsequent loss of that wealth. So, you might as well just let it drop.

What I found interesting, from the summary, is that there is no easy way to go around this clockwork mechanism. I think, when we build systematic strategies, what we try to avoid is precisely having those end of month, end of quarter kind of rebalancing schedules.

We try to be more frequent, we try to be more thoughtful of where liquidity sits. And maybe, at times, we only partially rebalance the portfolio rather than the whole lot. So, we allow some thresholds. I’m sure all the practitioners that listen to it, it would be music to their ears. So, there are ways we can try to avoid having a very, I guess, systematic manner of amending a portfolio.

But, I guess, the point that I would flag at the end is that strategic rebalancing and rebalancing as is, at times, can be hammered or can be impacted by slow moving internal processes. I think they make the claim that an investment committee would have to come together to decide upon how we’re going to rebalance the portfolio. But not only does it take time, but up until it takes all this time, it still has perhaps a negative impact that they document.

And perhaps now closing the loop, this is maybe the reason why some of those trend following strategies can also operate alongside asset allocation portfolios because they act, typically, at no motion, but also, they act systematically to capture opportunities. And that’s why I think there is also value in this regard. That’s probably like a quick, a very quick summary.

So to summarize fixed weight portfolios… By the way, the same thing happens with index rebalancing. We can think about ETFs, for instance, that have a very scheduled rebalancing activity. They can be exposed to front running. And I think this is an important consideration also for regulators, and how obviously the market operates, and what we should do as an industry to safeguard against that. And it was quite interesting to see that the paper does mention that going around that is not easy. It’s almost as if “this is the price to pay”. And that’s it, and thank you very much.

That’s the paper. So, the paper is called the Unintended Consequences of Rebalancing. I’m not sure if I mentioned that, but that’s what it’s called. And that’s precisely the point.

[00:56:10] Niels

Yeah, no, I think that was great, actually. I’m glad we just managed to mention it because it is new paper. People can find it, of course, given the name there. And as I also said there are some references on Bloomberg’s website and I’m sure many other websites will be picking this up in the days to come.

I think we did pretty well, Nick, for two busy people trying to agreed put together an hour’s conversation. So, I really appreciate that. I know you’re super busy at the moment.

So, I’m sure all of our listeners will send you some warm thoughts, maybe even some reviews on iTunes and Amazon and Spotify as a thank you. You never know. But thanks for doing that.

Now, as we start to wrap up here for this week, let me mention that next week I will be joined by Rob and he’s always fun to talk to and he will be gladly answering some of your questions, if you have them, within his field of expertise. So, as always, you can send them to info@toptradersunplugged.com and I’ll do my best to bring them up next week.

From Nick and I, thanks ever so much for listening. We very much look forward to being back with you next week. And in the meantime, take care of yourself and take care of each other.

[00:57:34] 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@toptradersunplugged.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.