The Nuances of Diversification, Risk Management, and Dynamic Position Sizing
This summary is written by Rich based on a conversation in our CTA series between Svante Bergström, CEO and Founding Partner of LYNX Asset Management, and the podcast hosts, Niels and Alan.
About LYNX Asset Management
Lynx's unique journey started in Stockholm, Sweden, with its founders developing models in the mid-1990s without prior knowledge of the CTA industry. This unorthodox approach led to a distinct model portfolio that sets them apart from their peers.
Today, Lynx has grown significantly, boasting over 80 employees and managing $7.5 billion in assets. Bergström explains that their investment approach began with pattern recognition models. However, they eventually incorporated trend-following models due to their potential for delivering strong returns. To create a more robust investment strategy, the firm has maintained a diversified approach by combining multiple strategies, which aims to improve the Sharpe ratio and deliver crisis alpha.
The conversation delves into the challenges of investing in trend-following strategies, which can be difficult for investors to navigate due to extended periods of drawdowns. Bergström attributes this challenge to human nature, as people generally find it hard to commit to long-term investment strategies that don't produce consistent returns. He believes that trend-following will continue to be a viable strategy in the future, as human behavior is unlikely to change significantly.
In summary, the discussion highlighted Lynx's unique background and investment approach, which has contributed to their success in the trend-following and managed futures space. It also touches upon the challenges of investing in such strategies, emphasizing the importance of understanding human behavior and maintaining a diversified approach to achieve better risk-adjusted returns.
Experiences from 2022 and Crisis Alpha
Niels raised a question about balancing diversifying strategies and maintaining a trend-following profile.
Svante explained that Lynx has managed this balance by staying true to their core approach and avoiding style drift, which their institutional client base appreciates. Lynx's process involves constructing a portfolio from 45 different models, ensuring the expected return aligns with historical performance in various market environments.
Svante then reflected on the year 2022, a significant year for the trend-following industry, as it demonstrated strong returns and adaptability amidst rising interest rates. He expressed pride in Lynx's diversifying strategies, which achieved an even better Sharpe ratio than their trend-following bucket. Additionally, he highlighted that Lynx's portfolio ran with limited risk utilization during 2022, resulting in the firm's second-best performance since its inception.
The discussion moved to the concept of crisis alpha and its dual mandate of creating absolute returns while also profiting during equity crises. Svante confirmed that Lynx aims to achieve both goals by maximizing the Sharpe ratio while providing portfolio protection. Their optimization software helps track key ratios, including crisis alpha and portfolio performance in different market scenarios.
In summary, this section of the podcast emphasizes the importance of balancing diversifying strategies with a core trend-following approach, reflecting on the experiences of 2022 in the industry, and the role of crisis alpha in a manager's investment strategy.
How Machine Learning Assists Diversification
Svante discussed the importance of diversifying strategies in their portfolio and how machine learning models contribute to diversification. These models performed well in 2022, particularly in market environments they had seen before. Svante explained that they pre-process data before feeding it to the machine learning model, which allows for more flexibility and adaptation compared to traditional models.
Machine learning models add diversification to the portfolio and have a slightly higher Sharpe ratio over ten years compared to other models. They may lose money in some environments but perform significantly better in others. Svante acknowledged the trade-off between diversification and the potential for reduced returns, but maintains that a diversified portfolio is necessary for investors to stick with a fund over time.
Alan and Svante also discussed the process of adding and removing models from the portfolio. It is easier to add new models, but deciding when to remove underperforming ones can be challenging. Svante mentioned that they usually remove a model when they find a newer, better version or when the model's performance significantly drops. Their software automatically reduces allocations to underperforming models over time.
Niels praised the transparency in Svante's firm, mentioning how they have shared their model adjustments and strategy changes in the past.
Views on Replication
Niels shifted the conversation to discuss CTA replication, a topic that gained attention in 2022. Certain ETFs that attempt to replicate CTA strategies have grown significantly, outpacing the growth of the managers themselves.
Svante shared his thoughts on replication, expressing scepticism that these replication strategies will deliver the same returns as the flagship programs they are trying to mimic.
Svante highlighted the resources dedicated to allocating diversification between markets and models, as well as the efforts in trade execution, which are not factored into replication strategies. Although replication strategies may deliver acceptable performance, Svante doubts they will outperform the industry.
He also emphasized the importance of confidence in this industry, pointing out that during drawdowns, clients can discuss their concerns with real managers who can explain market behavior and model performance. On the other hand, replication strategies may lack such communication and reassurance during underperformance, potentially leading investors to redeem their investments and shift to real managers instead.
The Importance of Execution for Trend Following Strategies
Niels asked Svante about the role of execution in trend following strategies, particularly in relation to the assets under management (AUM) and the different timeframes involved.
Svante explained that for long-term trend following managers, execution is not as critical because trading is less frequent, and even executing the following day will yield similar returns. However, Lynx is diversified in terms of timeframes, with both long-term and short-term models.
Svante emphasized that for short-term models with holding periods of just a few days, it is crucial to limit slippage and trading costs.
The focus is not on execution costs with brokers, but rather on reducing slippage. As execution algorithms improve and become smarter, they can facilitate trading even on shorter timeframes, which can lead to increased diversification, returns, and crisis alpha. As a result, execution has been an essential aspect of Lynx's business for the past 15 years.
How Much Should We Diversify?
Niels discussed market diversification in trend following strategies and asked Svante about the number of markets they trade and the value of diversification.
Svante revealed that Lynx currently trades 100 markets and has about 20 more on the way. He agreed with Niels that increasing the number of markets too much does not add significant value. While it is better to trade 50 markets compared to 10 or 100 compared to 50, adding markets beyond that point has diminishing returns.
Svante explained that the most liquid and major markets, perhaps the 50 biggest ones, are where the crisis alpha and trend following characteristics are best realized. When trading less liquid markets, the focus may shift towards adding return rather than generating crisis alpha. These less liquid markets require a more long-term approach due to their liquidity constraints.
For Lynx, the 100 markets they trade provide the desired crisis alpha and trend following characteristics, while the additional 20 markets they are considering may contribute a few basis points in return but are not a significant factor in the portfolio's overall performance.
Risk Management, Dynamic Positioning and Evaluating Program Performance
Alan turned the conversation towards risk management, dynamic positioning, and evaluating manager performance.
Svante believes that dynamic position sizing in response to volatility is a no-brainer and considers static position sizing to be an old-school approach. While simpler models may perform well in certain market environments, dynamic position sizing helps manage risk during struggling market periods.
Lynx targets an 18% yearly volatility for its standard leveraged program, but it remains flexible in terms of risk levels depending on market behaviour.
Svante highlighted the importance of choosing the right level of volatility based on investor confidence and staying power. He also emphasized that when evaluating managers, it is important to consider not just performance numbers but also the team, research process, and confidence in their approach.
Niels questioned the narrative that dynamic position sizing doesn't allow capturing big trends and believes it is still effective in doing so. Svante agreed, mentioning that their good performance comes from very basic models and that dynamic position sizing is now applied even to those models that didn't use it in the past.
Capacity, Fees and Flows
Niels steered the discussion towards capacity, fees, and flows. Svante responded by stating that capacity is not a fixed number, but rather a question of how much slippage a firm is willing to accept before returns suffer.
Svante explained that Lynx, with $7.5 billion AUM, could potentially manage $10-$12 billion without significant slippage increases. If they were to gain more assets, he suggested hiring more researchers to help increase expected returns and compensate for any increased slippage.
Svante stressed that he would rather close the program than accept too many assets and compromise performance. He also dismissed the idea that CTA performance is driven by capacity or assets under management. Instead, he believes that performance is driven by market behavior, and CTAs are a small part of the financial markets, with their actions having little impact on overall market moves.
Views about ESG and on Hiring Researchers
Two topics were then put forward by Niels: ESG and hiring researchers in a location like Stockholm.
- Hiring Researchers in Stockholm: Svante acknowledged the smaller talent pool in Stockholm compared to cities like New York or London. While they could hire people from these cities, they often return after a couple of years due to the weather, darkness, and high taxes. However, being the only large CTA in the region offers an advantage: they can provide a fantastic work environment and attract local talent. They have a low turnover rate among their senior researchers, who have been with the company for 10-15 years, and are all partners. This creates an open environment where ideas can be discussed without fear of employees leaving for competitors.
- ESG: Svante believes ESG is an important aspect of their company and personal values. As a futures trading firm, they don't have voting rights for stocks, which makes incorporating ESG more challenging. However, they do trade ESG stock indices and encourage exchanges to launch ESG futures. They also participate in a sustainability forum and engage with exchanges to make contract specifications more ESG friendly. Svante noted that ESG is still in its early stages and different regions prioritize different aspects, such as climate and fossil fuels in the Nordics or diversity and inclusion in the US.
Alan asked about liquidity in the markets and whether Svante has observed any changes or concerns.
Svante acknowledged that liquidity and market behaviour have changed over time, transitioning from floor brokers to electronic trading and eventually algorithmic trading. To adapt to these changes, they have integrated liquidity considerations into their execution algorithms for several years.
This approach ensures that they do not trade aggressively when liquidity is low and adjust their positions based not only on volatility but also on liquidity. By doing so, they aim to minimize their footprint in the markets and maintain a passive trading approach.
Management of Cash for a Trend Following Program
Niels asked Svante about cash management in the current interest rate environment.
Svante explained that they take a conservative approach to managing cash, primarily using government T bills. They aim to maximize returns from these T bills in the most efficient way possible.
However, they do not engage in credit management, as their client base consists of professional institutional investors who prefer that their margins are kept in a safe place rather than taking on additional credit risk.
Misconceptions of Trend Following
Svante addressed a common misconception about trend-following and CTAs. He disagreed with the notion that investors only need one or two CTAs in their portfolio due to their high correlation. While this may hold true during strong trending periods when most CTAs perform well, it is not the case during more challenging market conditions or sideways markets.
In such situations, CTAs can have varying returns, and having a diversified portfolio of CTAs becomes essential to mitigate risks and maintain performance.
Outlook for 2023 and Beyond
Svante expressed optimism for 2023, citing high levels of uncertainty as typically favourable conditions for trend-following strategies.
He also noted that central banks have somewhat retreated from their earlier positions, which may contribute to divergences between regions and varying inflation cycles.
These factors present opportunities for trend-followers.
While Svante acknowledged that the best environment for trend-following occurs when unexpected events arise, he remains confident in the strategy's ability to capitalize on such occurrences.
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.
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