Why Uncertainty Is a Trend Follower’s Best Friend ft. Mark Rzepczynski

[00:00:01] 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.

[00:00:35] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Mark Rzepczynski and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor. Mark, it is wonderful to be back with you this week. I hope you’re doing well, hope you’re enjoying the World Cup. I saw that England was playing close to where you are last night. I think it was.

[00:00:59] Mark

We’ve been having World Cup fever here in Boston, but we’ve had a little bit of a crisis in Boston associated with the World Cup.

[00:01:11] Niels

I have a feeling that’s going to be the one that’s on your radar in a few seconds. But as we always do, we have a great lineup of topics. Thanks to you. Thanks for sharing that. But before we do that, let’s hear about the crisis in Boston that you have been experiencing.

[00:01:30] Mark

We ran out of beer. The Scots were in town for the World Cup. They’re great guests, their enthusiasm is infectious. But they drank the city dry so they had to have emergency supplies brought in for beers. Some said it was four times greater than this St. Patrick’s Day weekend. So, if you can imagine how much beer that people have been consuming. But they’re great fans, great to have them in Boston, but it created a crisis.

[00:02:05] Niels

Well, compared to that, I’m not sure what’s been on my radar. It’s very, you know, can really compare. But of course this is the week where we heard about the passing of former Fed chair Alan Greenspan, who was the Fed chair from the mid-80s, ‘87, I believe, all the way to 2006. So, he was there for quite a while and of course probably known for a few things.

I think one term that springs to mind, and I’d love to hear your thoughts afterwards, would be kind of the great moderation, where we had a long stretch of low inflation and steady economic growth kind of from the early to mid-80s and pretty much right into the big crises. And there were kind of two of them. One that he oversaw and one that he left just before it really came about.

I think also that people would… blame is not the right word necessarily, but they would certainly link what happened with the great financial crisis to some of the monetary policies that the Fed conducted leading into that, without a doubt. So, I guess my question is we’ve just a new Fed chair come in as well and there are a couple of interesting things.

I don’t know if you know this, but back in 1994… So, this is when Greenspan had been around for a few years. This was actually the first time, or so I’m told, that the Fed actually announced when they made a policy change back in February 1994, they came out with a very short statement about them deciding to increase slightly the degree of pressure, as they put it, on reserve positions. That was the wording they used. And all in all it was just like a couple of hundred words. That was it.

And nowadays we have, when we have Fed meetings, we have, you know, tons of meeting notes being presented. We have, you know, summary of economic projections. We have a press conference very different.

Now Warsh, interestingly enough, he’s kind of moving towards the Greenspan or maybe the pre-Greenspan era in terms of not really wanting to share too much and certainly not wanting to make any predictions about the future. Anyways, I’m rambling a little bit, but I think this is some of the things that stood out to me about this news.

Anything, because you and I obviously experienced the full term of Greenspan in terms of our involvement in the markets, anything that you think about when you think about Greenspan versus today maybe?

[00:05:14] Mark

Well, I think that first I remember February of 1994 very well because I was running a fixed income portfolio with a lot of mortgages. And I will tell you, I had a lot of pain right after that announcement. So, that was one of the most painful periods of my fixed income career. The key takeaway here is that people at the Fed do matter.

So, sometimes there’s been a movement in history to move away from what we’ll call the great man or the key man in history. Yet what we find is that at key periods of time a single person could have a huge influence on the economy both in the US and around the globe.

And I think Greenspan, at some points, was the right person at the right time. But I think that, at the same time, he was also responsible for, as you talked about, the foundation for the great financial crisis. In fact, he was not able to identify or accept that there was a bubble after he lowered interest rates close 1%, which really sort of exploded the housing market.

[00:06:32] Niels

Yeah, it’s funny. So, in 1994, I don’t know if you were there, but I seem to remember that there was an MFA conference in the Fairmont Hotel in Chicago or something like that. And I seem to remember a lot of the legends from our industry sitting at a panel not having a great time because that year, because of these on kind of sudden changes…

I think this was the first rate hike, by the way, in 1994 for something like five years. And then it came kind of a bit out of the blue, and it was not well received initially by trend following managers. This is from recollection. I could be completely wrong, but this is how I remember it…

…But I do remember gloomy faces sitting in Chicago not being thrilled about that particular year, at least around that time when the conference was, which was probably kind of around a few months after the actual event of the rate hike.

Anyways, the other thing that’s interesting to look at and I didn’t do the research here, I just found a source (and the source is quoted as Barclays and Bloomberg) about when you do get a change in Fed chairman, how does the equity market perform the first three months after the new chairman comes in? And Alan Greenspan, I hate to say it, he actually had the worst performance. The S&P 500 lost 33% in the first three months of his tenure. And this is based on about 10 or 12 Fed chairmen and one chairwoman, I guess, over the last many years. Interestingly enough, the best performer of those was Ben Bernanke. It only lost 2%.

I don’t see any of these where the equity market has actually gone up after they took over. But 33% loss from Alan Greenspan. To put it in context, Jerome Powell down 7% in the first three months, Janet Yellen down 4%. Ben Bernanke, as I mentioned, down 2%.

There was one other big loser, Eugene Mayer lost 32% and another Eugene, who is called Eugene Black, lost 21% of the equity markets, so, I don’t know, we’ll see about that.

The other thing that actually caught my attention, not something that really is relevant for trend following as such, other than it’s actually the 10 year anniversary for Brexit this week. And you know, quite a lot of things have come following that, don’t have a strong opinion about it.

And of course, the last thing is that there are lots of reports, of course, about some normalization in the Strait of Hormuz in terms of a few more ships coming through. What it’s meant is that Brent now trades at four-month lows in anticipation of more flows. So, that’s obviously relevant for trend following because that’s a bit of a regime change, we’ve witnessed in the last few weeks, in that sector, which also has put a little bit of pressure on the trend following performance.

But speaking of trend following, performance doesn’t look too bad, at least as of Tuesday. I know yesterday probably wasn’t a great day, but not enough to ruin really the whole month, but probably put us a little bit on the wrong side of zero. Equities and some of the metals, I think, have had some meaningful corrections this month. And as I mentioned, energy for sure.

Another thing that might be a little bit surprising to commentators is that the US dollar is doing pretty well. I don’t know if that’s all the World Cup fans buying cash dollars to spend it on beer in Boston right now. But, you know, it’s getting a little bit of a boost at the moment.

[00:10:43] Mark

That could be. That could be.

[00:10:45] Niels

It could well be it’s the Scots again, thank you so much to the Scots, anyways. But another thing, I mean silver month to date down 19% quite a lot.

Anyways, that’s what it looks like if we look at the numbers. And the SocGen CTA index is up 36 basis points as of Tuesday, up 10.88% so far. The SocGen Trend index up 17 basis points, up 10.6% for the year. Short-Term Traders index up 16 basis points, up about 5.5% for the year. The BTOP50 is flat for the month, but still up 9.67% for the year.

And as of last night, MSCI World index down 2.21%, up 8.26% [for the year]. S&P 500 Total Return down 2.74%, up 8.22% for the year. And the S&P Aggregate Bond index, US Aggregate Bond index is flat for the month, and it is up 57 basis points so far this year.

Anything from your side on the trend following space? Something you’ve noticed in the last few weeks since we last spoke? Before we get into the topics per se?

[00:12:04] Mark

Well, I think the key from trend following is how, once again, much of the performance of trend followers is concentrated in only a few markets. So, everyone talks about, you know, diversification, you want to trade a number of markets. But I don’t want to call it one of the dirty secrets of trend following, if you look back over a given year, most of the money will be only made in a few markets.

Let’s say oil is a perfect example for the first half of the year you had the big run up, you know, right at the beginning of the Iran conflict. Then we have the reversal, and whether you were a profitable or very profitable CTA, right down to this year, was whether you could be able to exploit the run up, be able to then manage the risk at the turnaround and then be able to make money on the other end.

So, we look at bonds as a perfect example. Gold is another example where you know, let’s say the run up was from last year. But you know, you look at, we’ve gone from like 5,200 down to now we’re close to 4,000. That’s a huge move, when you think about it, in these markets. And you wouldn’t have expected that given the world conflict. It’s the same with the dollar. The dollar was getting bashed and now, all of a sudden, we’re starting to have a strong upward trend.

The exception has been, we’ll say, bonds. If you look, from a yield perspective, the 10-year has been trading between 4%, 4.5% for, you know, almost a year. And, say, if it gets below 4%, it seems it’ll bounce higher. If it gets above 4.5%, you might start to move a little bit higher, but then it comes back into range. So, if anything, it’s been some of these lesser markets that have been driving performance.

[00:14:14] Niels

So okay, before we move into the topics, I want to stay on this a little bit because it is a topic that comes up so often and on one side we obviously have some replicators who will argue that, you know, 10, 12 markets are enough. On the other hand, all the managers with big budgets, with decades of experience, they would probably say no, that is not enough. And that is the reason why we trade 50, 75, 100, some even hundreds of markets. Right?

So, my question to you is it just because one is mimicking, trying to mimic a performance through regression analysis and therefore you can express the output? You don’t know what the positions are, but you can infer where the exposure is, or the high correlation to exposure. So, you can do that and get enough quote, unquote, different kinds of exposure by trading few markets.

But as soon as you step into the arena and you want to trade your own trend following system, those rules don’t work and you need to, in order to manage your risk properly and to find opportunities, you need a much broader set of markets. Can you share some light on that? You may not agree with this but can you share some light of how you think about those two opposites?

[00:16:00] Mark

Well, I’ve always been in the middle ground where, instead of saying just a few markets versus the all the markets…

[00:16:10] Niels

And I would agree with that. I would.

[00:16:11] Mark

You want to try to stay in the middle ground because that allows you to be able to maintain liquidity and then you could over diversify because, again, what we find is that just a few markets might drive performance. So, the critical issue, from a trend follower, is, say, capture the movement in oil but I didn’t have enough exposure in it and that was the big move. So, the problem that you have to balance out is that I don’t know which market is going to have this big move. So, I need to trade a larger basket.

At the same time if I trade too large a basket or if I don’t manage my positions carefully, then what will happen is that I capture those right markets but I don’t have enough of it.

So, that’s the tradeoff is that capturing and trading enough markets so you get the exposure when you have these large aberrant moves. At the same time, not trade too many markets because then what you’ll have is you’ll have not enough exposure in the things that are moving.

[00:17:26] Niels

Okay, so that makes perfect sense however, just to visualize this a bit further. So, I think it’s perfectly fine to think of the fact saying yeah, I get all my energy exposure through crude oil. WTI, it’s super liquid. It is what we think of as oil.

Having said that, I’m just looking at the futures price movement of the various markets in the last 12 months and crude oil, yes, it’s up 37%. That’s great. But its cousin, heating oil, is up 130%. So, you left something on the table by only trading crude oil in this instance.

[00:18:07] Mark

Right, well this goes to my dirty secret number two or correlation.

[00:18:13] Niels

Oh, okay, there’s a second one.

[00:18:15] Mark

I might have more dirty secrets, but we’ll hit just two of them today. And that is that everyone said, I want diversification. Yet, at the same time, if you want to be a very successful trend follower, you actually like when markets start to get correlated because then it increases the shock effect from a given shock. So, let’s say if you say, well, I trade the energy complex. Well, then what you want to have is that you want to have a shock to energy. It affects not just one market, like crude, it also affects Brent, it also affects heating oil, it also affects RBOB. When all of those start to move together, then once you get a multiplier effect across your set of positions, you could have an issue of, let’s say, you know, heating oil just has a much more larger move than crude and you’re able to exploit that.

So, you actually say I love diversification. But then when there’s a shock, I love the fact that then markets start to become correlated and I start to make money across a number of markets. And, in some sense, when you think about, it could be gold versus the dollar, or oil versus stocks, in some sense you don’t care about whether it’s positive or negatively correlated. All you care about is the absolute correlation.

So, you could be short one market and long the other. So, when there’s a shock, you want to exploit it and you’re worried about the absolute correlation across markets because you might be long or short across that spectrum of markets.

[00:20:19] Niels

All right, Mark, we are going to dive into your topics and from my understanding, I think there are kind of two main ones, but there are lots of sub things we need to get into for each of them. Maybe there are more. But if you can guide us through slowly, I’ll do my very best to keep up with you in terms of what you want to discuss today.

[00:20:47] Mark

Well, I think that it’s always the right time to go back, at the half year point in the year, to start, say, okay, let’s talk a little bit about what happened in the last six months and what might happen in the next six months. So, in some sense, we’re up double digits in a CTA index number, have done really well. And so, the question comes in, can this continue? Why will it continue? And what do you have to do to exploit that? And I think that will be sort of like the first major topic I’d like to talk about.

And then the second will be just some hedge fund research, in general, that I’ve done that I think is consistent with what we’re going to talk about, but also consistent with some of the thinking that, you know, we’ve had on some of these podcasts for a number of years.

So, we’ll go from the macro down to the micro. So, when you look at the first half of the year, it was a good year, maybe not where we expected returns were going to occur. We’ll say that the uncertainty or geopolitical uncertainty, you know, came out of left field. But at the same time that was a chance for a great opportunity for many trend followers.

So, if we look at what is going on for the next year, you’ll say to yourself (from a trend follower perspective), Mark, Niels, you guys, you’re just following prices. Why should I care about what’s happening in the economy? And we’ll sort of say that if you just want to make some predictions on asset allocation, what you want to look at is are there going to be regime changes or dislocations in the market that could lead to longer term trends?

So, if you’re an asset allocator, you want to think about what are the possible regime changes that would sort of say, yeah, maybe I should put more allocation to managed futures.

[00:22:55] Niels

Just curiosity and maybe we have some new listeners to the show this week. When we talk about regime change, how do you, how would you define, what is a regime change when we think about it?

[00:23:10] Mark

Well, it could be…

[00:23:11] Niels

Can it be defined at all? Or is it just something we say because things are different?

[00:23:18] Mark

Well, there are regime changes in behavior, there’s regime changes in structure. So we’ll separate the two and both will be an adjustment in the economy that leads to longer-term trends? We’ll call that a broad definition regime change.

A structural change, which we’re going to talk about would be a change in the head of the Fed. Okay. Because the person will put their own stamp on behavior, and that could lead to structural changes in how monetary policy is actually managed, and that will then spill over to financial markets and to other markets around the world. So we’ll call that more structural.

Then behavioral change will be the response to some shock that might occur. So, a behavioral change maybe, okay, we’re facing a lot of uncertainty because of geopolitical risk. How do you respond to that geopolitical risk?

Generally, we find that if there’s higher uncertainty or we’ll sort of say, if the environment has more uncertainty, then markets will generally slowdown in their behavior because people will sort of, in very simple terms, they’ll dollar cost average their behavior. They’re not going to get out or get in the market. They’ll bleed into the market their capital. And so, consequently, there’s a greater chance for trends.

So we always believe that if you have a regime where there’s high uncertainty, then there’s going to be more caution in behavior. If there’s more caution in behavior, then the price adjustment to a new equilibrium will take time and a trend follower will try to exploit that time dimension.

From a structural perspective, if, let’s say, that there’s a certain way in which the global economy is working and you have a structural change, and that could be a person or how policy is implemented, that will then convert to a new trend or reversal in the existing trends as their behavior or the structural change is then implemented in the marketplace.

[00:25:56] Niels

Could it be AI? Is that a regime change, do you think?

[00:25:59] Mark

Well, this is another area of research that we’re working on which is not on our topic list. But you know, when you look at for example, the use of natural language processing models and then you know, we’ll call it large language models, that’s really having a big influence on how analysts are doing their work and how people are behaving and adjusting in financial markets. It’s having a true influence on what is the work of an analyst and how people respond to different phenomena.

Now I use NLP and LLMs because what they’ve done is try to say like they’re trying to take soft information, qualitative information that we’ve seen in let’s say earnings calls, in Fed statements, in measuring of uncertainty through what we call bag of words is if we have more words that are sort of good or bad that might influence sentiment. And they’re trying to now convert soft information into numerical information or hard information. And that extraction of doing that is changing the way markets respond to different phenomena or different announcements.

[00:27:23] Niels

Cool. All right. Now I didn’t mean to derail your thought, but I thought it was important just to get it defined a little bit. All right. We were talking about the fact that we follow price, so we are not so concerned about what’s happening per se, except that something is happening. So please continue where you left off.

[00:27:49] Mark

Well, why don’t we… I’m going to dive into, you know, and since we’re talking about regime change, and we say there are subtle differences of regime changes, but the structural change may be the monetary policy. And with that particular one and you have to really talk about the new chairman, you know, chairman Warsh.

And so, we’ll sort of say that most of the reason we say, well, why was he nominated by President Trump? Or why was he going to be the new person at the Fed? And I think that the view has been that he was going to be less independent, that he was going to be more dovish, that he was going to bend to the will of the executive branch. So, and that this would actually lead to lower interest rates to some degree.

And that would be the regime change that we would expect, or that was the anticipated regime change that they fought with… Is that what we’re going to get? And I don’t really think that that’s going to be the case. So, it doesn’t seem that he’s as dovish a Fed chairman as what has been perceived. We’ll say that, you know, the Fed is actually sort of, we’ll say running a target. The target that the Fed is looking at is between 3% and 4% inflation.

What I say is, if we get to 4% inflation, the Fed is probably going to raise rates. If we get below 3% inflation, then there’s going to be the drumbeat that we should actually lower rates. So, surprisingly, with all the talk about a 2% inflation target, we’re actually running, you know, a policy based on a range between 3% and 4% – now that’s in reality.

But let’s look at what we’ve seen from Chairman Warsh to date. What we’ll say is that everyone has talked about this, the politics of the Fed and Fed independence. And they always think about the independence between the central bank and the executive branch. But in reality, the politics of the Fed is much more complex. Yes, it’s the executive branch versus the Fed, but there’s also the politics between Wall Street and Main Street. Okay.

And in that sense, the politics is saying that we got to get inflation under control. But the third politics that often is not discussed is the internal politics of the Fed. And that could be by the amount of dissent that we see in votes. And we saw that right before Warsh came in, much more dissenting.

And the politics between the Fed and the academics is that the academics validate what the central bank is doing. And so, they’ll sort of say, yes, what they do makes sense from our perspective. That doesn’t mean it’s good policy. It just means that within the context of an academic and their modeling, they’d say like we feel that their action is justified.

Now why are we talking about this politics? Because the one thing that in terms of, again, talking about structural regime change is that Chairman Warsh talked about five task forces that he’s now going to set up within the Fed. And we don’t know who are on the task force. We don’t know exactly if they’re set up. But there are five areas that they’re going to look at.

I think that all of these are important from the perspective of any systematic trader and any CTA or trend follower. And we’ll talk about why that in a second. But let’s just talk about what are the five task forces.

So, the first one is that they’re going to look at forward guidance. We already know that Chairman Warsh is not a fan of forward guidance. He’s going to be a ‘less is more’ type of person. And when they tried to pin him in a press conference, to pin down what you mean or what you’re going to do, he was not having any of that. He did not provide a dot for the dot plots.

So, let me put it this way. If the Chairman doesn’t give you a dot for the dot plots, how much longer are the dot plots going to be around? And I think he made some side comment about, you know, like, I think the dot plots are in pencil, not pen, which is telling us, that is gone.

So, let’s go, we’ll go through the five and then we’ll come back on how that affects trend followers. The second is the balance sheet. And we’ll sort of say all of his history says he’s not a fan of the large balance sheet from the Fed. Which has tremendous influence on what’s going to happen to fiscal policy. Because if you don’t have an accommodative Fed with a large balance sheet, then that means that the federal debt in the US is going to have to be financed from other sources, from private sources, or from official reserves from other institutions. That changes the dynamics of how the bond market will behave.

So the third task force that the Fed is actually going to use, we’ll call it the Fed and data. And this is an important issue because the quality of data that’s being introduced into the marketplace from the US sources is not as good as what it has been in the past. And part of this has been by the fact that much of the data that we collect is survey data.

The survey data, actually, then if people don’t respond to the survey, then you’re going to have lower quality data. And what we see that the response rates are much lower than what we’ve seen in the past. So, we need to get better data and that influences on price-based systems versus fundamental systems.

So, the fourth task force is going to be inflation. How do we get greater stability? We’ll call that the politics of Main Street. And the fifth task force is on AI productivity. We were talking earlier about Alan Greenspan and you know, he was the one who probably really noted that there was a productivity boom in the 1990s. We’ll sort of say that affected how he was going to run monetary policy.

That is, again, the fact in the current decade where, if we do have an AI productivity boom, then what happens is that monetary policy could be held a little bit looser than what you would expect if there was not a productivity boom. So those are the five task forces we talk about.

So, Niels, you’re probably asking, okay, how does it affect me? How does it affect a trend follower? How does it affect someone who’s looking at systematic modeling? We could go through for each one of these, and whether it’s good, bad, or indifferent.

[00:35:36] Niels

Yes, absolutely, that’s exactly what I’m thinking. But I also want to make sure we don’t forget, because it has also become very much in vogue to talk about economic trend where you look actually at economic data, and it’s been doing very well for those who have done that the last couple of years. So, let’s not forget to touch on that, whether these things actually matter to those types of strategies as well. But I will, again, let you drive from here.

[00:36:09] Mark

And I think that that’s a point we’re not going to forget. And this probably affects myself because I’m sort of a trend follower plus fundamentalist. And what I mean by that is that macro trends will drive price trends. Hence you want to look at fundamentals to be able to give you a support or another indication on what will be the direction of prices.

So, given that framework, that will sort of say that what happens in the macro economy is then displayed through prices. A trend follower will say that I just need to look at the prices themselves. The other information may be more backward looking or it doesn’t update as quickly. But, you know, there might be a middle ground between the two. So let’s look at each one of these and whether it’s good, bad, or indifferent for trend following.

So, the first is forward guidance. I think that if we actually reduce the focus on Fed words, that will be a good thing for the marketplace in general and specifically for trend followers because then prices are going to be more driven by the fundamentals as opposed to the speech or a press conference from some Fed official. So we’ll sort of say that forward guidance may have served a purpose when we are at the zero bound, but now we’ll sort of say that it’s the actions that should drive prices and drive markets and that means we should diminish the importance of forward guidance.

So, less forward guidance may be good for trend followers. It’s going to mean that prices aren’t going to be as noisy going forward.

Balance sheet; we’ll sort of say that the Fed has had an inordinate influence on bond markets given it’s the 800-pound gorilla in terms of the balance sheet. So, if you reduce the balance sheet, or you sort of reduce the Fed purchases or the Fed intervention in markets through its ample reserve policy, I think that this is going to be a good thing for markets.

Now, that doesn’t mean that markets are going to be better in the sense that it’s going to lead to rising stock prices and lower bond prices. It just means is that a single player is not going to drive prices. It will now be driven by the supply and demand across all agents within the marketplace. And I think that that’s good for trend following and good for market price information.

[00:39:12] Niels

So, the only caveat I would just mention to this is someone has to buy the bonds. It may not be the Fed. So, my thoughts would be that they may not now be the direct buyer but they’re just going to push someone else to buy it i.e. the banks, somehow with some kind of rule that, you know, makes it more tenable for banks to own more bonds and whatever. I don’t know the technicalities, but I don’t know that it’s going to make a big difference who owns the bonds, but someone is going to own them and there’s lots of bonds coming as far as I can tell, with the debt.

[00:39:51] Mark

Well, someone is going to have to buy the bonds. But in reality, we would like, if you’re a capitalist market practitioner, we would like to have the people who buy or sell bonds are doing it because they have clear profit objectives. That the reason why they’re buying the bonds is because they think that the price is going to go up or it’s a good investment, not because of some policy issue or driven by people who are not profit motivated.

[00:40:29] Niels

Sure. But I don’t disagree with that. I don’t disagree with that at all, Mark. I just say, in reality, I just think that someone’s going to be asked to buy whatever the Fed is not going to buy. But let’s not argue too much about that.

[00:40:44] Mark

Yeah. Let me put it this way. Someone’s going to have to buy it. That means, and it’s likely that the market clearing price may be, in this case, the rates are going to be higher…

[00:40:56] Niels

Right.

[00:40:56] Mark

… relative to what you would have if the Fed was buying.

[00:40:59] Niels

Okay, that’s a good way put that.

[00:41:00] Mark

Fed and data, I think that, in the long run, if you could get better data that’s being placed in the marketplace and announcements, that’s good because then you’re going to reduce the noise and you’re going to increase the link between the economics and prices.

In the short run we’ll sort of say that if data is poor then that means that the people like, we’ll say, the quasi-fundamentalists, like myself, who want to use data to also look for additional signals, our value is going to be diminished and the value of the person who just focuses on price is probably going to be more valuable in a poor data environment.

[00:41:50] Niels

Yeah. And my only thought on this, about the data, is I’m always kind of concerned that there probably is a motivation, in terms of changing the way data is collected and what data is even collected. I just think it’s going to change because it’s going to somehow magically make the data look better than the current way we’re looking at data. But anyways, that’s just my initial reaction.

[00:42:17] Mark

We’ve actually had both where we’ve had the Bureau of Labor Statistics adjusted labor data and it looked like we were generating more jobs, and then they did another revision, and then we found out that it was less jobs. And these are major revisions.

And if, let’s say, that you’re not sure exactly what the unemployment number is or how many people are employed, this is going to have a big impact on how you react to fundamental information. So, the inflation task force, I think that this is a good thing. But right now, Fed policy is not conducive to price stability. So, we’re still running at well above, and it’s been running for, we’ll say, five years plus above the 2% target.

And we’ll sort of say that you talk about Fed Chairman, we go to Ben Bernanke and Chairman Yellen, both of those said that the real problem we are going to be facing is deflation. The real problem is we have too low of inflation.

They actually said this during their chairmanships that they said the problem is too low of inflation. Inflation we could solve. It’s the deflation that we have a harder time solving.

And lo and behold we’re five years out, it’s still above target inflation. So, the final task force of AI productivity we’ll sort of say it’s unclear, it’s neutral in effect on how it affects trend followers.

We’ll just know that it’s out there, that it means that the economy could actually grow much stronger. That’ll have some impact on fundamental prices. But I think that productivity is going to be important for the global growth because right now global growth is relatively poor.

[00:44:20] Niels

Yeah. Cool.

[00:44:21] Mark

So,, overall I think that we started with the theme of well, what is going to happen for the second half of the year? What are the potential regime changes?

In that sense we’ll sort of say that the big structural regime change is going to be in monetary policy. This is something people should take a look at. It’s not going to affect the P&L immediately, albeit we saw a reaction to Warsh. And as you stated earlier, let’s say like the first three months of new Fed chairman, you don’t know what you’re going to get and some of it could be extremely negative.

[00:45:02] Niels

Yeah, that’s true. That is true. Well, it’s certainly an interesting time to take over just around the same time as we just had the largest IPO in the world. Not necessarily based on the most modest valuation of a company as far as I can tell, but there we are.

[00:45:25] Mark

Right.

And that’s another area we’ll sort of say that when you talk about price-based systems for others versus other systems, you look at the fundamental data, you look at survey data. Survey data is, people are not as… there’s more uncertainty, there’s more fear, expectations show for higher inflation, business optimism is relatively low. I think consumer confidence, if you look at the confidence board, numbers are closer to 2020 as opposed to a high period. So, if you look at this, the confidence numbers and survey data, this is not a very strong economy. And so, this is going to be something that’s going to have a bigger impact on whether we can continue to have equity rallies in the second half of the year.

[00:46:22] Niels

Yeah. Before we move on to the other big topic you wanted to talk about, we talked about economic trend and I’m still not entirely sure if we really got to kind of the thoughts that I have or question that I have and that is if you build a trend model based on economic data inputs, what do you do? Because clearly, we’re going to have, at some point, another set of data which we’ve never had before. So, what do you do in that situation? Do you turn it off for a while? Do you hope that it works well on the new set of data or…

[00:47:05] Mark

Well, most of the research in this area, and I probably would agree with this, is when you think about it, you could have your price-based system and then you could have a fundamental system that is run almost as a separate system, and then if you systematically weight the two of them, then the combination will be better. You’ll have lower volatility and have a smoother, you know, return pattern.

Now, one of the ways when you optimize between these two systems, let’s say, if the quality of one system declines, then the weight on that system is going to be reduced. We’ll say that the weighting on the fundamental system has been lower than what I’ve seen in the past when I look at models.

So, you can think of that you’re changing the weights between fundamental and price-based, that the price-based systems are given a higher weight relative to a fundamental system.

[00:48:14] Niels

Okay. All right. Now, you had one other big kind of theme that you wanted to talk through today. So again, I’d love to hear what’s what you have in mind.

[00:48:28] Mark

Well, we focused it on my macro, and I want to switch gears and talk a little bit about the micro. It’s been some research I’d been working on where I wanted to look at, you know, differences in behavior across all hedge fund strategies. Because oftentimes when you talk about trend following, the discussion is often about like, well, how does one trend follower compete with another? Or how does one CTA compete with another, when in reality the issue is much broader.

It’s almost as though that you can think of competition within your industry, but if, let’s say that there are players outside your industry that might have an impact on your business, you have to look at that too from a competitive landscape. So, think of it that, if I was looking at sports and I was competing, say, for focus among different football teams to capture people’s attention. Well, you also have to worry about, well, people could look at soccer right now, they could look at baseball, they could look at other sports, or they could go to the movies. You have to think in the broader sense of entertainment as opposed to one specific type.

The same applies to hedge funds. There are well over 10 different hedge fund strategies. And so, the question comes in, why should you choose one over another relative to, let’s say, manage futures?

Now, in particular, what I wanted to do is compare hedge fund strategies. But look at this in terms of how are they sensitive to risk, not in terms of systematic risk like their beta, but how to look at risk in as a measure of uncertainty through, let’s say the VIX index? And when you think about it, you could think of risk in two dimensions.

One dimension you could think of is what is the risk regime? I’m in, and I’m using the word regime again, but you know, I’ll make a careful definition. Think of it, you could be in a low, medium, or high-risk environment. And we’ll say a high-risk environment is when the VIX is extremely high. Low-risk environment is when, you know, the volatility in the VIX is relatively low.

And the second thing was we can look at risk shocks, and that would be the change in the VIX. You could have high risk-shocks and you could have low-risk shocks. So, the question we want to ask is how sensitive are different hedge fund strategies to the risk regime or to risk shocks?

Now, the hypothesis is that, well, these hedge fund guys, they’re pretty smart guys and so they can be able to skillfully manage risk. So, their performance should be independent of the risk regime that we see. It should be independent of the risk shocks that we see.

So that would be sort of the basic premise, that if they’re skilled portfolio managers, they should do a pretty good job of being able to handle this kind of risk. So, Niels, I always view you as the sophisticated common man. So how do you think the hedge funds will behave to different risk regimes or risk shocks?

[00:52:21] Niels

So, the way I would think about it is that actually when you look at the kind of the universe of different alternative investment strategies or hedge fund strategies, I think what you find is (and correct me if I’m wrong, which I’m sure you will), is that a lot of them are actually… They have a lot of similarities and very high correlation when things get difficult in equity land. So, they have negative skew, essentially, compared to a few, of which trend following is one, that is exactly the opposite. That would be my contention.

[00:53:01] Mark

Yeah. And I think your intuition is pretty close to the mark. But I think that there are some nuances going on here that I think you and listeners might find very interesting and that effects on how they should build their portfolios.

So, we first ran the betas, and we’ll sort of say that, okay, you get a different set of betas, and I’m not showing anything new or surprising, the beta for managed futures is close to zero. Some of the others are positive. But you know, we’ll sort of say that, you know, they’re not close to one, they’re not zero, they’re somewhere in between. So, you get diversification for all hedge fund strategies.

When we look at the, you know, risk regime, we’ll sort of say that a number of strategies have no sensitivities whatsoever. Some have a negative sensitivity, sort of what you’d expect. You know, let’s say if like fixed income arb, there’s a negative sensitivity to the risk regime. Higher volatility might be a little harder to deal with arbitrage strategies, and the same might apply to risk shocks. That’s not that surprising if you have bigger risk shocks, positive risk shocks the market may not do as well.

But we want to sort of decompose this a little bit more and sort of say like, well let’s look about whether we break down the risk regime into this low, medium and high. So, we standardize the risk regime and then we sort of run sort of the regression but in bins.

So, we look at a low-risk bin, a medium-risk and a high-risk. And what you find out is that low risk environment, with all hedge fund strategies, no sensitivity to the risk level. Okay, medium, we’ll sort of say it might be slightly positive but in general we’ll sort of say they’re not that sensitive to the medium risk.

But all of a sudden if we look at a high-risk regime, you know, excess returns diminish significantly. There’s a strong negative impact that, if I’m in a high risk regime, these strategies do poorly in terms of measured excess return even after accounting for beta. But there are one or two strategies that seem to be exceptional. And so, and you know, Niels, I’m going to put you on the spot again. What do you think is an exceptional strategy for high-risk regimes?

[00:56:06] Niels

So, I mean obviously you can be on the right side with your tail risk strategy. But my favorite would of course be something like trend following. Am I going in the right direction here?

[00:56:18] Mark

So yes, I don’t want to lead the witness but this sort of like you’re absolutely correct. So, what we find out is that in high-risk regimes there’s no sensitivity to managed futures. So, the excess returns are not affected in managed futures, whether you’re in a high-risk regime. Now, your beta is also close to zero.

So, if you sort of say that we go from a low-risk regime and we’re in a high-risk regime, like high VIX, there are a lot of strategies that they can’t really manage or handle that risk very well. Managed futures has a positive but insignificant influence on the high-risk regime.

Now the same also applies to global macro, but the coefficient is negative. So, we’ll sort of say put a little less stock on this. So, if you feel that we’re going to be in a higher-risk environment, and you say, well, where can I get better diversification? I want to be in managed futures. So, this is not just your beta effect, this is just about the risk regime.

We do the same thing for looking at excess returns for these risk shocks, and risk shock will be just measured by the change in the VIX. And again, we’ll sort of say that most hedge fund strategies have a negative coefficient relative to high-risk shocks.

Managed futures is insensitive to high-risk shocks. So, it doesn’t mean that it’s making money. But where others are losing money, the managed futures actually is indifferent to that, which has tremendous implications on how you should look at your portfolio. Now, look, we can go and decompose this a little bit more.

So, we looked at, you know, the alpha for hedge fund strategies and the argument is, from a lot of other hedge fund strategies, they say, yeah, well, maybe our beta is a little bit higher, but we create alpha from our unique strategies whether it’s event driven, market neutral, you know, convertible arb. And generally, you find that there are some strategies that actually produce positive alpha. Managed futures is not one of them. There’s not an alpha component. We’re just looking at a simple, you know, beta analysis.

But what you do find is that in high-risk regimes the alpha that you thought was positive for many strategies turns negative. So, if you’re thinking that you’re going to get alpha from other hedge fund strategies in high-risk regimes, that’s not going to be the case. They might actually produce this alpha when there’s medium to low-risk regimes. But high-risk, it’s alpha negative. And the same applies to the case for risk shocks.

If you have high risk shocks, their management skill of other strategies is such that it has a negative coefficient on high-risk shocks. Now, finally what we did is we looked at what happens to the beta for different hedge fund strategies in different risk regimes and risk shocks?

So, Niels, I going to have to put you on the spot again. What do you think happens to beta for other hedge fund strategies in high-risk regimes or high-risk shocks?

[01:00:31] Niels

Well, I would expect it to be lower, but you tell me.

[01:00:37] Mark

So, now, you’re absolutely right for managed futures, you would say for high-risk regimes the beta actually gets to be negative and significant. The same is for risk shocks. So, your beta actually gets more negative for managed futures in high-risk regimes and high-risk shocks. On the other hand, for other strategies. In many cases, when you have a high-risk regime the beta actually goes up.

So, you become more sensitive to systematic risk, say when there is a high-risk regime. And similarly, you’re going to have higher sensitivity to risk shocks for other hedge fund strategies. So, the long and short of this is that and your intuition was correct for managed futures. This is actually a better benefit for the case of risk regimes, in terms of the beta going negative for both risk regimes and risk shocks. That’s not the case for other strategies.

So, in some sense, if you’re worried about uncertainty, and you measure uncertainty based on the VIX indexes as an indicator, you’re actually going to have better benefits. You should probably increase your allocation to managed futures if you believe that we’re going into a high uncertainty, high-risk environment.

[01:02:30] Niels

Okay, that’s fair. Now of course a good example of that would be maybe the past 12 months or so. That has certainly been more uncertain than we’ve seen for a while. And actually in the case of managed futures trend following, it’s been pretty solid 12 months.

[01:02:50] Mark

And if you look at, you know, you could do anecdotal evidence, when we had a big shock to the VIX index, you know, and that was sort of correlated when the performance for managed futures actually improved. Other strategies were having (if you follow other hedge fund strategies), they were having a more difficult time with the high volatility environment. Now we don’t want to extrapolate from one case, but you know, you could look at other examples, and you see high volatility.

Well, what happens… Let’s say that you’re trying to manage your long/short book, you’re seeing that you might have some of structured trades on. What you find out is that more likely there’s going to be some disconnect, that there’s going to be some change in the environment so that your strategy may not be as effective.

Now there are some interesting cases of, you know, equity market neutral in terms of how it does in different risk regimes. Surprisingly, I found equity market neutral is, in terms of the structure of when we have shocks, they might do a little bit better in some environments.

But in general, we find that if you think that your approach to alternatives should be that you bundle a number of different strategies together, just put them together to get a bundled set of strategies, that might work. But if you’re trying to sort of protect yourself against high-risk regimes and risk shocks, that may not be the best strategy.

[01:04:56] Niels

Yeah, perfect way to sum it up. A perfect way to end our conversation this week. Mark, this was great. What people don’t know is we had a few technical problems during our conversation. So, I’m going to wrap it up now. Before we run into any more of them.

But I really do appreciate your time and appreciate you putting together all of these topics that I’m sure will be very useful and interesting for people.

We did some analysis on our side at DUNN, also in the similar vein in terms of analyzing alternative investment strategies versus trend following, and obviously we come to similar conclusions. I think I’ve shared this on the podcast before, otherwise people can email me. In any event, next week I will be joined by Cem. He’s back and if you have any questions to him or for him, email me at info@toptradersunplugged.com and I’ll do my best to get them answered. And other than that, just make sure you follow Mark’s work. He writes a daily blog and they are great and informative. So, make sure you go and have him in your feed.

That’s it for now from Mark and me, thanks ever so much for listening. We look forward to being back with you next week. And until next time. As usual, take care of yourself. And take care of each other.

[01:06:25] Ending

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