Shownotes
Join Katy and I as we delve into the intriguing dynamics of trend following in the context of changing interest rates. We cover how trend-following strategies can be a valuable addition to investment portfolios, especially in high-rate environments where traditional fixed income may offer diminished diversification benefits. Katy shares insights from her latest paper, which explores the performance of trend-following strategies during various economic crises, emphasizing the importance of adaptability in turbulent markets. The conversation also touches on the recent Nobel Prize buzz surrounding MIT and its implications for innovation in finance, as well as review the latest quarterly insights from Quantica. As we navigate through market trends, you are encouraged to consider how a well-allocated trend-following strategy can enhance portfolio resilience amidst ongoing economic uncertainties.
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Episode TimeStamps:
01:06 - What has caught our attention recently?
04:01 - What is going on with Danske Commodities?
06:29 - Energy traders are the new star athletes
07:47 - Industry performance update
09:55 - How has 2024 treated us so far?
13:58 - The implications of major regime transitions
18:33 - What made Katy write her paper, "Trend Following in a Defensive Rotation"?
24:22 - How has fixed income behaved over a long period of time?
29:02 - How does trend following portfolios react to the correlation between stocks and bonds?
33:27 - Katy's thoughts on the large dispersion between managers this year
36:44 - Can you use carry trading with the SG Trend Index?
39:48 - Timing trends is a fool's game
42:31 - Bill Eckhardt is coming on the podcast next week!
43:35 - The outlook for trend following
46:42 - How do trend following strategies perform in different interest rate environments
52:15 - Do investors agree with the findings of the Quantica paper?
55:31 - Are investors disappointed about the trend following performance?
01:00:40 - What is up for next week?
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Transcripts
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:Welcome, and welcome back to this week's edition of the Systematic Investor series with Katy Kaminski and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global markets through the lens of a rules-based investor.
Katy, it is so great to have you back this week. How are you doing? What's been going on where you are?
Katy:I'm good. Things are good. Fall is in full gear in Massachusetts, and we're doing well. Just interesting times.
Niels:It's a nice time of the year. I don't mean what's going on in the world. I just mean that it's actually a nice time of the year where it's not too hot, it's not too cold, and there's a little bit of color on the trees.
We're going to try and put some color on the financial markets today. But as we always do before we dive into all the fun stuff, I'm always curious to hear what's been on your radar outside the topics we're going to be talking about in the last few weeks since we last spoke.
Katy:Well, I think a fun thing that's been happening recently is, I don't know if you saw, but the Nobel Prize went to two MIT professors plus one from Chicago. So, I think there's just been a ton of buzz here and excitement. There's also been some prizes for chemistry and other interesting places related to MIT.
So, all of us are just like in the full Nobel coming kind of like excitement right now, just innovation and people doing exciting things that have contributed to society. That's kind of been a hot topic this week at work.
Niels:Yeah. I mean, it's a great achievement.
I know you and I talked about it before pressing record, but there was this article out a little while ago, recently, talking about kind of the concentration of Nobel Prize winners across universities. That there are certainly, definitely some universities that produce, if we can call it that, more Nobel Prize winners than, than others. But as you rightly pointed out to me, it doesn't mean necessarily people are from the same country. They can be students from abroad, I guess.
Katy:Yeah. I mean, what's interesting and what I've loved about being connected to the MIT community is it's people from everywhere. And so, I mean, obviously MIT is one of those places, and what they have really fostered is this culture of bringing so many people together with so many different… I mean, it's just diversification. Right? You know, you have a higher Sharpe ratio when you have more diversification. People from everywhere.
So, I think they're also expanding and doing things more outside of just the US as well. So, it's kind of about a culture of innovation and bringing different ideas together.
Niels:Yeah, absolutely. I still have very fond memories of my own guided tour by you on the MIT campus many years ago, I will admit. But yeah, I still remember it very clearly. And so fun, and very interesting to see. And of course, very interesting that your offices, as far as I remember, are right across the street from MIT.
Am I right?
Katy:Yeah, we were, but we actually moved downtown. We grew up, we moved downtown. It's because MIT has become tech central. So actually, our building got basically taken over by Google and now it's all biotech and, you know, and the technology companies that are very much in Cambridge. So, we're actually downtown, closer to some of the other quant firms that are in Boston as well. So that has been a move for us a few years ago.
Niels:Okay, there we are. There we are.
All right, well, I was going to bring up my topic that's been on my radar this week, somewhat related to our industry, but in a completely different way because I know you know a lot about Scandinavia. There is actually, and maybe, you know, even this company, but there's actually a company in Denmark called Danske Commodities. It's a company that trades power and energy, but not just in futures, like we do, but also moving stuff around physically and what have you.
power prices exploded back in:And this is a company that, according to television program I saw, I mean, they trade not only commodities, which is similar to what we do, but they are also highly systematic and in fact they do on average like 30,000 trades per day, and on a busy day, like 100,000 trades. So, it kind of sounds like high frequency. Could have been like a lot of these companies that we know from our industry. Now here comes the interesting part.
So, this week they announced that based on some research they have done, they have found that their traders actually should be treated like star athletes. So, in order to have these high performing traders what they are doing, they are installing like these cold plunges where you can take a cold bath after your performance. I guess after a hard day at work.
They are providing breathing exercises like you would do with your athletes. And they're also going to give them an extra day of rest each month. Because the argument is it's like a football player, if they played both Champions League and two games in their local league for the same week, you need a little bit of extra rest.
So, I thought that was quite interesting to kind of marry how star athletes perform better with certain things in their life. And now it's moved into our little world in terms of “star traders”. Do you think this would be something for you, Katy, to have breathing exercises and cold plunges?
Katy:I do actually have a cold plunge, cause I'm a huge fan of it, and I have a Scandinavian husband. So, sauna, cold plunge, I would suggest it to anybody, I think it's really good for your health.
But I think this is fascinating, Niels, because I know many years ago, also my PhD advisor from MIT also, they were studying the physiological response of traders to the market. And it is true. Their point was that it's really a physical activity. So, taking risk is a physical activity that we underestimate the physiological.
And there were also a couple articles in Neurofinance where they showed a correlation between cortisol levels and the VIX. So, to me, if you're an energy trader, if you think the VIX is bad, try trading heavy energies. You’ve got to be ready. So that does not surprise me at all. And maybe we need a cold plunge in the office.
Niels:Maybe trend following is a little bit less energy intensive.
Katy:It's a medium to long-term strategy, so maybe we don't need to do the cold plunge every day.
Niels:No, that's true. That's true.
I think actually investors have had a little bit of a cold plunge over the summer, looking at the performance, but we'll get to that in a few minutes. Now jumping into something much more usual for us, namely trend following.
Now, of course, we are in October, kind of halfway through ish, and we'll dig a little bit deeper in a few minutes into how you see things and what may lie ahead of us. But it is a continuation of what we saw as a difficult environment over the summer, no doubt.
This month specifically, I would say we've seen some corrections in the currency sector showing up. Markets that like British pounds and some of the commodity currencies, Aussie and Kiwi dollar for sure. Fixed income, of course, markets that have continued their somewhat correction that started a couple of months ago also. But then also a few bright spots actually in the grains area. Gold, US equities of course, I mean the unstoppable us equity markets.
So, performance wise, still not a great month as of a couple of days ago, since we are recording a day early this week on Thursday. So, this would be numbers as of Tuesday night. We do have the BTOP 50 index down 1.5% for the month, still up 2.6% for the year. SocGen CTA index is down 2.14% for the month and it's kind of flat, up a quarter percent, roughly, for the year. The SocGen Trend index, it is down 3.25% and it is down now for the year about 1%. And the Short-Term Traders index down 67 basis points this month and down 14 basis points for the year.
Comparing that, of course, to the traditional markets, the MSCI up, MSCI World up 33 basis points in October, up 17.86% for the year. The S&P Global Development Sovereign Bond index down 47 basis points and up almost 2% for the year. And the S&P 500, as I mentioned, on a tear up another 1.39% this month, up 22.5% so far this year.
We'll come to themes and other things that I'll comment on that's going on, but I want to kind of dive in with you on this topic. Now, so far, it's kind of been a year where it's given us everything you could expect from trend following.
We've had joy and excitement in the beginning of the year with a super strong Q one. Then the challenges, the reversals, the pain during Q two and Q three, culminating in kind of a difficult start for Q four. Just as we head into one of the biggest events, not even for the year, but maybe for more than a year, which of course is the US election.
We've seen meaningful dispersion of returns between managers. So, I'd love to hear your thoughts on all of these points. And by the way, we've also seen some pretty large tracking error is how I describe it, between CTA replicator and the indices that they're trying to benchmark against. So enough to talk about, I think so. Jump in here.
Katy:Wow, that's a lot.
Niels:What's been going on?
Katy:No, it's been a very… I've gotten a lot of interesting questions about this year and when I step back and look at this year, what I see is the best. You always have to think from a trend follower’s perspective. What were the trends and what markets were sort of driven by volatility and uncertainty where there wasn’t really a sort of a key macros theme that was very persistent? I mean, that’s just a simple concept.
And if you look at P&L for CTAs, it has been predominantly positive for equities. Commodities has been mixed and positive in certain pockets. But really the thorn in the side has been currencies and fixed income.
And if you look at that sort of from 50,000 foot, what you're seeing is we're in a world this year where we're trying to navigate a pivot in monetary policy. And the markets have been focused specifically on expectations for monetary policy, for fixed income, and in currencies.
And so, at the beginning of the year, everyone was saying, like, here we go, we're going to have cuts. They didn't come. And then over the summer, there started to be some economic concern, some data coming out that was a little more concerning. So, we saw a pivot from a focus on inflation for monetary policy to economic slowdown and potential for demand destruction. And as you saw that, trends did a rotation into a more defensive posture. So, we saw commodities start to go down.
And then as we moved into the fall and we started to see, for example, the Fed finally come into the game. Then this month, what we found is that people were too far ahead of themselves in expecting that Fed policy would be aggressive. And then you had that sort of reevaluation of Fed expectations that happened earlier this month.
asn't been. like there was in:So really, it's been very hard to trade those two asset classes this year, which is not at all surprising considering once you look back at it from more sort of a policy perspective. Because really, in the trend world, we like things to be extreme, disruptive, consistent, and it's been very much, yes, no, maybe mixed data, et cetera, on those two asset classes.
Niels:I think that’s a great summary, and I completely agree with you in that characterization.
I’m thinking back whether it’s normal for us, as trend followers, to be impacted so much by changes in sentiment, if I can call it that, rather than actual changes in policy, because it’s not like we were surprised that rates would go down at some point, but the timing certainly has played a role.
I mean, without dating ourselves, Katy, are there any years in the past where you can think that it's been a little bit the same types of sentiment drivers, not so much the sector price changes, but just what caused them to get, as you said, excited about and then less excited and so on and so forth? Or is this normal when central bank policies kind of transition from one regime to another? Is it just that?
Katy:I think it really is. I mean, because whenever you're going through sort of a transition, it's a question of stabilization of the trends that we measure. And if you look at what has happened this year is that, you know, whenever you ask anybody what's going to happen, everyone goes back and forth. I mean, this is what I'm noticing in sentiment.
You go from the first half of September being like, everything's terrible, to the second half of September being like, nope, it's fine, everything's good. And that's been kind of the theme over the past few months, that the market is just grasping for something to know, where are we going?
And I also think, I mean, and this may be a more philosophical question, is that, you know, if we don't think about behavioral bias, then we're kind of missing the point because especially trend followers are very behavioral focused. The truth is we've moved from a regime of low interest rates to higher interest rates.
And we have a large number of people that are still holding on to this idea that we're going to go back to normal. We're going to go back there. And I think that hope magnifies the sentiment. And so, I think only with time will we know is sort of what is the result of this change.
to go back to the regime post:And so, I think that at some point something had to give, and what we saw is that inflation had to come back. And so, I think that people are still grappling with that. And then the next phase is going to be how do we handle this new regime where cash rates are higher and also where inflation volatility, the potential for inflation is there.
I’m not saying that we’re going to go to 4% inflation, I don't think that. But I do think that we are in a world where sort of the baseline of rates may be higher, and that's something people are going to have to get adjusted to. And that's why this year has been kind of a strange year in that sense.
Niels:Yeah. And I would say, I mean, again, I like the way you've described that. I was listening to a podcast earlier this week. I think it was actually with the chairman of the Chicago Fed, Austan Goolsbee, from memory, I think he was called. And I mean, actually, I really kind of liked the way he was talking about some of these issues and challenges that they have, but also being very open to the fact that not a lot needs to go wrong in order for them having to really rethink the plan.
But at the moment, you could say the plan probably is that we have 12, 18 months of a cutting cycle. It comes down to 3%, 3.5%. But as you rightly put, it's certainly much higher than what the low point was last time we had a rate cutting cycle.
So, it will be interesting, and somewhat related to the second paper we're going to be talking about today, in terms of trend following given certain interest rate regimes. So anyways, so let's leave it at that for now in terms of what's been going on in trend and focus on something very important, namely your latest paper that came out…
Katy:I think it came out for you, Niels. I actually told them. I was like, all right, I'm talking to Niels. I’ve got to tell Niels about my new paper. I'm so excited.
Niels:Okay, well, then people have something to look forward to.
Katy:Oh, it did yesterday, I think.
Niels:So. we'll give a teaser and actually a bit of a deep dive. And of course, it's always best to get it from the source itself. And the new paper is called Trend Following in A Defensive Rotation: Reflections on Past Crisis Periods. First of all, what made you write this paper?
Katy:So, this is a good question. And really what I saw happening this year, and I think what's super fun about being a trend follower is that you're really following where is the market going? And so, you're getting this sense of what trajectory the market is moving in, and based on data, not based on your own predispositions.
And so, what was interesting for me is that in the spring, you really saw this dichotomy between how equity markets were just super hopeful and happy, and fixed income markets were still short. So, this higher for longer narrative.
But then over the summer, there started to be a lot of noise in trend, and you started to see a much more defensive pivot in trend following positioning. So, you saw positions go from being short fixed income to long fixed income. You saw energy positions and commodity positions that were generally long moving to short, particularly things like energies. The dollar position, let's just not go there. It's been very hard. But either way, whenever you see that type of move, so you're seeing more buying of bonds and selling off of commodities. That's a relatively defensive position. It shows some potential for economic weakness, potentially repricing of recession expectations.
And so, as we saw that pivot, to me that's always interesting because it's the delta of where we were and where we're going. And so, to me, I started getting a lot of questions from some of our clients, like, okay, Katy, what does that mean? It's a defensive pivot.
t you saw at the beginning of:And it made me think, let's look at, just for fun, like if this is defensive and something happens, what kind of positioning works well, if that happens?
So, we've basically looked across different asset classes, ignoring equities altogether, except for equities being the conditional variable. And examining were we tending to be long or short in different crisis periods and drawdowns for equities in the different non equity asset classes and what worked and what didn't. And so, I think that to me was an interesting thought question of, we're defensive right now. What happens if that defensive positioning is sort of a precursor of a potential drawdown?
So far we haven't seen that drawdown yet. But what I did find, and this is very interesting, is that fixed income in every crisis period was a positive contributor for trend following. So that is kind of consistent with that trader commentary, that the bond market is smarter than the equity market in that people who have nerves, they go to the bond market, and the bond market is a good place to get that diversification. But I'm not talking just long, I'm saying long and short.
So, if you're long or short, and this is important now, especially now that we have a higher cash rate and potential for inflation, fixed income is a really good diversifier, but a dynamic trend following exposure to fixed income seems to work well in crisis. And then when you look across currencies, it is somewhat mixed. But being long, the dollar has worked sometimes in certain events.
it was being short energy. In:So that was what the paper demonstrated, is that the versatility of being able to move with prevailing trends, in a moment of disruption, or moment of change.
Niels:Which, of course is part of your original definition of crisis alpha, because I remember we talked about that, and that is this opportunistic and without bias, and liquidity, or in liquid markets themes that we talked about. You've mentioned Covid a couple of times. I think that's still recent enough to people remembering that. And you're right.
I mean, there are certain similarities when you look at the positioning right now. And maybe it's an unfair question because I'm sure you've looked at a lot of data, but are there any other periods that you can talk to in terms of…
Because this is the interesting thing, in a sense. If you have a 60/40 portfolio, people will have relied on the negative correlation, and probably without knowing it, the fact that we were in an interest rate cycle that just kept going down as their protectionist or the protection for their portfolio.
With trend following it’s a little bit different, of course. We don't know exactly how the markets will react and therefore how we will react in terms of positioning. So, I've never done that historical analysis. I'm curious as to what you found, maybe for some of the bigger asset classes, if there are some commonalities.
Katy:Yeah, I mean, I think what's interesting for me, for fixed income, we have done some research over longer horizons, and that's why I was excited. You sent me the Quantica paper as well, that we'll talk about later.
When you look at fixed income over longer time horizons. It's hard to look at trend falling over longer time horizons unless you stick to just trend following signals in one asset class, because obviously the infrastructure, the futures markets, you have to make a lot of assumptions.
But what was interesting to me, and that's why we wrote that other paper, Bonds Behaving Badly, is that as you look over longer horizons for fixed income, whenever you have higher inflation, you tend to have higher volatility for bonds, and you also tend to have more positive correlation between stock stocks and bonds.
And what we demonstrated in this paper is that by having a dynamic long/short, being able to be long or short, and following trends in those asset classes, you actually can get strong negative correlation from that dynamic strategy. Which means that, I guess the takeaway for the typical investor is bonds are great when rates are going down and we have very stationary environment, but bonds are much more volatile and less predictable as a diversifier in an environment with higher rates and/or inflation as a potential threat for bonds.
And so, for the typical 60/40 investor, that means that 60/40 is still a good investment. But some of the correlation benefits and maybe even volatility properties change with bond dynamics. And thus, there's an opportunity for more long short exposure that can improve some of the correlation properties of your portfolio based on just finding something that could find that negative correlation. And whether it's long or short in positioning is going to depend on the environment. But definitely you can see that.
I've seen that in data of much longer history, back into the seventies. It's harder to do it in the sixties, but it gives you an idea. I'm not saying that we're reliving the seventies, we're definitely not. But there are some things to learn from history and from empirical analysis.
Niels:Yeah, I think maybe it was your co-author, Alex Greyserman, I think he once published a paper where they had done some analysis on which sectors in the portfolio does best during crises. And I think they found that actually one of the more consistent ones was commodities. Does that ring a bell?
Katy:I think so.
Niels:From a trend following…
Katy:I think commodities come in second. In our paper, we focused on energies, so specifically, and it's been so heterogeneous in the commodity sector, so it can vary quite a bit. And we focus on energy because it's kind of a core commodity that a lot of people think about as sort of a proxy for demand, and also some sort of indication of general themes of demand that could flow into sort of a shock against global growth or things like that.
So, I agree. I mean, commodities is a more diversified asset class, and it's probably fixed income and commodities that provide the most interesting trends in those environments. Currency is tricky. It depends.
Niels:Yeah, I mean, we've talked somewhat about this sort of correlation difference that we sometimes experience, certainly between stocks and bonds, but of course also within a trend following portfolio correlation for most managers, not all managers, but for most managers, I think correlation does play a role in terms of their risk management. Now, I know we will come to the next paper where we look at sort of trend following performance during high and low periods of interest rates.
But just on the topic of correlation, have you any sense of how trend following portfolios might react differently or perform differently, maybe, depending on whether correlation between stocks and bonds are positive or negative, and maybe in relationship to crisis and so on and so forth?
Katy:So, I haven't done that study explicitly, and it is actually harder to do. Right, because there's been very few periods of time where stock/bond correlation is positive. So, it does become an empirically challenging task where our data set is going to drive that.
That's why I was so interested in a longer data set that included the seventies or the sixties, and I couldn't look at trend following explicitly as one particular strategy, but I could look at how trend signals in bonds might behave so that I could understand that one asset class.
But I do think in an environment where there's positive correlation between stocks and bonds, you do have less diversification in those two assets, which could, I haven't done the analysis, but could indicate that there's a more polarized view with stocks and bonds. And as a result, being long, both of those, you don't have as much diversification. But you also might. Generally when that happens, it's when inflation is higher or interest rates are higher. So those things are all connected. Right? So, the correlation has to come from somewhere.
One of the things that I get a lot of questions about is what drives positive correlation between stocks and bonds? And my answer to that is that a core driver can be inflation. And we've seen that. So, if you think about bonds from the perspective of that they are basically fixed on long term cash flows.
And so, in a world where long term cash flows are relatively stable and there's not a lot of disruption from inflation devaluing and valuing cash flows, then bonds are sort of naturally just a risk-off asset, which is sort of a safe haven asset.
But in a world where inflation expectations are non-negligible, there's always this balance between the risk-off properties of those fixed cash flows and then the vulnerability of those cash flows to inflation shocks and other issues. So, when you're holding a bond today, if you think inflation could be there, there is an actual threat to bonds with inflation.
So, they just behave very differently when inflation is a potential factor for bonds. And we saw that very clearly in the last two or so years. And it's been interesting, as inflation disappeared, what happened to stock bond correlations? They've gone back to normal.
Niels:Yeah, I mean, it's exactly, it's changing.
Katy:So now we've seen the classic risk-off behavior, and that's what I saw this summer. Starting in the summer, we started to see the markets play back the old rulebook, like stocks are down, bonds are up.
But we went through two years where stocks are down, bonds were down. And to me, the only thing that's very different between those two periods is inflation went from very high to closer to two, two and a half. And so that shows that without inflation, bonds are sort of more of a pure safe haven trade because they're fixed cash flows, they're safety. But if you take away the safety by adding inflation and devaluing those and adding volatility, the asset class becomes much more unclear.
Niels:Yeah, I'm curious about how it plays out from here, actually, in the sense that… Because I actually don't think, necessarily, we're going to see it also just go back to this negative correlation that we saw for these decades, or for the first couple of decades of this century. But we'll see. We'll see.
Also, while we're in this part of the discussion, I also want to ask you, I know it's not part of the paper, but I do want to ask you a little bit about what you see in terms of and whether you get questions about this, the dispersion between managers this year. It's also quite large, I would say noticeable. Have you any thoughts on this or what's the answer you give to people when they ask?
Katy:Well, I usually start with, it's best to start with simple explanations first. And when you think about trend following, usually it has to do with the environment. But the first thing I usually look to are two key factors. One is asset classes, and the second is speed.
When you look across the space, let's start with speed. Slower, I think has tended to be a little bit better this year because there were a lot of undulations. And you can see that just by looking at, if you compare ETF performance with some of the managers that are a little bit more complex and actually looking for crisis alpha and having faster signals. When you look at ETF performance, what is ETF performance tends to be more medium to long-term trend.
And so, if you're medium to long term trend, you probably did not jump on the bandwagon as much in some of these undulations, which helped you to hold through some of the themes this year. I think that's one factor. I haven't studied the factor explicitly, but that seems to, in certain pivot points, have been a big difference.
Another thing is just asset class allocation is the second I go to, because just like any investment strategy, it's where do you have your risk? And if you have your risk in the right places, that makes a difference versus other managers.
So basic trend signals suggest that equities and commodities were the two areas where there were key themes, whereas fixed income and currencies were challenging. So, it's a combination of speeds. It's also a combination of how much risk you had in those asset classes and the timing of these moves. So those are two.
The final one, I would say, is non-trend and macro signals. And the reliance on things outside of trend could matter as well. Let's say carry, for example. Carry had some pretty messy stuff going on in August, and you saw what happened with the yen. So that's going to be the third dimension.
So first, time horizons and where the frequency that you're trading really mattered through some of these undulations. Secondly, where did your risk, where was your risk by asset class? And third, how much other non-trend signals did you have that were exposed to some of these rather violent moves? For example, the carry trade in August and other themes that were more relative value this year could really matter comparing from, say, pure trend managers and non-pure trend managers and even a small allocation. If carry has a difficult and you're doing relative value carry, it can have a big delta. And carry had been working very well most of the year. So that adds a lot of noise to relative performance.
Niels:Just out of curiosity, when you look at our industry, and let's just say we look at either the SocGenTrend index or the SocGen CTA index, just to keep it simple, how pronounced do you think it is today? And I know that's an impossible question to really answer with any certainty, but still, we give our best guesses here. How pronounced do you think it is to have, say, carry in these programs?
Katy: er since then. I think it was:But what we did see is that if you look early on, the reason this matters to me is people look at the SG Trend index and think that it's an index that you invest in, but it's actually a living, breathing, changing set of managers depending on the year and the themes and markets.
ack in the early days, around: is was particularly true post:It'd be interesting to do that study now because trend has actually been back in vogue. I think given this year and last year were a little trickier. But you definitely have seen the macro shifts have been made pure momentum a lot more desirable in a higher interest rate environment. So, you might see actually a shift the other direction. So, I should redo the paper.
Niels:I think you should actually, and then you should come and talk to me about it. Because also, in a sense, because there was so much focus in August on, “the unwind of carry”, even though it lasted a relatively short period of time, the damage wasn't too bad or anything. But still, it's a point of reference. It's some evidence that might show up in your research. And so that's why I think it is actually quite relevant to talk about and to analyze. So, yeah, well, there is your homework for next time.
Katy:Oh great. That was a big paper, by the way, too. So, it was like a factor analysis of multiple strategies and it was quite an ordeal. But I do agree it would be cool to do it again.
Niels:Sure. Before we leave your current new paper, what else would you like to highlight from it?
Katy:I mean, I think for me, what was interesting in this particular exercise is, and I've told you this already. Earlier we were talking about this year. There's been so much. I go through two weeks where I'm thinking, oh, here we are, and then things look challenging, and I'm wondering what the next big moves in the markets are. And then two weeks later I'm going, well, it looks okay. So maybe I'm just correlated to the sentiment of the market as well.
But I think what I appreciated about writing this paper and what some of our clients were interested in is just more like to understand that it's not about really what trend they think is going to work, that they need managed futures as something that reacts to those trends. Because timing these things, it's just, it's a fool's game, right? So, when is something difficult going to happen?
It seems to happen. And then after the fact, we might think we knew what was going to happen. But usually these type of big changes, they occur. And it takes us a while to actually realize that that's what's happening.
And so, I think this paper helped me to kind of remember that as well and sort of clarify that there could be an extremely different trend this time around. That could be the, the next sort of shock that we navigate.
if you really think about it,:I think that's what, as a trend follower, you're trying to think about is what's the next big macro regime and when's that going to start? And we never know, but our positions are going to be trying to indicate where the markets are going.
Niels:Yeah, for sure. And I think that even if you are a trend following skeptic, then I think at least you would probably acknowledge that looking around the world today, it doesn't look very convergent compared to five years ago.
Yeah, it's going to be messy. It's going to be volatile. But I have a strong belief in at least the ability for trend followers to navigate and adapt and hopefully profit from whatever is to come, because I think it's going to be so different to what we may expect.
Now, just before I forget, but I know you're going traveling, so you'll have some spare time, I'm sure, in an airport or wherever you may be. I will just tease up a little bit of an episode that we're bringing out on Wednesday because Moritz had a fascinating conversation, actually, with the “co-founder”, or I don't know if he was a founder, but Bill Eckhardt, who obviously with Richard Dennis, had the Turtle Experiment and has actually never been on a podcast before.
So, this is perhaps the first time ever to hear his side of the story. And I've listened to a little bit of it as I go through it just to approve it. And it's a fascinating conversation. So well done for putting that together and hopefully people will enjoy that on Wednesday when it comes out.
All right, before we dive into the Quantica paper, you had mentioned, well, maybe we already talked about it in terms of what are some of the biggest things we're thinking about right now for trend and what we should expect? Anything you want to add to that?
Katy:Or this is, I mean, I think we've kind of talked about it a little bit, but I think the things that we are thinking about, and as a trend follower, I'm always thinking about what are the things that investors are underestimating? Particularly, what are they being overly hopeful about that may be a little unlikely?
So, for example, concept of things like soft landing, it sounds fantastic. But I think for us, the bigger risks on the medium to long-term are more an uptick in inflation and sort of what does that mean? And we've already started to see that in some of the bond, not the bond positioning, but for commodities. They really took a fall starting the summer, and they've been kind of resurging recently, which kind of makes me think, okay, so you have an uptick in the CPI in the US a little bit, and then you have commodities starting to surge a little bit. You have China flirting with stimulus, you have port closures in the US and sort of weather effects and things like that.
And I'm just starting to think it's sort of like landing in turbulence, like you're going to land, but you could easily have a little bit of turbulence. So, I think for us, the biggest question, going into next year, is going to be what happens with inflation and how does that kind of affect markets?
And the other thing I think that has become more clear recently is also in a world where economic data is reasonable and inflation is still not really at bay, we might just be in higher for longer rates or at higher cash rates for quite some time now. Because it does really feel like a lot of people, and you mentioned the election, a lot of people have been in a wait and see kind of pattern this year. Let's wait and see what happens with the US election. Let's wait and see with monetary policy.
So, to me, at some point, I think people have to kind of decide what camp they're in, where they're going to move. But I think it's been very hard to make decisions because it feels like there's a lot of things that have to be resolved before we know sort of what the real state of the economy is and what the next direction is.
So, I think next year it's the things that possibly more of a pause in rates and also a potential for uptick in inflation that could drive trends going into next year
.
Niels:Yeah, actually, I don't disagree with that at all. So, it will be super interesting. And also, actually, whoever wins the election, things may not be that different, really.
So, a lot of the policies that Trump installed vis a vis China, they have continued under the current regime and probably will continue, whoever wins and so on and so forth. So, we will see how that goes.
All right.
Well, let's jump into another paper. We like what Quantica is putting out in their quarterly insights. And the latest one that came out last week is interesting in many ways because I know I and I think you've written about the same topic.
What they're looking at specifically is how do these strategies perform differently, and if so, in higher interest rate environments and lower interest rate environments? I think maybe, and I can't speak for them, but certainly one of the things I've come across in my conversations when interest rates went higher was this conclusion, well, why do I need trend following because now I can just buy bonds at 5%.
And I think it's a fair statement. But it also shows that maybe they don't fully understand the benefit of what we provide, because actually you get most of the 5% inside your trend following as well. But anyways, leave that as it be.
Let's talk about some of your takeaways from the paper, and maybe you can then put it into context as to your own findings around the same topics.
Katy:Yeah, I really like this paper. I like it because they took it another level. Let me explain. What I mean is that they designated between high and low cash rates. Then they also explain the different statistical properties of asset classes during these two different regimes, showing, in essence, that the biggest thing that they highlight is the fact that bond correlations change significantly between stocks and bonds when cash rates are higher. And this goes back to our inflation story.
They didn't focus on inflation, but they focused on the level of REITS, which is somewhat correlated but not the same thing. And so, if you think about that from a portfolio perspective, having that higher correlation means that your traditional 60/40 portfolio has less diversification.
I also really like how they showed that during trend following’s performance during periods where you have high or low cash rates, they find that trend falling is negatively correlated with bonds; trend following and bonds are negatively correlated, whereas during low cash rates, they're slightly positively correlated with bonds. That suggests sort of a different dynamics, consistent with what we talked about before.
I do also think it's interesting that they did show that trend following has a little bit more volatility in return during higher cash rates environments, and then also expected return ranges were higher. So that's kind of what we were just talking about, that there's a little more volatility in relative performance as well. Return range was wider, as well as the volatility range during that period.
So, to me, what I appreciate with the paper is they focus on how the dynamics of trend and these traditional asset classes change when cash rates are higher. But how, if you're building a portfolio, that you need to think about those things in terms of what is the right allocation to get a typical 60/40 type exposure.
And then what they showed is that using some simple assumptions that as cash rates are higher, you're actually better off adding trend because of the negative correlation to your portfolio. And so, they kind of demonstrate that when cash is higher, trend is a good alternative to fixed income, which is exactly what you were just saying, but done in an empirical way. That trend following gives you that return, but then also gives you the correlation benefits that bonds seem to lose.
So, bonds, as a long only investment, seem to lose some of the diversification. That, yes, you get a higher return, but you lose some of the diversification, which means that adding trend is more beneficial when rates are higher.
sk them is the data starts in:And they're dealing with the same problem that I dealt with in the paper on Bonds Behaving Badly, is that when you try to ask yourself a question with even higher rates, or longer periods of high rates or periods of inflation, is the story the same? And I think the positive thing is it's very consistent with their findings. I can't speak to trend folding as a strategy as a whole, but I can speak to the impact of the fixed income asset class as a diversifier.
And so I think, stepping back, they kind of suggest that today, when allocators are thinking about adding to their portfolio, it may be that bonds, even with higher rates, because they have perhaps poor diversification properties, they need to look to alternatives and other strategies to enhance their 60/40, whereas we went through a period where the 60/40, with negative correlation between stocks and bonds, performed very well.
Niels:Yeah, I think actually in their conclusion, just maybe to put some numbers on it, I think what they conclude is that in low cash environments, a 55/35/10, with ten being trend, would be more optimal than 60/40. And in higher cash rate environments, it's actually 55/25/ and 20 to trend. So, a larger allocation to trend to put some numbers on it.
Do you think..? I mean, you and I and probably many of the people who listen to this, you know, we can kind of very easily agree with these findings. Do you see any evidence among investors that they agree with these types of findings?
Katy:I do, and I think that's why I appreciate this paper, because why I pointed out that I like that they actually go through the allocation discussion is that we get a lot of questions, what's my size?
And sort of part of the reason that I did write that paper about bonds behaving badly is sort of the first notion is bond yields are higher, so they're back in vogue. Well, yes and no is what I would say to them.
And that's why I do actually positively see a lot of investors, though, asking themselves these questions and considering, and we do see investors that are allocating to manage futures. And thinking about it, particularly in the US, when I'm speaking to some of the, even RIAs who have been saying, we've been using managed futures.
ke it was pre Covid. And that:It kind of helped people to realize this can happen again and caused people to start thinking about is it 10 or is it 20? Is it 5, is it 10? So, I do think that is something that helps investors. That's why I like the paper a lot, because it was very practical.
Niels:And maybe we can make our own little conclusion, Katy, and that is if people don't have time to figure out if we're in a high or low interest rate environment, they should just simply pick 15 as the core allocation to trend, which in an odd way is not necessarily a bad number. Of course, people inside the industry would probably go for something much higher. You know, 15% is where it starts getting meaningful and being able to help out if there is a crisis.
But the 2% and the 3% that we often hear about that just neither here nor there in terms of what they can do to help investors as and when they need it. But I agree, it's another great paper. Of course it can be found on Quantica’s website and it's their Q three quarterly report.
Anything else as we start to sort of wind down? I mean, we still have lots of ways to go before this year ends in terms of things that may happen. We've seen some changes. We've certainly seen, I don't know if you've seen that on your side, I've certainly seen that. Or it seems to me that risk has generally come off, come out of trend following portfolios because of the changes in correlation and exposure in the equity and bond relationship, for sure.
Of course one can never predict, but it certainly seems like a much more low risk “entry point” where even in a drawdown. That doesn’t necessarily predict anything.
But do you feel that people are, when you talk to them, feeling, oh well, trend has been disappointing, it gave up a lot of the performance in Q one, or are they saying to themselves, well actually we've made good money on traditional assets this year, trend has just given some profits back. So, we think actually it's an interesting time to be looking at the space. What's your sense from investors at the moment?
Katy:Well, I think investors that understand the strategy, understand that you don't need it until you do. And what I am seeing, and I think the interesting investors who look at it as, you should think about actually allocating to trend when trend is in a drawdown, as opposed to getting into it when it's up quite a bit.
We've written some papers about this as well. And Alex and I talked about this in our book on trend following as well, is that over time there are these huge changes in macro regimes. Trend captures them, they then consolidate. And when you have sort of a period where there’s (and that’s what I was writing about) the rotation, is that when you have a period where consolidating trends, this is often a period before new trends emerge.
And so, I think if you think about it from that perspective, it's usually better to allocate to trend in a drawdown than it is to trend following or trend following squared is what I would call it. So, I do think that there are investors out there that recognize that and they're saying equities have done really well. Who knows how that goes?
Bond yields have been high, so at some point there will be change, and so there will be other opportunities at some point. So, I think pointing out from a signal perspective, I was just looking at this, this week, is that trend signals across different asset classes are pretty even.
So, there's nothing that's really sticking out at this point, which to me suggests that it's a point of inflection where we're going to see what the next big trend is. And maybe it's post-election, maybe it's sort of the Fed meetings that spur a change in direction, or a different global event that changes things. But right now, it's definitely wait and see and consolidate until you see the next big theme.
Niels:Finally, I wanted to just to bring up one other thing we had written down, and that is, is there any other research that you think is relevant at the moment?
Katy:That's a good question. No, I mean, I don't. I think we've been talking a lot about fixed income, so I think I haven't seen. I was really glad that you sent me the Quantica paper because I think this one's very apropos. And for us, it has really been more some of the research on fixed income, just because fixed income has changed quite a bit. But I'll definitely send something to you if I see something exciting.
Niels:Sure. No, absolutely. Well, I can't wait for your update on, now I'm putting the pressure on, of course, for the update on non-trends.
Katy:The paper was called CT Style Evolution. Is that not so cool?
Niels:It's such a great title.
Katy:Yeah.
Niels:Good stuff. Katy, you're off to talk to some of our trend following friends. I know. So that'll be good fun.
I wish you safe travels and look forward to having you back in a few weeks as we get close to Christmas. Maybe for the group conversation. I need to organize that so we can get everyone together and make our outrageous predictions.
You know, one of my predictions have already, just to gloat a little bit, but my outrageous prediction was that neither Biden nor Trump would be, you know, on the ballot. Now, one of them is still there. You never know, of course, in this world, but, yeah, I thought that was interesting. Do you remember what your outrageous prediction was?
Katy:I don’t. I have to look it up. I'm like a macroeconomist. I don't ever check on my predictions.
Niels:Oh dear.
Yeah Katy, thank you so much.
Next week I will be joined by Rob and so that'll be a good time to challenge him with some questions, maybe on system design or something like that that you feel relevant. Info@toptradersunplugged.com is the usual email, so feel free to send it there.
And if you, as much as I do, appreciate all the hard work that Katy puts into these conversations, go and find your podcast player of choice and leave a rating and review and show your appreciation.
From Katy and me. Thanks ever so much for listening. We look forward to being back with you next week. And until next time, take care of yourself and take care of each other.
Ending:Thanks for listening to the Systematic Investor podcast series. If you enjoy this series, go on over to iTunes and leave an honest rating and review and be sure to listen to all the other episodes from Top Traders Unplugged.
If you have questions about systematic investing, send us an email with the word question in the subject line to info@toptradersunplugged.com and well try to get it on the show.
And remember, all the discussion that we have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Thanks for spending some of your valuable time with us and well see you on the next episode of the Systematic Investor.
