What Crisis Alpha Really Means

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This summary is written by Rich based on a conversation in our CTA series between Katy Kaminski, Chief Research Strategist of AlphaSimplex Group, and  the podcast hosts, Niels and Alan.

About AlphaSimplex Group

The company, with over 20 years of experience, focuses on a range of quantitative strategies, including managed futures, alternative risk premia, hedge fund replication, and more. Their largest strategy is managed futures, and they have been in the trend following space since 2010.

AlphaSimplex's philosophy revolves around offering its best ideas to all investors and providing alternative, diversifying returns to help investors at multiple levels of the investment hemisphere. The firm is very focused on liquidity in most of its strategies, catering to both retail and institutional clients.

Andrew Lo, the founder of AlphaSimplex Group, introduced the adaptive market hypothesis, which is a core part of the company's investment philosophy. This approach involves constantly innovating, changing, and adapting to different and evolving market environments. Trend following is seen as one of the best examples of an adaptive strategy and has been a core aspect of the business.

For their managed futures program, AlphaSimplex aims to deliver the purest form of trend following, focusing on crisis alpha and capturing difficult environments while adapting to volatility. The firm is not focused on maximizing the Sharpe ratio but rather on maximizing the trend experience and ensuring robustness and consistency in capturing key global market trends.

The Adaptive Markets Hypothesis (AMH) suggests that financial markets are not always efficient, as they are influenced by the behavior of market participants who adapt to changing market conditions. According to the AMH, investors' decision-making processes are driven by heuristics and biases, which can lead to market inefficiencies and price discrepancies. Over time, market participants learn from their experiences and adjust their behavior, resulting in the continuous evolution of market dynamics. In contrast to the Efficient Markets Hypothesis (EMH), which assumes rational behavior and perfect information, the AMH provides a more flexible framework for understanding financial markets, incorporating insights from behavioral finance and acknowledging the complex and adaptive nature of market interactions.

The Dual Mandate of Absolute Returns and Crisis Alpha and the Role of Sharpe

Niels and Katy discussed the focus on Sharpe ratios in the trend-following industry and the importance of understanding an investor's objective. 

Katy agreed with Cliff Asness that trend-following has two mandates: absolute returns and returns during a crisis. She emphasized the importance of focusing on total portfolio Sharpe instead of individual strategy Sharpe, as this depends on the investor's preferences and objectives.

Katy suggested that the most successful trend-following investors create segregated mandates and educate themselves and their boards on the strategy's purpose and performance during different market environments. She also acknowledged the challenge of managing clients' expectations, especially when trend-following underperforms equities.

To cater to different clients, Katy's firm offers both pure trend and more diversified trend-following strategies. The latter can involve adding more markets or alternative risk premia strategies to create a smoother return stream. The choice depends on whether the client is looking for a diversifier or a smoother individual line item. Katy emphasized the importance of understanding the client's objectives and guiding them to the right solution for their needs.

The Original Intent of the Term ‘Crisis Alpha”

Niels asked Katy about the original intent of crisis alpha, trend following, and the role of commodities in a crisis. 

Katy's original intent for crisis alpha was to understand what makes a strategy succeed during periods of stress. She was asked by a pension fund to explain why managed futures did well during the 2008 financial crisis. Drawing on the adaptive markets hypothesis, Katy focused on identifying the key characteristics of strategies that help them be successful during stress. These characteristics included liquidity, being opportunistic, and not having a specific bias. The concept of crisis alpha was then developed to encompass potential opportunities during periods of crisis, with trend following being one example of a strategy that possesses these characteristics.

1. Liquidity: A liquid strategy enables an investor to quickly enter or exit positions in response to changing market conditions. During a crisis, market dynamics can shift rapidly, and having the ability to move in and out of positions with ease becomes essential. Liquid strategies offer the flexibility to adapt to the evolving landscape, mitigating potential losses and seizing opportunities that may arise.
2. Being opportunistic: An opportunistic strategy is one that can identify and exploit a diverse range of opportunities across various asset classes and market conditions. During a crisis, each event is unique, and the opportunity set can differ significantly. An opportunistic approach allows investors to capitalize on these distinct opportunities, whether it's being long or short on a specific asset class or taking advantage of dislocations in the market. This adaptability helps a strategy navigate the uncertainties of a crisis and potentially generate positive returns.
3. Not having a specific bias: A strategy without a specific bias is not constrained by a predetermined view on the direction of the market or a particular asset class. This absence of bias enables the strategy to remain flexible and adapt to changing market conditions. In a crisis, having a strong bias can be detrimental, as it may cause investors to hold on to losing positions or miss out on profitable opportunities. A strategy without a bias can be nimbler and more responsive, allowing investors to capitalize on emerging trends and adjust their positions as the situation unfolds.

By incorporating these characteristics into a strategy, investors can enhance their ability to navigate periods of stress and potentially generate positive returns during times of crisis.

Katy went on to discuss the importance of having more tools in one's toolkit, such as commodities and currencies, which can provide alternative sources of opportunity and diversification during a crisis. She noted that the reason investors tend to focus on equities is because they have experienced major crises in equities over the past 20 years. However, recent events like the bond crisis have shifted the focus to other asset classes as well.

Regarding commodities, Katy highlighted that they play a key role in crisis alpha because they offer additional opportunities during stress periods. Access to more asset classes, including commodities, allows investors to capture various opportunities during crises. The ability to be opportunistic and have more tools at one's disposal is crucial for success during periods of stress.

Katy believes that crisis alpha and trend following are separate concepts. Crisis alpha refers to the positive returns generated during periods of market stress, while trend following is a strategy that can sometimes capture crisis alpha. She emphasized the importance of understanding these distinctions and educating investors about them. The three key characteristics of a successful crisis alpha strategy are liquidity, being opportunistic, and having no bias.

Speed is important in a crisis alpha strategy because it allows the program to adapt quickly to changing market conditions. This can be achieved through allocating enough resources to short-term strategies and incorporating nonlinear approaches that adapt to market environments.

Volatility management is another essential aspect, as it involves sizing positions based on the opportunity set and time-varying volatility. This allows the program to take more risk when opportunities are bigger and consolidate when opportunities are weaker.

In addition to these points, an equity-aware trend system can help prepare for difficult market environments by either avoiding or filtering equity signals. This can result in a lower Sharpe ratio on average but may offer better performance during equity crises.

Katy also highlighted the importance of differentiating between a crisis and a correction, as not all negative return events are crises. Educating investors about the distinction between crisis alpha and trend following can help them understand when a strategy might work and when it might not.

Views on CTA Replication

Niels asked Katy about her views on CTA replication, its pros and cons, and how it is implemented in her firm. 

Katy mentioned that they have been doing replication of multiple forms, including hedge fund and CTA replication strategies. She emphasized that while replicating correlation is easy, replicating exact returns is more challenging. She believes that there is a diverse ecosystem within trend following strategies that caters to different investor needs.

Katy highlighted that there are differences between a replicator and a diversified trend-following program, such as the number of markets and daily rebalancing. A diversified program may include up to 90-100 markets, while an ETF might focus on core macro exposures with a more concentrated approach. She views this as an exciting development, as it allows trend following strategies to reach different types of investors.

In summary, Katy believes that CTA replication has its merits and drawbacks, but ultimately, it depends on the investor's preferences and what they are looking for. The wide range of strategies available caters to different trend following investors, indicating a healthy and diverse ecosystem.

Machine Learning and Benefits of Sophisticated Strategies

Alan asked Katy about the success of machine learning in AlphaSimplex's trend-following program and what researchers can focus on to add value in a stable trend system. Katy shared that they have been using machine learning for many years and it has made a positive contribution to their program. They prefer simpler and interpretable machine learning models that allow for a nonlinear response to trends, enabling them to react at different speeds in various market environments.

Katy explained that machine learning helps capture trends faster or slower when needed, thus enhancing the performance of a trend-following system. In addition, a sophisticated trend-following strategy pays attention to details and factors such as risk management and how they integrate with each other.

When asked about the benefits of a sophisticated trend follower over a simpler system, Katy stated that while these strategies don't have high Sharpe ratios, adding a small amount of Sharpe can make a difference over a long run. Sophisticated investors understand the value of diversified or complex programs, as they can outperform simpler strategies over longer time horizons.

CTA Style Factors and Other Research Ideas

Katy discussed her interest in CTA style factors and their relevance in understanding tilts in trend-following systems. She mentioned a new factor called the long bond bias factor, which has become particularly important in light of the recent significant moves in bonds. This factor looks at whether strategies have a long bias to bonds, which can be detrimental during crises.

Katy explained that for the past 40 years, long signals were generally more profitable than short ones for bonds. However, with the recent downside in fixed income, a long bond bias could be harmful. Her team investigated why systematic managers, who are supposed to be unbiased, might still exhibit this bias. They explored constraints, non-trend strategies, and machine learning models as potential sources.

Katy noted that machine learning can easily learn a long bond bias from historical data, but the real question is whether these models can adapt to changes in the data. She added that there was a wide range of short bond exposure in the industry last year, leading her team to investigate the reasons behind these different positions. They found that the long bond bias factor could explain a significant portion of the relative performance in the past year, particularly since short bonds were the best trend during that period.

Niels, Katy, and Alan discussed the performance of trend followers in bond markets, especially as interest rates change. They also talked about the relationship between managed futures and macro uncertainty. Katy argued that trend following strategies perform well in times of high macro uncertainty, as they thrive on change and movement. She pointed out that most asset classes struggle in uncertain times, so it's crucial to find strategies that can adapt and perform well in such environments. 

For example, commodities do well in high inflation environments, while bonds struggle. 

The conversation emphasized the importance of understanding how trend following can be a valuable strategy when there is a lot of change, such as during periods of high or rising inflation.

Misconceptions of Trend Following

Niels asked Katy about the one thing she disagrees with most about trend following. 

Katy said she dislikes when people refer to trend following as a "hedge" or "protection" for equities, as it oversimplifies the narrative. Instead, she prefers to think of it as a tool in an investor's toolkit, offering philosophical diversification. 

Trend followers focus on what markets are doing rather than what they should do, reacting differently to various environments. 

Katy emphasized that seeing investments as a tool in a toolkit helps to avoid making promises associated with risk. 

Niels also pointed out the importance of considering the diversification of the investment process itself, which is a part of the power that trend following can bring to a portfolio, in addition to the diversification in terms of return streams.

Outlook for 2023

Katy is excited about the changes in the world since 2020, particularly the rise in inflation and the potential for tactical strategies and investments to become more interesting in the coming years. She noted that globalization has made investing less exciting, but the changing landscape has created new opportunities for trend followers. Some of the trends that pique her interest include the increased focus on commodities, currency trends, and the rising interest rate environment.

Rising interest rates offer a different set of opportunities, and Katy highlighted that during such environments, short signals tend to work well, especially in inverted yield curve situations. As the world is currently experiencing an inverted yield curve, she believes that investors will see intriguing patterns and opportunities that haven't worked for a long time, making it an interesting period for investing.

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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.