SI325: Why Adaptive Strategies Matter Now More Than Ever ft. Graham Robertson

Intro
00:00:01
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.

Niels
00:00:23
Welcome and welcome back to this week's edition of the Systematic Investor series with Graham Robertson and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor. Graham, it is wonderful to have you back this week. How are things in London?

Graham
00:00:37
Niels, it’s great to be back. Yeah, it's, I guess, a classic London December at the moment. It's a bit gray. It's a bit drizzly, all looking forward to taking a bit of time off and hopefully a bit of sunshine.

Niels
00:00:48
Yeah, absolutely. I think we all do. We've got a really good lineup of questions, thanks to you, and topics that we're going to be discussing today. But first of all, I always love to hear what you have had on your radar the last few weeks. So, let's dive into that first.

Graham
00:01:09
Yeah, absolutely. I mean, I guess what's been on most investors’ minds, in the last couple of weeks, has been what's been going on in the US and the President elect, and its effect on trend following, I guess. We'll talk, I think, a fair bit about the US, and the dollar, and US Stocks today. But really, that's been the interesting thing.

In particular, I would say what was fascinating to me was just what was happening in bonds globally before the election came out - bond yields going higher, bonds selling off. So, I think in general trend followers were somewhat well positioned for that happening. And the Trump trade has been okay.

But if you look at what's been driving returns, it's just astonishing how much the US comes across, whether it's the dollar, whether it's US Stock indices, or whether it's bonds. It's just key to what's going on both in trend following and, I guess, in markets in general.

Niels
00:02:04
I completely agree. What's interesting about it, in my opinion, is that I think before the election, maybe in the first few days after the election, I think investors, if we just look at the markets, had a pretty clear idea as to what should happen or what will happen with inflation and rates and so on and so forth. I feel that the opinions are starting to be more open minded to maybe that it won't necessarily mean higher inflation and higher yields and so on and so forth.

So, it's kind of interesting to see that. Of course we have no idea and we, you could say, don't really worry about it as much as maybe other types of investors, but it is interesting to see how these things change. And of course, also, I think it did help a lot when he announced who he would like to be head of the Treasury. And so, we'll see. We'll see.

My radar is a little bit different, and it's not really something that is kind of my specialty whatsoever, but it does relate to the US because I guess that's where we have the data from. And it's something I've been discussing with Cem on a recent episode. You may not have much to say about it as such, but I do think it's interesting to note, and that is this single stock correlation, which is something I would never necessarily pay attention to, but it is hitting some historical lows. Meaning the correlation between these major single stocks, I should say, in the US. So, they are starting to behave very differently to each other, if I could put it like that. Of course, we know with correlation, what's interesting about correlation is that often when there is a crisis, everything goes in the same direction. So, correlations jump up, you could say.

So having low correlation kind of fits in with the fact that we're making new all-time highs all the time, it seems. But it may also be maybe a little bit of a warning sign that perhaps this can't go on forever. And of course, as we get into January and the new president takes over, who knows, that might actually be a time where people say, well hang on, let's, let's try something different. I don't know, is it something you follow?

I mean, you have so many products on your side or I don't even know if you cover this in your remit sort of strategies that trade single stocks. We don't on our side, which is why I don't really follow it.

Graham
00:04:36
Yeah, it's, it's not something I would say that crops up on the radar too much from our kind of macro futures perspective. We do look at stocks, but more in terms of baskets, you know, factors and looking at that side. But you know, what you say sounds quite nice. You know, it sounds like things are going to happen and we love it when things happen, basically.

Niels
00:04:58
Very true, very true.

The other thing that caught my eye, and I do know we're going to talk about this in a little bit different ways later, but I had put this down before I realized that. And this is nothing new, it's been going on for a while, but it's this divergence in performance between the US and pretty much everything else. But even in Europe, where you and I are based, it's quite incredible to see how US centric performance is at the moment.

Graham
00:05:30
I couldn't agree more. And it manifests itself in so many different ways. And diversification is generally, good. Right? And we've seen US stocks just take off.

You've seen what's happened in France recently. Europe's really looking quite weak. Korea obviously as well. But yeah, the US just goes from strength to strength. Who'd have predicted that? Who knows?

Unpredictability is just what's out there. And it's something that you've got to have an adaptive strategy to deal with that kind of thing.

Niels
00:05:59
Yeah, yeah. This is the other thing that I kind of was thinking of, not really on… not a lot, but a little bit. And that is when you have a year like this where, and again, when we talk about equities we tend to think, at least I do, about the S&P 500. It's kind of the one that we kind of think about. So anyways, it's having a great year, very similar to what other election years have been. In particular, as Cem Kasan had done research on, during populist periods equities tend to be doing really well.

Anyways, I was thinking, and you and I are kind of on the same side of the industry, what do you think that might do to our job in the next year when we're coming out flagging the need for diversification or alternative investments and people are looking at their investment book and saying, well, you know, a 25% return last year in equities, I'll take some more of that.

Graham
00:07:02
But I guess the answer to that is it's 25% if you're looking at a US weighted index. I don't know how many people have got that. But yeah, you're right.

It's quite clear that diversification isn't necessarily playing out at the moment. You'll probably hear from the people that have got it right. But we know that long-term diversification does work.

But yeah, I do spend a lot of time looking at the composition of MSCI, and looking at the compositions of quant portfolios, whether it's cash equities, whether it's futures portfolio and equities. And there are marked differences, but yeah.

Niels
00:07:36
Am I right, Graham, in saying, and this is something I have heard but I don't remember it clearly, that even the MSCI World Index now is like 60% US equities?

Graham
00:07:48
Yep, yep, I was looking at that exactly this morning. It's 50% plus. I think 60% was a ballpark number. And you know, a classically diversified portfolio across equities is going to be much more like a third. So yeah, you've got material differences, and it does make a big difference.

Niels
00:08:04
Yeah, yeah, absolutely.

All right, let me quickly give a little bit of color in the first few days of December in terms of performance, and maybe I'll ask you to give me your perspective of the year so far. But just staying with December, we obviously saw a strong recovery in November.

Trend followers had a solid start also to the month of December, even though it's early days, of course. And so far, to me at least, from where I'm looking, December looks like a mirror image more or less as of November, meaning that we still see good trends in North American equities in particular. And also, soft commodities like cocoa and coffee are doing really well. Maybe a couple of the grain markets have joined as well.

But unlike November, we are getting also a little bit of help from precious metals and some of the currencies are doing a bit better as far as I can tell. But anyway, so far so good, you could say, although the month is really long and plenty of things will happen, no doubt, from here.

But going back to the comment I made before, we are obviously getting close to year-end, so it's natural, I think, for us to talk a little bit about our observations. So, I’d love to hear your thoughts, Graham, on this.

Graham
00:09:22
Yeah, I guess when we last talked, Niels, we were just at the end of what was a good first quarter and we did crunch some numbers recently, and I think the first quarter this year was the second best first quarter in the history of the SocGen Trend index. Can you guess what the first one was?

Niels
00:09:44
Oh, so 2014 was a good year, but I don't know if it was the first quarter.

Graham
00:09:51
It's very recently. That's your clue.

Niels
00:09:53
Ah, okay, 2022.

Graham
00:09:54
Exactly.

So, this is the second best first quarter. I guess, since then, I've been speaking a lot to people who probably are a bit more bearish than they ought to be. And I think it's because we've come off a really strong first quarter. I mean, the indices, as you said, flat, small up at the moment. But in the context of a great first quarter, there's a little bit of frustration there.

So, it's just, I think, getting people comfortable with that these things happen. There's nothing out of order, and just framing it is what we spend a lot of time doing. The reasons, I guess, since we last spoke, so covering Q3 and Q4, there’s a fair bit of idiosyncratic noise. We'll talk a little bit about that today. We call it Yenmageddon, it turns out it's not widely known, but the events in August, for example.

Tariff economics is another one that's cropping up recently. We’re coining lots of new phrases. I suspect there's going to be a fair bit of that. But there’s just fair bit of idiosyncratic noise.

So, the Middle East situation was a little bit random as well, in October, and counted against us. So, a few bits of idiosyncratic stuff. We'll talk later about what has been going on in bonds and FX linked to central bank stuff.

But I guess more recently the Trump election has gone broadly well for us because the markets were reacting beforehand and we were kind of positioned well for that.

Niels
00:11:24
Yeah, I think that's definitely true. One thing I wanted to bring up with you, I mean, you write a lot and so I'm sure you've written about these things. So, when we talk about performance, just like you said, we talk about certain key drivers, events even. But if we talk about drivers of what causes, for example, dispersion in performance between managers and so on and so forth, we often mention a few things. For example, it could be the composition of the portfolio. It could be financial markets. Some funds are more financially heavier than others. Others are diversifying, including commodities. The other thing we also talk about is just the number of markets that we trade. Some funds are, like us, kind of below 100. Others are in the 300, 400, 500 markets. So, we can discuss that a bit among ourselves at least.

And then we talk also about speed - speed of models. You know, are you fast, are you medium, are you slow? That can also cause differences in performance, and then also purity of the strategy. You know, is it pure trend, or have people added some diversifying strategies, as they often are labeled?

But there's one thing that we don't talk about so much. I’m not sure why the reason is, but it's something I actually feel that this year could have been also playing a big role in the performance difference, and that's size. Because, in my mind, those funds (at least these are just from looking at the data so far this year) that have done well, there's always going to be exceptions, but those funds that have done well, I seem to think that they are a little bit smaller in size.

And why I believe this also has an impact is that in a year like this year where some of the “smaller” liquid markets still, like the softs, can play a big role. Then clearly, if you're trading 300, 400 markets or if you're trading 5 billion, 10 billion, the allocation to those markets may not be as meaningful than for those managers who trade smaller amounts. Is this something… I'd love to hear your thoughts on this. Is this something you have looked at or have thought about?

Graham
00:13:53
Absolutely. I mean I guess when you're putting together a trend flowing strategy you've really got to think about the markets you're allocating to.

And I think the point you're trying to make is that, as you get incrementally bigger you're going to hit more and more thresholds on some of the markets that you trade.

So, I guess an important point of putting together your capacity numbers is figuring out okay, as we increase in size what's the effect that has in the Sharpe ratio? How meaningful is that degradation?

Also factoring in the likes of, well if you're going to develop your execution platform, if you're going to look more at, let's say, harder to access markets, classic alternative markets, we might call them OTC markets, there's definitely a higher cost. You need more hands-on-deck if you like to trade those. So, there's a little bit of a tradeoff there but you know, it's absolutely something you factor in and you look at your capacity numbers based on that.

Niels
00:14:49
Yeah, one thing just this, it was just sort of a little bit of a simple research on my side. But I was looking at kind of a standard trend following type model-ish, let's put it that way. Just looking at year-to-date, at different look back periods, the performance for different look back periods, I don't know what your experience has been but it looks to me like you know there's been a massive difference between short-term and long-term. But then you would think well, then medium-term is probably somewhere in the middle. Not according to the data I'm looking at. Medium-term has actually been even worse than short-term. What are your thoughts about this?

Graham
00:15:33
They’re exactly the same. You can't just linearly interpolate between fast and slow and say, well, okay, medium is going to be good. You know, it completely depends. Especially if you bring something like breakout models into the mix.

I mean, you've got a concept of speed there too, but when these things kick off, you know, it's putting on a position really quite quickly and that's where performance can really diverge from this kind of linear approach that you might have for moving average crossovers, for example. So that could be a huge part of it. But that's observed.

I mean, what we tend to see is that for the long-term, slow might have the better Sharpe, and I'm being very cautious with my words here, but slow tends to be a bit higher Sharpe, but the faster side gives you the better risk management properties, your better crisis alpha. So, there's a little bit of a trade off in there.

But you're dead right Niels. These are generalizations, and at any point in time it's not linear across speed at all. It depends on the market. Especially when you have something like August where you have sudden moves in markets, and then a sudden rebound. And you look at the Nikkei, what was it down 12% in a day and then most of it rebounded quickly.

You look at the one in the last few days, down tons and then up. You can have huge differences just depending on the type of models and the responsiveness. It's very hard. I think we discussed this last time. It continues to amaze me. In an industry which is, in theory, looking at trends, which conceptually is quite simple, the range of manager returns is huge, huge.

Niels
00:17:13
This year it's definitely interesting.

The other thing that's so “funny” about this is that earlier this year I came across a very large allocator, probably not far away from you, I would imagine. I never talked to him directly but what I gathered from my intel from the people having some contact was that in this search for finding a couple of trend followers he was dead set on medium-term timeframe. There was no argument about it, that was the best timeframe. And I'm thinking, I hope he's listening to this and it's not to be, you know, cheeky, it's just be a little bit more open minded about these things and don't get too hardened on a particular narrative about these things because as you say, things are changing and adapting all the time.

Graham
00:18:07
But I guess the key question for me, in that context, is what do we mean by medium-term? Right?

I mean, my concept of medium-term is managers in SocGen Trend, in the BTOP50 and you know, roughly speaking, I'd say that average holding period trend length is what, two to six months? That's what I would classify as medium trend. And you can drive a bus through that estimate, which is quite different to short-term, but in the medium-term itself is not unique.

Niels
00:18:38
All right, so a quick update on the numbers.

So, in terms of the trend barometer, that closed yesterday at 39. So. it's a bit weak, but I will just remind people that it does use actually, funnily enough, shorter-term time frames in its calculation. So, it's kind of in line with what we see in the shorter-term performance numbers. But be that as it may, it finished at 39 yesterday and has been pretty quiet for the last few weeks.


in terms of performance, BTOP50 (and this is as of Tuesday of this week, since we're recording Thursday), BTOP50 is up 75 basis points for the month, already up 4.34% so far this year. SocGen CTA up 82 basis points, up 1.93% for the year. SocGen Trend up 92 basis points, up 2% for the year. And the Short Term Traders index up 19 basis points, but it is down for the year 14 basis points.

As we talked about earlier, traditional assets are doing well. MSCI World up 1% already in December, up 21% and a half-ish for the year. The S&P US Aggregate Bond index up 19 basis points, up 3.5% for the year. And the S&P 500 Total Return index up 61 basis points and up a whopping 29.24% so far this year.

All right, with that said, let's dive into some of the topics that you brought along. I'm going to, more or less, just give you the headline, Graham, to remind you of the order of these things, but I'd love to dive into some of this. A lot of it is related to the great writing that you and your colleagues do over at Man. So, people should definitely go and check out the Man Institute to read some of these papers that we are talking about.

The first thing (and we already touched a little bit on this), we talked about idiosyncratic risk, so talk us through that.

Graham
00:20:41
Yeah, so look, I mean, I think Ian McGedon, in that August period, centering on the end of the carry trade in Japan was fascinating. Why? Well, essentially, we had a three day vol spike. Now that really asks questions. Can we expect any strategy to deal with a three day vol spike?

We did a little bit, or my colleague reported a bit of analysis on this, essentially looking at how does trend perform in a relatively short term period? And what we got out of that was in a sense not too surprising.

We'll have discussed this on the podcast before, but trend following works well in a crisis. But that crisis has to be somewhat sustained, right? It's not a sharp, VIX spike type crisis. It's more of a kind of toss of a coin whether a trend works because it's somewhat dependent positioning. And that's the analysis. That's what the analysis showed.

I mean there really isn't much relationship between trend following performance in the short-term, big VIX spikes. Incidentally, I was slightly surprised by that. My instinct would have been trend might have been slightly negative on a very, very sharp spike simply because you're probably going to pick up long risk premia in the long-term. You're probably going to be long risk. But actually, the analysis didn't show that. But you're neutral. Trend is kind of neutral to a sudden vol spike.

But talking of the papers, Niels, at the Man Institute we have relatively short, digestible papers but we've got colleagues around the floor that do academic tomes, you know, your 50, 60 page things. And one thing, that one paper that we wrote, gosh, I think it's going back about five years now, it's called The Best Strategies for The Worst Of Times, and showed that yeah, trend is great in sustained sell-offs but what is also really nice is long/short equity, quality cash equity, quality strategies.

Now I like that a lot just intuitively because if you've got a long/short cash equity strategy, quality strategy, then on a sudden flight to quality, by definition you should see that strategy do quite well. So, the academics showed that, and we've actually had two really nice out of sample periods recently that showed the same.

So SVB, which was really painful, I think you'd agree, for trend followers last year. But also, Yenmageddon, this year that August three day VIX spike. In fact, I think some of my colleagues in the fund-of-fund business were saying it was about the only strategy they knew that actually did okay over that period.

So, I think it further emphasized to us that just sitting alongside trend, that can give you complementary type characteristics. Similar to trend, if you look at trend, your crisis alpha Sharpe tends to be higher than your Sharpe in the good times. Long/short quality strategies, similarly defensive, has that kind of characteristic but importantly, for me, it operates on a kind of different timeframe and gives you, I'm not going to say protection but can help you a little bit on these short Sharpe spikes. And the short Sharpe spike does trouble me.

I'm not sure. I mean, in retrospect the best thing to do over that August first week was nothing. The markets fell and came straight back. The best thing to do, in retrospect, was nothing.

Should you have something in your portfolio that can help defend against a one week-long fall in markets? I think it's hard to say that. Probably the only thing that can, properly, would be a long vol strategy but that's going to cost you in carry.

So, I think that's a decision people want to have if you want to protect yourself from that kind of event, you're probably going to have to pay for it. But there are ways of maybe mitigating it a little bit. That was our conclusion.

Niels
00:24:36
Yes. As you were speaking Graham about this, a couple of questions sort of popped up in my mind. One is about just the whole volatility space.

I think a lot of people were convinced or compelled to get into long vol strategies because of what happened during COVID where a lot of people not only made a lot of money but they also were smart enough to monetize it at the right time. And so, we saw big, a lot of interest and probably also a lot of flow into long vol, which I think for many investors has been a very disappointing experience. A lot of funds have closed down subsequently, etc. etc.

Now, of course, that doesn't mean that from time-to-time long vol is a great thing to have in your portfolio. But as you said, there's a bleed. But there's one thing that, at least, I have, as a novice vol observer, noticed at least, and that is it seems like the whole nature of volatility has changed. It’ll probably change again. But the sell-offs after these spikes, the sell-offs in vol are equally as fierce as some of these spikes have been.

For example, during this August Yenmageddon, I think that vol sold off at its fastest speed that we've recorded ever. So, I wonder if it's even possible nowadays to capture this. As you said, what kind of strategy can do that?

And also,I guess for trend followers, there are also crises that are so short that it actually makes very little difference for us. It may mean that we reduce our positions a few days after because vol, generally, has gone up a bit. So, we'll adjust accordingly. But in the first day or two, our vol filters will probably not, you know, make a lot of change. So, that was one of the observations that I noticed.

The other thing I wanted to ask you about, because this is something I definitely don't know, and that is when you talk about these properties the long/short equity may have in a portfolio as kind of a good risk mitigator during these periods, are you thinking that they are actually net/net positive, or are they just relatively better than a pure long-only strategy to own?

Graham
00:26:56
Certainly, what we've looked at… So, the academic piece I mentioned, The Best Strategies for The Worst Of Times, it looked at quality as a factor. And I think that in that paper there are about 17 different quality metrics. And if you construct that, what you tend to find is that you've got classic, what I call ‘yieldy put’ characteristics. In the good times it does fine. It doesn't shoot the lights out, but it's really there for the bad times. That's what it's there for.

And that, a bit like trend I would argue, it helps you around this classic long vol strategy, this classic tail protect strategy. People tend to buy those when vol is high, “Oh, I should have had that, let's get it in the portfolio now,” and the bleed is terrible. It's really costly.

So, I guess the beauty of both trend and long/short quality is that it gives you that defensiveness in a way, but without the pain of holding it. Now, I think if you were to do it really well, I would say your first line of defense would be an outright long vol strategy, but it's going to cost. Your second line of defense might be capturing that flight to quality effect for a really short, sharp burst like Ian McGeddon. I think SVB was a little bit longer. And then your third line of defense is trend. Maybe if you were really looking for something defensive, combining all three would be really nice. But you're going to have to take that carry hit if you're going to have the long options or the long vol part in your portfolio.

Niels
00:28:32
Yeah, it's kind of funny to me because when I listen to some of the most successful investors in the world, and in this case, I was listening to Stan Druckenmiller recently who did an interview and he talked about part of his success was really the willingness to go concentrated, and have big bets. He talked about how he learned the thing about sizing from George Soros and stuff like that.

And I also think about trend following, that usually when we really make a lot of money is when we have concentrated portfolios. So again, with higher risk, higher vol comes the reward. And at least, when I do just very simple portfolio constructions, a simple allocation, 50% stocks, 50% trend following is incredibly powerful. I mean, it's like it doesn't even give you the average of the two. It gives you almost the sum of the two. It's just extraordinary.

But we know that those two strategies will get caught, from time to time, in the same direction in their equity book. And often, especially if a “crisis” comes from an all-time high in equities, you can be sure the trend follows going will be long equities at the same time.

So, I'm always kind of struck by this enormous behavioral bias from investors to want to remove all the painful periods and give up that powerful long-term compounding combination just to see if we can remove that one month where we lost 15% or that week where we lost 5%. Even to the point where I've heard investors talk to me about, yeah, I'd love to make sure that we can hedge against days like that. I mean, ‘days like that’, you're a pension fund, you've got unlimited timeframe. what are you concerned about ‘days like that’? Is that something you see as well?

Graham
00:30:38
I would share your concern. Yeah. My feeling is that it is like that catching the falling knife analogy. If you really want to protect your portfolio from that kind of thing, you have to accept the consequences which are likely to be massively diminished long-term returns. So, really think about what you're trying to do there. You know, you will have some strategies that will take down risk if you have a very responsive volatility scaling, like I suspect.

I know there's a bit of a raging debate on this podcast or that one, but if you have responsive volatility scaling, it's going to cut your position quickly on a Yenmageddon type scenario and you're going to miss the rebound. But if it had gone any longer, then you're going to mitigate the downside. But there's a tradeoff there and I think people have to be very aware of that. It's very hard to get everything right.

And on your first point, Niels, I thought that was fascinating. Just on the, you know, we obviously talk about diversification as being key for a trend following strategy to work. You know, we look at pairwise correlations as measures of diversification. What's apparent, if you look at the data over time, is that pair-wise correlations pick up dramatically over 2008. Now that's kind of the banner year for our industry. That effectively means that you're sensitive to very, very few themes at that point. But that was the theme that made you the money in 2008.

Niels
00:31:58
Yeah.

Graham
00:31:58
That was the concentration.

Now, to bring it back to the theme we were talking about, there was a bit of a payback in 2009. You know, that was a difficult year, as soon as Hank Paulson stood up and launched his ‘kiwi bazooka’, that single bet was no longer the right thing to have. But you know, it did work in 2008. So, there's always a quid pro quo.

Niels
00:32:19
All right, well you wanted to dive in a little bit more on some of the challenges we've seen. And this year, when we think about our portfolios, we've talked a lot, we've given a lot of time to talk about how great equities have been specifically in North America. But there have been a couple of troublemakers in the classroom this year. So, talk to me about that.

Graham
00:32:44
Yeah, so I think, for context, one of my great challenges is to help people understand trend following strategies. I think if more people understood it properly and what it was doing, I think we, as an industry, would be more represented in portfolios. That to me is a great challenge.

And on the face of it this year, if you asked many investors, “What's done well this year?” Well, it's US equities, it's Mag 7 for example. And my suspicion is, if you dig under the hood of most trend following strategies, they've probably done quite well out of that. Similarly, you mentioned cocoa, right? I mean cocoa 47-year high was the last thing I heard. You know, we've probably done well out of that too, as an industry.

But of course, what tends to go a little bit missed is people don't necessarily see the more range bound markets. And specifically, this year this has been on the bonds and I guess, less so, the FX side. And that was something that we dug into a fair bit. And sitting on a desk, just living markets on a day to day basis, it was certainly apparent to me that what was driving them was the perceptions of central bank rates. So, we entered the year, what, with six rate cuts priced in? We got to, I think it was, two over the summer? And this is just on a 12 months ahead basis.

By the end of September it was 10 rate cuts, assuming a rate cuts are 25 bits for the Fed. And then there was a reversal after that. So, this kind of rate cutting narrative: will they, won't they? And it doesn't really matter whether you're looking at the Fed or whether you're looking at the ECB.

This narrative was oscillating, and we talked about, the holding period of trend followers, you know, that medium-term trend followers being kind of two to six months. So, let's say on average it's a three to four month holding period. Well, guess what? These oscillations in rate cut expectations that were going through markets were roughly in that period as well.

Now. we call it internally the harmonic frequency of death. You know, if you're a trend follower and you're moving into position every three months to get a decent position on, and then it reverses, you know, that's kind of the worst place. Now that's not to say, as you know Niels, that we're just running one model.

You run multiple models, multiple frequencies, but on average, that's roughly where it comes out at. So, there's this been sensitivity this year, particular sensitivity I think of trend followers to the gyrations of central banks.

And there are two aspects to that maybe worth talking about. One is fixed income has been very closely related to FX this year, particularly the dollar. We're kind of at that cuspy point. Are central bank's going to start cutting? There's a new cycle going to start and that's why there's an increased sensitivity. So, you see very high correlations between fixed income markets globally. I think central banks are probably doing similar things.

In a way that it's particularly high at the moment. So, that sensitivity of markets to central banks is high, and indirectly our sensitivity to that is also high. And if you go back just a couple of years, really, market prices (and by inference trend followers) weren't really watching that. There's very little link at all.

And I think there's been a few academic studies as well, and we listed them in our paper going back decades which show that the sensitivity of markets to central banks is just particularly high right now. And it's just, it's been difficult because of that oscillation.

What gives me, I guess, a little bit of comfort is that we've identified that it's fairly transient, this sensitivity. It's quite high right now for, I think, intuitive reasons. You know, everybody's watching to see what's the next cycle going to be. And even the last, what, month or so, the dispersion we're starting to see, particularly Europe versus US, gives me a lot of hope that that kind of one factor is going to be driving things less going forward.

European stocks were weak. US stocks were strong. US bonds were weak. European bonds were responding to different economic cycles. I think that's starting to change.

Yeah, I think that's been an issue this year. But I do think that possibly the end is in sight on that front.

Niels
00:37:23
Yeah, just the fact that, when you think about central bank policies at the moment, that it's the Europeans and the US who are cutting, and it's Japan who are raising rates. You think, okay, that's not business as usual.

Graham
00:37:38
How ironic is that?

Niels
00:37:40
Yeah, absolutely. indeed, I completely agree.

It is interesting and, in some ways, central banks were very influential on trend following returns in the aftermath of the great financial crisis because they really made it difficult. They were so good, or so lucky to get inflation under control and actually keep it stable. But also, GDP was pretty stable for a while and that took out some opportunities, I think, from trend followers, which is fine, it’s completely normal. But I think things will be different this time.

And you know what, we'll talk about it maybe a little bit later. But I think another factor that plays into all of this, because I do agree central banks will play an important role here, is just the fact that we have a new administration, and that administration is not going to let the US Central Bank probably do exactly what it wants. It may not change anything, but as we know, the financial markets don't necessarily need actual change to react. Just the thought of it; perception can make us a little bit worried.

Okay, I think you ended your segment there with, is there an end in sight? I wanted to maybe dig a little bit deeper into that, and, you know, you talk about trend following being long things.

One thing that springs to mind for me is that the US obviously, like many other countries, has an interest in their deficits being funded, ideally by other countries as well. But we have seen a change in that, and you refer to TINA, but in a new context. So, if you can maybe talk a little bit about how that's changed from what we got to know TINA for and to what you see it as now.

Graham
00:39:49
We did some analysis recently, just looking at very long-term performance of equities and bonds. And if you go back 50, 60, whatever years, you tend to find that Sharpe ratios of bonds and equities are about the same. It's, I guess, the foundations of a risk parity approach when you're looking at long only investing.

What's been fascinating, in the last 10 years, is that the Sharpe ratio of bonds has been pretty much zero. Interestingly, the Sharpe ratio of equities, I mean, we perceive equities have done really well. The Sharpe ratio of equities is about the same, actually.

It's this relative outperformance. It's not really the absolute performance, but the relative performance of equities that really stands out, particularly with bonds being much more on the sidelines. I guess that was what has really struck me recently.

Niels
00:40:46
Yeah. And so, for me at least, how I think about it is, at least, that maybe it's not the US Bonds that China and Russia are lining up to buy anymore, but it's the US equity market. It's the US, maybe, real estate. I don't know, but it's just other things. But it's still US. The money is still flowing in there, but maybe not the way we have been used to seeing it.

And then again, without becoming political, there is, or at least in my mind, I would imagine that the new administration (whether you like him or not, it doesn't really matter), I think it's just going to be more unpredictable compared to what other administrations may have looked like.

And in that sense, and I probably mentioned this once or twice before last week and that is, well, if you have something where the largest economy in the world is becoming potentially more unpredictable, wouldn't it be nice to have a strategy in your portfolio that actually doesn't make any predictions and is just following whatever they decide to do and however markets react to that. So, I'm kind of optimistic, in a funny way, for these types of strategies.


Graham
00:42:06
I find myself channeling my inner Donald Rumsfeld on this one, What was his famous quote? “The known unknowns and unknown unknowns.” I mean, I don't know, coming to the start of the year, given the way that President elect Trump left his administration last time, I guess the fact that he's in again might be a surprise to many. Similarly, who'd have thought martial law in Korea was something that was going to happen this year. You just don't know.

I mean, all these curveballs keep coming out of somewhere and it just, to me, and I think we're in agreement here, it says have something in your portfolio that's adaptive, that you're not necessarily predicting anything. Returns are incredibly hard to predict. We do it every single year.

I think we might have discussed this last time, but if you look at the S&P returns predicted by the major investment banks on a year ahead basis, all very interesting. But if you actually, objectively look at how good they are, it's incredible. You know, the S&P is very rarely correlated with where people think it's going to be.

Niels
00:43:13
One thing I've noticed is that maybe not the same institutions every year, but there are always some institutions that come out with a report saying, well, the next 10 years of equity returns are going to be muted, like, you know, 3% or 4%. How many times have we heard that? And you know, one day it'll happen, of course, but it is just unpredictable.

But speaking about having something that's adaptable in your portfolio, you also mentioned that you had picked up on a conversation I had with Nick Baltas, a couple of months back. Actually, two months to be exact. I think we published it on October 5th. And he had a slightly different way.

I think it was based on a paper he wrote a while back, but it was a slightly different way of looking at how do we get trend following into the portfolio, and if we do, how much? So, take me through your thought process and some of the things you've read up on when it comes to these things.

Graham
00:44:12
Yeah, I thought it was a wonderful episode that you did with him. I mean, Nick's approach is very eloquent and coming in, his academic credentials really come through. Maybe I'll start with a point.

So, Yash and I wrote a piece recently, and I know you picked up on very quickly, called Honey, I Shrunk the Trend Following, which I think has generated attention because we make the point that there's a very large amount of trend that should be in portfolios. The point of the piece, I mean, when we wrote that piece, we certainly were under the impression that wasn't you.

We knew the alternatives investment community know that by any conventional metric there should be far more trend following CTAs in your portfolios because of these wonderful properties lack of correlation and, even better, negative correlations in the tails. So, we kind of knew that.

I think the point that, actually, we were trying to make in the paper was, hey, look, do you want to look at it in Sharpe terms? Do you want to look at it in drawdown terms? How far back? If you're doing a historic regression, do you want to look? All these factors can vary the amount of trend you “should” having your portfolio. But the bottom line is you probably need more than you've got.

And I think Nick's really nice insight there was trend following just breaks that asset allocation mold. It just doesn't work in that context. And perhaps you should look at it more in a tracking error point of view. And that resonates totally.

We speak to investors, maybe not the biggest sovereign wealth funds, who might not look at it in that approach, but you speak to investors and it's this, how much do you want to deviate from a benchmark, whatever that benchmark may be? And trend following’s unpredictability of returns, if it works well for you in one way, then great, but if it works for you at the wrong time, then that's particularly bad. So that resonated a lot, and you're going to come out with different numbers.

So, I thought that was a really nice episode and got that angle of it across. And I completely agree. That was really nicely done.

I was contacted this week, actually, by a gentleman called Matthew Hughes, who's written a paper on SSRN looking at the problem in a slightly different manner, saying, well, if you say that trend following is underrepresented in portfolios, could there be another reason for it? And he's postulating complexity. And again, that's something that resonates with me.

I think one of the biggest problems that I have, as a communicator of the strategies, is helping people understand why a trend following's return is such. And April was a wonderful example this year.

So up until April this year, trend followers had made money being long equities, we were long equity beta. And the question I was getting at that point was, well, if equities turn around here, are we going to lose money?

And April came along, equities turned down a bit, but trend followers were positive. Not from a pure equities point of view. We did lose money in equities, but of course we trade bonds, we trade currencies, we trade commodities, and they were accretive. And so just getting that level of understanding out there is incredibly important.

It's not just about a headline in the Financial Times, Wall Street Journal. You need to look at all asset classes and understand positioning. So, it is straightforward, but you need to have a bit more information to figure out how a trend follow works.

Anyway, I'm digressing, but Matthew's point was let's introduce into a kind of classic portfolio methodology some allowance for a complexity parameter. If investors struggle to understand trend, for example, let's see if we can equate that to some kind of complexity premium. And that was his angle as well.

So, bottom line, I think Nick's approach makes a lot of sense. Matthew's approach, trying to project it into a complexity framework, whatever it is, I think we're all agreed that probably people need a little bit more, and we need to help people understand how it works so they get comfortable with it.

Niels
00:48:34
Yeah, I mean, I caught up with Nick yesterday. We recorded our year end conversation, which will come out in a couple of weeks, the first part at least. He brought it up in a slightly different context as well, where he said, listen, the industry (in this case we're just using the Barclay Hedge number for the size of the industry), if you look at it, it's kind of gyrated between 350 billion and 400 billion for… years. And the question is, are we failing in our education of investors since it's not really growing?

I mean, I've been doing this for 30 plus years, and the last 10 years on this podcast. So, it's not like that there aren’t people, yourself as well, writing lots of papers. I mean, I think we are trying to educate people. The question is why is it not catching on?

And to some extent, I mean, I think Nick's paper about, well, how much should they allocate, versus what we see in the “normal” optimization models, I think makes a lot of sense that you can't deviate too much, even though it may not give you the “optimal” allocation.

I think Matthew's point may explain why we're not making a lot of headway in terms of compelling investors to have a meaningful allocation to trend following or have an allocation to trend following in the first place. And so, for me it's about, well, who are the ones who make investors believe that what we do is so complex compared to other strategies?

I mean, I would imagine that analyzing private credit, private equity, whatever, is probably, deep down, equally complex or even more complex. But our strategy is labeled as complex because it's math, it's computers, it's systematic, and maybe we need to dumb it down a little bit and say, well, deep down it's just following rules. And yeah, we use the computers to help us execute in a disciplined and systematic fashion, but the rules themselves are not necessarily super complex. Where it gets a little bit hairy, and I admit that, is when we talk about the risk management. So anyways, it's probably a topic we're going to come back to next year.

Graham
00:50:58
It is maybe just… There was a former colleague of mine, Yoav Git, he writes a blog, if you haven't seen it, his blog this week was fascinating, and I think he does a wonderful job of just boiling it down to two numbers.

He says, pick your Sharpe ratio of your traditional portfolio, pick your Sharpe ratio of trend, and then just very, very simply you can see what the value add of that trend following portfolio is. And he was saying something like… and he was picking numbers out of thin air, deliberately not using formulas because he knows it spooks people.

But he was saying, even if you think it's something like 0.2 Sharpe or something like that, I think his numbers were something like 10%. You should have a 10% allocation to trend in your portfolio. And he writes really nicely and succinctly. His point is just, you know, in purely complementary terms, having a decent amount in your portfolio makes sense.

Niels
00:51:53
Yeah, I think actually, funnily enough, it's funny you mention him in this context because I think your last topic, which is a discussion I had with Rob Carver in late October, is somehow linked to Yoav because, obviously, the three of you have worked together in the first place. But also, he had written a pretty thought provoking article about the notion that trading more markets is going to make your portfolio more diversified. And he had a slightly different… I don't know if that's where you're going to go with this, but that's how I remember the conversation at least. I haven't listened to it again, of course.

Graham
00:52:34
Yeah, so it's linked. So, you're right. So, Rob ran the fixed income book at AHL for a number of years and I'm pretty sure Yoav it was that picked up after him. I hope I haven't got my chronology wrong. I'm sure both of them will pick me up if I have.

But yeah, I guess the point I was going to make on that one, again it was linked to your conversation with Rob. You can think about these things in mathematical terms. So, any market can trend, but it's going to be a relatively low Sharpe. Math says that you can increase that Sharpe effectively by the square root of markets, assuming independence, so that you can get up to a portfolio level Sharpe that's worth investing in.

Speeds, allocation to markets, make a difference in terms of the way competitor works, as we've discussed, and transaction costs will factor into all of that. So, all of that kind of makes sense, I think in terms of just increasing the number of markets (and I'm coming onto, I guess, this alternative versus traditional trends type thing), it's simplifying things again. But traditional markets, traditional future markets have got a great sensitivity to macroeconomics.

Alternative markets, broadly OTC, tend to have far less sensitivity to that. So just by adding the markets, you're not just adding markets, you're actually looking at different prices, different price drivers. So, I think it makes a bit of a difference. You're not just adding markets, but they're different markets and that's the key point.

And if we look at, we did this a couple of years ago, looking at the characteristics of traditional trend following and futures markets, you tend to find that that crisis Sharpe is really nice. And you just need to look back to 2022 to see that you're Sharpe in the non-crisis periods is a little bit lower. And alternative markets trend are less crisis Sharpe, but slightly higher Sharpe in the good times.

And to me, the intuition there is that if you're trading traditional trend, when we talk about crisis, we're talking about the S&P typically. I mean, that's where most people envisage the crisis to be. So, you really want to be trading that. And that's a classic traditional market.

Now pick my favorite alternative market, Nord Pool. You know, it's Scandinavian hydroelectric power. What drives the price of that: temperatures in Scandinavia, how much rain is falling. There's very little macroeconomic sensitivity that. And it just works in different times. So, to me, it's just taking away from the academic framework, more markets, more diversification. These are just genuinely different markets and that’s what really makes a difference. So, I think you would certainly agree with that as well.

Niels
00:55:32
Yeah, that's true. Very true indeed. I only follow a couple or few really alternative markets. Obviously, we've had some of them on the show as a guest a couple of years ago. Back then the narrative was, you know, in their favor, I guess. Even though some of these funds, not all of them, some of them are newer in terms of track.

And at the time I remember that they had certainly outshined traditional portfolios or CTA portfolios. The last few years, the last two or three years, to me, from again, not having studied it carefully, it seems to be a little bit of the reverse. Whether you agree with this statement or not, I don't know, but I remember some of the narrative, not coming from you, but just coming from alternative funds were that those markets simply trend better. It's always been something I struggle with accepting. I've always felt that when I looked at the data long-term, there was no difference.

I mean, but the difference was they were performing at different times than the core fund. So, if you were, say, a fund of funds and you had to structure a CTA portfolio, it kind of makes sense to have some managers that are structurally different.

But I've never really bought into this idea that you could have markets that were trending better than other markets because obviously we don't know what the future holds. And some of these alternative markets have not been around for very long anyway. But the fact that they trend at different times, I completely agree with that.

Graham
00:57:12
Yeah, yeah. I mean, I guess the heyday, if you like, where alternative markets probably started to shine was in that, we talked about Hank Paulson in his bazooka, post 2009, and the Fed put. The Fed put, I would argue, gave the industry in general a bit of a tough time. Every time equities at least went down, somebody popped up and propped up the market.

The alternative markets, at that point, seemed to be a bit more resilient to that effect, probably less sensitive to macro economies. So, I think it was when traditional trend was really struggling in that, call it broadly, 2009-‘19 decade, alternative markets did relatively better. And I think that's where they started to figure into people's agendas.

2022 was fascinating. That was the year of inflation. Big trends in bonds down, big trends in stocks down, big trends in commodities up. And I think traditional markets, your futures markets, really came into their own there. That was a year, if I remember correctly, that the simpler you were, the more core markets you traded, the better you got on. And the diversification didn't necessarily play in your favor.

So, I think there's maybe a factor where recent years have been more focusing on the traditional side rather than the alternative side. But ultimately, diversification is good in my book, whether it's alternative markets, whether it's China, whether it's bitcoin. The more you do, the more trends you can capture, the better you should be.

Niels
00:58:49
Now, the next thing I wanted to ask you about has nothing to do with financial markets. Something I thought about when we, when we talked. And I can edit this out if I'm dead wrong on this, but you are Scottish by background, right?

Graham
00:59:02
I am.

Niels
00:59:03
Okay. So, I came across, last week, you know how we talk about AI and how it's going to take over and all of that? I don't know if you’ve ever seen this. It's kind of funny. I think it's a few years old, but it's this video where you see two Scottish people entering an elevator and it's an elevator that is, what do you say, sound activated. And they just start complaining about the fact that this AI thing, whatever, doesn't understand the Scottish accent.

Graham
00:59:35
I can assure you it's not just the AI thing. I look at all the people around me sitting at their desk and they have exactly the same problem.

Niels
00:59:43
It was quite funny, actually, I have to say. I'm sure it could have been made up with all sorts of accents, even my Danish accent, but it was pretty funny. And since you were on and I thought, yeah, okay, I'm going to jump into it and ask you.

Graham
00:59:56
Well, I guess our listeners will decide, Niels, if they can't, maybe have to get me translated for it.

Niels
01:00:03
Oh, good one. All right. Anyways, we're going to wrap up our conversation today. First of all, if you want to show some appreciation for Graham and all the work he did in preparing for this, head over to iTunes, Spotify, Amazon podcast, wherever you listen to your podcast and leave a nice comment rating review to show that appreciation.

Next week it won't be me, but it'll be Alan with Katy, as I'm traveling again. And then after that I will come back and we're going to release part one of our year end conversation where I bring together most of the co-hosts. I mean, obviously Graham kind of should be part of that now, but I'm sure he will be next year.

So, it's going to be hopefully very entertaining and educational to hear all these different views when you bring together nine people in one recording. Also, a little bit chaotic with technical issues and all of that good stuff, but that's just how it is.

If you have any questions you want me to share with Alan for his conversation with Katy, send them to info@toptradersunplugged.com and I'll do my best for them to be brought up.

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

Ending
01:01:21
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 risk 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.