Today, we examine the intriguing dynamics of systematic investing, focusing on the theme of volatility sizing and its implications for trend following strategies. We discuss how volatility often expands during profitable trades, highlighting the importance of managing risk through dynamic sizing compared to static approaches. We explore the interplay between equities and managed futures, emphasizing how these strategies can complement each other while navigating the complexities of correlation risk. As we look ahead to 2025, the conversation touches on broader economic themes, including inflation volatility and its potential impact on investment strategies. With insights from recent research, the episode provides valuable perspectives for investors seeking to understand the evolving landscape of systematic investing.

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Episode TimeStamps:

01:05 - What has caught our attention recently?

02:13 - Industry performance update

03:48 - Our takeaways from 2024

09:20 - How different speed has performed in different markets

13:25 - Has market correlation been lower than usual this year?

14:15 - Concluding on 2024

15:55 - Interesting news in the ETF space

18:29 - Key takeaways from the Hedge Nordic Roundtable 2024

20:18 - Optimism for the managed futures space?

23:10 - A historical perspective on volatility sizing

30:50 - How different styles of trend following work and perform

35:51 - When is long vol a good strategy to use?

37:41 - The challenges of trend following as a strategy

41:36 - Our perspective on running portable alpha

49:15 - Where does portable alpha sit in a portfolio?

51:59 - Tweaking your trend following portfolio to accommodate equities

54:06 - Thoughts on going into 2025

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Intro: 00:00:02

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.

Alan: 00:00:24

Welcome back to the latest edition of Top Traders Unplugged where each week we take the pulse of the markets from the perspective of a rules-based investor. It's Alan Dunne here sitting in for Niels again. Niels is off on his travels again and delighted to be joined by Katy this week. Katy, how are you?

Katy: 00:00:40

Great. Nice to chat with you today, Alan.

Alan: 00:00:43

Very good, yeah, looking forward to it. How's all in the Boston area? Are you getting ready for Christmas or how's the holiday season?

Katy: 00:00:51

Yeah, I mean honestly, it's been really cold here so, it just kind of always hits me in December and I say, oof, what happened here? Yeah, so we're definitely in full swing for winter here.

Alan: 00:01:03

Good stuff. Yeah, well somewhat similar here in Ireland.

We always like to kick off asking people what's on their radar and what's been keeping you focused in the last while?

Katy: 00:01:16

Well, I think it's been pretty quiet in the markets, but I was trying to think of what are some of the fun market movements that I've been watching? I think reading that Quantica paper that we're going to talk about today and thinking about commodities like honestly, coffee, cocoa and some of these sort of baseline mocha latte trades, and just the price changes. It's going to make it a rough winter season with those expensive lattes.

Alan: 00:01:42

Absolutely, yeah. I mean as you say, softs have started to move again, coffee is up to new highs for this move. So yeah, I guess we're going to feel that in our pockets soon enough. I don't know if they'll start, what do they call it, shrinkflation? Will it start cutting the size of it? I suppose that coffee is mainly water, but yeah, I don't know if they'll start cutting the size of it.

Katy: 00:02:02

Well, maybe we'll have to switch to like green tea or something, I don't know. We'll have to like find a substitute, you know, who knows?

Alan: 00:02:09

Well, I should say we've started to see some interesting moves in the softs and so maybe that's a good segue into performance. We can talk about performance before we get into the main part of the conversation.

So, in terms of monthly performance, The SocGen CTA up 1.7% month-to-date, and the SocGen Trend up more or less the same. And on the year-to-date, both are up just under 3%, so hanging in there as nearly as a somewhat positive year.

And yeah, obviously this month has proven to be reasonably positive. We've seen breakouts again in coffee and in cocoa. Equities have been trending higher, particularly European equities. We've seen renewed momentum there. Elsewhere, I guess on the fixed income side, still somewhat choppy. And on the FX side, some of the currencies like the euro have been under pressure. But in terms of this month, anything standing out to you, Katy, in terms of performance?

Katy: 00:03:06

Yeah, I mean, obviously what I'm seeing is the currency trade is the biggest one this month. I mean, it was interesting. Yeah, because last month, you know, everyone was talking about that Trump trade. So, the long equities, long dollar, and maybe a little bit of short and fixed income. And this month so far, the biggest mover and thing to watch, out of all that trade in November, really has been currencies.

So, you know, I'm definitely seeing that has been the more consistent move. I mean, the dollar has been very strong. So, you know, not usually currencies and trend, but you know, when they work, it's exciting.

Alan: 00:03:39

Yeah, for sure. And it's, I guess, where the attribution has come has obviously shifted through the year, which is often what we see in managed futures.

write something, so reviewing: 2024

Katy: 00:04:11

tle of the paper is Themes Of: 2024

And so, I think that kind of sums up something that was really interesting that we noticed. So, when we looked at the year in review, it has been sort of, in some sense, a false start and a reemergence by the end of the year.

So Q1 was, you know, guns blazing. It was a phenomenal quarter. You had equities up, you had commodities doing well. And then, honestly, in Q2, Q3, there was a lot of back and forth related to monetary policy. Then Q4, there was the relief over the election and now you're starting to see some trends related to sort of changes across different global regions. And also, this sort of pro US kind of theme that has emerged especially in the last six weeks. So, you know, it was a difficult year for trend, but certain types of trends really worked.

So, you know, one thing that we do which is super interesting, and I've been a big fan of it since some of my early work with Alex Greyserman, even in our book on trend following 10 years ago, about CTA style factors and what these CTA style factors do.

I know you're really familiar with them, Alan, is they kind of take a plain trend system and then they perturbate some of the design decisions within the system to isolate a factor of decision in terms of how you build your system relative to a trend benchmark, to create CTA factors to help us understand sort of relative tilts and design decisions and how those perform from a year to year basis can be very helpful for understanding return dispersion across the space and also sort of understanding which tilts, you know, work when and how. And so, I'll just mention these four factors that we usually talk about the most.

One is our speed factor. So, are you faster or slower than your peer set? Secondly, the size factor, and it's very similar to, you know, our classic size factor in that how much do you allocate to smaller versus larger markets? Then you also have your co-movement factor, which is inspired from our friend Nick Baltas, and defined in exactly the same way as some of his papers. This is meant as a proxy for crowded trades. And then we also have the correlation factor which is how much do you lean into less correlated markets versus more correlated markets? So, the dollar versus like the Mexican peso, for example.

So let me just tell you what we saw, which is pretty exciting. You know, we always like to look at this because what's important is each year is very different. Because trends are so idiosyncratic, it really depends on what trends came about this year. And you know, something stuck out really quickly. Slow minus big was massively different.

So, slow systems had very highly positive returns and faster signals had much, much worse negative returns. And this was true across all asset classes. So that was kind of shocking how big the divide was this year. So, it means like if you just look at the long-term trend at the beginning of the year and stuck with it, you've been avoiding all the noise from monetary policy, which is awesome.

Then the Other three, and I'd love to hear your thoughts on it once I tell you all the results, the other three were less notable, but large markets perform better than small markets. And this was particularly the case for equity indices as well as fixed income, but mostly equities.

And what that means is like if you stuck to the S&P 500, and the NASDAQ, and the highly liquid markets, versus more esoteric ones, that helped. Co-movement and correlation didn't do as much this year. So, in certain years they are really important.

I expected a little bit of that from the commodity sector, but some of these esoteric commodities we talked about before, they're just small, so they may not have a huge impact on the overall portfolio.

Alan: 00:08:30

Yeah, interesting. Yeah, I guess what you say makes sense. From my perspective it seemed that a lot of the dispersion was driven by different positioning in fixed income, in particular related to speed. So, I remember coming into last year, some managers got long fixed income, I think maybe in December and did well then, but then did badly in January when the markets reversed, and others would have been slower to reverse.

And we have had a lot of flipping in fixed income, haven't we? You know, at the start of the year inflation proved to be… Well, coming into the year there was the expectation of rate cuts, and then we had sticky inflation, and then we had like recession fears reemerged during the summer, and then we had the Trump trade. So, it's kind of flip back and forth four or five times. So, it's no surprise there that speed factor.

I think, in our group conversation, which we'll give a quick plug for, that's coming out soon, you mentioned the magnitude of this dispersion at 10 vol. It seemed quite large. Can you say what it was?

Katy: 00:09:35

So, if I look at the dispersion across managers, I have a plot right in front of me here, so I can take a look at it. I don't think it was exceptionally larger than certain years in general. You know, you saw a lot of dispersion in Q1. So, some managers were up a little and some were up quite a bit. You saw a lot of dispersion in Q2 and Q4, but a little bit less in Q3.

I think you actually hit on something that we also pointed out, in what you were saying, is as we looked at our trend systems across each asset class, across windows of time, there's a big asymmetry in fixed income. So, anything in the shorter-term, around six months or less, PET really struggled in fixed income. So, you can imagine that with a six month time horizon it's just getting whipsawed by exactly what you said, this inflation worry and then boom, recession worry and then are we cutting or are we not cutting?

So, the longer-term signals did better in fixed income, say 10 months or more, you know, around that horizon. But generally, most short-term signals had a lot of volatility and fixed income was probably the most affected by that.

Alan: 00:10:50

And in terms of the markets and market size, I mean obviously some managers seem to very much benefit from the cocoa move earlier in the year. Is it a bit surprising that doesn't feature more in the size factor?

Katy: 00:11:05

Yeah, I think that made the size factor a little more mixed because we obviously look at it by asset class. So, you do see that, actually, the correlation factor for commodities was positive. And that kind of, you know, might suggest that like less correlated markets did a little better, especially for commodities. So, things like cocoa, coffee are much less correlated than energies and metals. So, we do see a little bit of that in there. But I think from a whole portfolio perspective it's going to depend on how much exposure a manager had to cocoa. And you know, I think it varied.

I did want to like point out one other graph that's really interesting that we were looking at. And this is why I love the CTA style factors because you know my history, like yourself, of being a CTA fund of funds person many years ago. Why I love these factors is we applied them to all the managers, the biggest managers in the Morningstar category in ETFs. We do a bivariate regression where we just look at the coefficient for the speed factor for each of the managers across the space. And the reason the return dispersion matters here is you have managers who are down like 5 and you have managers who are up 10 or more. And so, you have that pretty wide range.

I can't say statistically that it's more than historically, but it's definitely what investors typically get concerned about. If one is up a lot, does it matter? And when we looked at the regression outputs for speed versus performance, it has a remarkably good fit to sort of what you see.

And so, what you see is a lot of managers who have a dedicated allocation to faster signals and are trying to really capture that crisis alpha and, you know, get there versus some of the ETFs that focus on replication and sort of slower moving signals. The difference between those two could easily be explained by sort of the tilt in speed and how slow just was so much better this year.

So, I think that's important for investors just because, depending on your objective, you could have a very different year next year if we had a recession or something - an event. And so, I think it's a balance over time. Reactivity is important in trend, but each year is different.

Alan: 00:13:26

Yeah, interesting. And you mentioned correlation being one of the factors as well. I mean, I don't know if you look at it when you look at correlation across markets this year, anything to observe on that front? Have they been more or less correlated than usual, would you say?

Katy: 00:13:40

I like to look at correlation across asset classes, and I think that's probably a big driver. You know, frankly, for the last two or three years, because inflation has been a topic that's coming up, you are seeing a lot more cross-asset class correlations that are varied. I think that has created some challenge for fixed income because fixed income has been sort of positively correlated with equity sometimes and then negatively correlated other times. It does make that, you know, trickier, I would say.

Alan: 00:14:15

Yeah. Okay, so it sounds like conclusions for the year are slow and steady won the race. Just because you did well this year or if you did, and being the slow manager, it may not be the way it'll play out next year, but we shall see.

The other thing you mentioned was within equities, and obviously makes sense, larger markets, the S&P 500, (okay, the NASDAQ has been better), but the S&P has had a phenomenal trend, and if you can contrast that, I guess, to some of the other equity markets. European equities rallied in January but then kind of did nothing the rest of the year. You know, the Hang Seng went down, then had a big spike, then kind of disappointed.

So, it’s easy to see how some of the other equity markets have been choppy. And you know, I suppose if you were a slow trend follower, heavily focused on the S&P, you probably did quite well this year. I don't know if there are many CTAs like that out there. But if that was your construct, yeah, it would have worked well.

Katy: 00:15:11

It would depend on how many markets you trade too. And I think that's the thing, for a smaller market set, if you have 20 or something you definitely have a tilt.

Alan: 00:15:19

Yes.

Katy: 00:15:20

To the bigger markets, and, you know, it's just a different strategy, in my opinion. So, I love CTA style factors.

Alan: 00:15:29

I mean, it's always great for conversation and analysis, yeah.

Katy: 00:15:33

It's just a good way to kind of think about the different design decisions. It gives us a chance to kind of look at a year and say, okay, these are the styles that worked, and who has those styles, and why, and in which asset classes? So, they're a lot of fun. So, I'll probably keep writing about them for a long time.

Alan: 00:15:50

Absolutely. I'm sure investors will be keen to read your paper when it comes out in January.

Now, you mentioned ETFs and there was some interesting news recently on the ETF front. What was that?

Katy: 00:16:05

Yeah, I mean, I think people have been chatting quite a bit about a filing by BlackRock to launch a managed futures ETF. And I know it's obviously still early days, but, you know, it kind of is consistent with what we were talking about, and back in Stockholm as well, at my former home place. It’s just the ETF space and how it's really becoming more mainstream, especially as you have more and more players entering the marketplace.

I know Niels and I talked about this paper that we wrote, which is great for anybody who wants to read about this, called The Managed Futures Ecosystem, the Rise of the Managed Futures ETF. And what we're kind of explaining here is like, changes in US regulation have really made active ETFs a much more viable product structure.

And we explain, and what's exciting to me is that we explain how, with any new space there's different phases. There's product proliferation, then there's innovation, and consolidation, and then maturation. And so, we saw that in the mutual fund space. And I'm excited because I feel like this example is just another example of product proliferation.

And so, kind of it's a space where BlackRock getting into the space is just a sign that this is a space that could have a viable allocation in a disaggregated US pension fund world.

Alan: 00:17:30

Yeah. And have you heard or read any more about what's the nature of the managed future strategy they're running or the personnel who are going to run it?

Katy: 00:17:38

I don't know much about that yet. I think we will find out. I mean, obviously these things, there's a window of time. But for me it's more just saying, hey, there's a lot of people that see this space as a place to be. It's a very, very different set of investors and I think, just given the structure of the US pension fund system and how few people have access to managed futures, I think that's exciting.

Alan: 00:18:06

No, for sure, yeah, no, it definitely will be interesting to see. And also, is it a replication route or not? I had a quick look at the filing that was sent around. I didn't see much mention of replication. But equally the people involved as PMs seem to have mixed backgrounds; some equity, some kind of income. So, it would be interesting to see what the final product looks like when it emerges.

But you also mentioned that you were in Stockholm recently and you were with all of the greats of the managed futures industry, at the Hedge Nordic Roundtable, and they've just published their summary of the conversation. How was that? What were the interesting themes that you took from it?

Katy: 00:18:50

Well, it's always fun to go back to Stockholm for me, I love it. It was a fun conversation. I really enjoyed it because one theme that I think that I have seen is consistent with what we just talked about. You know, the year before I was at the same conversation and myself and Otto van Hemert, who was there as well, and we were talking a little bit about ETFs.

This year it was exciting to see that the conversation was actually much more extended and there were more views and more people talking about that. So, that's just another example of how this is a new, exciting avenue for managed futures. Although it’s very, very different than, you know, your classic manager space.

Whereas you know, we tend to see that there are just different products for different people, and there are different wrappers for people, and we're excited about both. I think we think replication is an exciting way to get exposure, but we think about combining it with bottom-up approaches like direct implementation and risk management.

he opportunities for trend in: 2025

Alan: 00:20:21

up-and-down years. Obviously.: 2022

to the end of, say, September: 2022

Katy: 00:20:49

I think there's some optimism especially now because you know how it is, it's like trend goes through periods of consolidation and then it goes through periods of really finding incredible trends. And I think I always believe that trend is a strategy that likes macro change and stress. And frankly if you look at last year, you know, the typical equity investor, especially a US one, is not so stressed. I mean they had volatility but things still look very good.

So, I think, for us in this space, it goes in cycles. It's really about what kind of key things and change always comes. We just can't predict exactly when that will happen.

So, it does feel a little bit like some new trends have kind of emerged recently and that this dollar trade, the US versus you know, other has some legs. But you know, of course there's also risk. There are policy mistakes. There's geopolitical conflict that could get in the middle, and trade conflict. So, there's a lot of room for turbulence and I like that. So that's what we like.

Alan: 00:21:56

Yeah, definitely. And I mean I saw a chart, somebody was posting a macro strategist like sentiment in the equity market, at an all-time high (or like in relative to recent years), and some notable bears capitulating under bearish views, which is always a kind of a warning sign that maybe things are getting really over exuberant.

I mean obviously we've had a very persistent rise in equities and hard to stand in its way. But you've got to think at some point we'll see that tested and see some more turbulence there. Not without timing it, but you'd have to expect that'll be a feature of the landscape at some point.

Katy: 00:22:34

Yeah, I think so too. I mean, but you know, it's always so shocking. I thought that last year.

Alan: 00:22:40

Of course, yes, I know.

Katy: 00:22:41

I mean, but you must agree, Alan, it's so funny being a trend follower because it's like you always think that doomsday is coming, right? Because you're like, oh, things could get wild and they eventually do. But that's why I think we're interesting to talk to because everyone else is looking for a bull and we're looking for a bear. So, you know, it's always good to ask us what we're worried about because sometimes they come to fruition.

Alan: 00:23:06

Yeah, for sure.

Good stuff. Well, maybe good to move on to one of our main topics, and again from our good friends over at Quantica, who have been a great source of materials for us to discuss on top Traders Unplugged. And they have a paper out recently on a topic that has a long history of debate on Top Traders Unplugged as well. Isn't that right? So, it's on volatility sizing. But they've done a really good job of framing the debate and looking at some historical data around that.

Katy: 00:23:44

Yeah, that was a great paper. I mean, great bedtime reading, right Alan? You know, they're like, ooh, position sizing. Or maybe not. You might have too many dreams about position sizing.

But yeah, I read the paper, and I was so excited because I love a really clean research paper on something like this which makes a point, which is interesting. And you know what I loved is they kind of like address the age old question of okay, if you're going to trade a trend, do you sort of buy a certain number of contracts and like hold it out to a certain level? Or do you sort of buy it and then size it as volatility increases to kind of like manage your risk over time? Like that's sort of the classic CTA question.

And what I love the most is how they also looked at sort of volatility and they kind of looked at sort of what was the ratio of volatility entry to exit point for a full trade for any of the trades that they looked at over a 30-year period. It was only 1.05 for a ratio of increase in volatility for sort of losing trades.

But they found that the winning trades had a volatility ratio of 1.2 and that the winning trades for trend; the top, big, hit it-out-of-the-park trends had the highest increase in volatility. And this is endogenous, right? You and I know this.

Obviously, if a trend with profitable volatility is going to be higher, but sort of the relative differential between those twos was interesting. I got all excited because I started thinking about how many people in my career have asked me the question, how is managed future similar to volatility? And they didn't talk about this in the paper, but if they were here right now, I'd ask them about this.

It's like always people are asking me, you know, how is managed futures similar to long vol? And you know, if you look historically, and I've written a couple papers about this, there's like a 20% correlation (and that's just a ballpark) between managed futures trend and vol.

And what could have been cool for them to measure is like what is the vol correlation for a static portfolio sizing versus dynamic. Because I would guess (because they show this) is that dynamic volatility sizing is really its benefit is risk management. It's sort of reducing the overconcentration of your portfolio to those few cocoa trades.

And so, I think if you looked at the vol exposure, a classic trend with static position probably has a 40% or higher correlation with long vol. And so, there's just a very great pure play example of how we are exposed to long vol. And that long vol is often a very desirable characteristic for many investors who are looking for risk mitigation.

Alan: 00:26:38

Yeah, it's interesting. I mean, as you say, that was one of the interesting features of the paper is that how they have volatility changes in the trades, the trends they get into, and how volatility tends to rise into profitable trades. And that's something we intuitively know.

And it's one of the great features, an attractive feature. If you can get into a market at low vol with a decent sized position and then the volatility expands in the direction of a trend, that's great. Obviously, by vol sizing managers manage risk.

One of the things I noticed, because I was thinking, I wonder, then, kind of as you're saying, if you look for markets for volatility is expanding, is that a signal by itself? But I guess one of the things that you see is volatility expands, but then it tends to expand even more under reversal.

So, if you look at say the cocoa trade and look at the realized vol in that market, yes, it did expand as it went up, but then it really expanded. It went from, say, I think 20% annualized vol to 120%. It hit 120% when it started to turn down from the peak.

And that's part of the read, that's part of the justification for the volatility sizing, isn't it? Because intuitively the argument is that you tend to get more volatility as you're hitting the turning point, and you want to manage the risk. So, yeah. So, curious to get your perspective on that. Is that why you think, would you agree with that? Is that, is that a reason for the vol sizing?

Katy: 00:28:08

I think so. I think what I also started thinking about, based on what you're saying, is that when I was reading the paper, I was thinking about that I liked how clean cut they made it. That it's just dynamic volatility sizing or static. But the truth is that the way that you measure your volatility will also matter. So, you can actually think about this as a spectrum.

So, if you thought about the static is as if you treat the volatility as irrelevant and the dynamic is like you're moving with it a lot. So maybe, you know, that shows the art as well of like, where do you hit on that spectrum? Because you're right, you pointed out that the volatility isn't just in the up, it's also in the down.

So, that's where some of that risk management comes in, is that, you know, although you want that upside of that huge trend in cocoa, you also kind of benefit from less exposure to the high volatility and reversal like behavior of trends when they go overextended.

Alan: 00:29:06

Yeah, yeah. I mean, it's interesting. This has been a topic that's been debated by lots of people on this podcast. But reading it again, it's interesting because even if you look at the results, it proves what everybody is saying in a sense because people who do volatility scale and rebalance all the time, they'll say, well, by doing that you get a better Sharpe ratio. And that's what the Quantico data proved.

And advocates of not volatility sizing and constantly rebalancing say, no, forget that, we're not looking for a higher Sharpe. We're looking for a higher absolute return. And the data proves that as well because you did get a higher return, albeit with higher vol and a lower Sharpe. So, it didn't kind of settle the debate. It kind of proved that both perspectives had validity. Isn't that fair to say?

Katy: 00:30:02

I would agree. And that's why the point of it depends on how you implement it too. If you have really active vol scaling, then obviously you're taking more profits. You look a little bit more and more about risk management.

Whereas if you had a slower volatility window, and this matters, especially when you think about slow systems or replication, these things matter because, you know, you're actually much more in the middle of the spectrum, I think. I think people will make different choices depending on how they measure volatility and how reactive their system is, will put you at different points on the curve.

So, I think that was something that I also think about from a practical perspective that, you know, this implementation can vary as well. But it was a great paper to kind of say, both of them are right.

Alan: 00:30:50

Yeah, it is. But I think the issue of concentration is interesting as well because I think you've nearly got two different philosophies on trading here. Like one philosophy is very much kind of a portfolio manager statistical perspective that, why would you want to have more concentration in the market where volatility has spiked up and has trended versus another market which is trending but hasn't shown net volatility expansion? So, from a kind of statistical perspective, there's no reason why you'd rather have more concentration in the first market.

But the classic trend follower viewpoint, and hopefully I represent it accurately, is you do want to have that concentration to capture the possible outlier. So, it's kind of a different mindset, a different philosophy. They're both kind of trend followers. But there seems to be a different philosophy underpinning the two styles.

Katy: 00:31:49

Yeah, I agree, and I love that because why I've always been so fascinated with trend following as a strategy is it's really a behavioral strategy. And they also pointed out in the paper just sort of the hit rate. And that's something that a lot of people don't realize with trend.

And when I explain this to investors, it's sometimes an aha moment because they think, how's it possible that like everything trends all the time? I'm like, no, there's just not that many things that trend or that often.

But when they do, if you have this strategy, you capture most of your… you know, it's that positive skewness, right? That sort of bang that you get from cocoa, which you don't get this year from say, you know, I don't know, aluminum, just picking a market.

So, I think that sort of is a very different type of hit rate than most investors think about when they think about equities or value and things like this. And so that's where the philosophy comes in. And these are trends that are extremely profitable but rare and not 50% of the time. And so, it's about how you manage those rare trends.

You manage them to kind of capture the most return but make yourself vulnerable to extreme reversals or do you kind of say, look, we want a smoother ride, and we want to capture a good part of the meat of those trends, but we also want to balance our portfolio to kind of be a little bit more risk managed. So, I think that was a great paper.

Alan: 00:33:12

I think so. I mean that was one of the things that… I mean this is like from speaking to investors over the years. I mean it is one of the biggest bugbears.

If trend followers make (a bit like this year), if you make 10%, 15% in Q1, but then give it back quickly, it tends to annoy people. So, you might say, well that's just the way it is. This is where the behavioral challenges come in and do you want a smoother ride for investors or not? Or do you just say no, we're in this strategy to capture those occasional moves.

The move we've seen in cocoa is kind of, you know, probably not something we've seen in 20 years. I mean they showed cocoa as an example but actually the move in interest rates is even more extreme. The volatility expansion that we saw in, say, the SOFR contracts, or the two-year note, is an even greater multiple.

So, I mean these trades, they come along but you have to be very patient. So, the behavioral side is another aspect. And I know we were talking beforehand about the bits that we wanted to quanticate that they didn't mention that.

One of the things that I don't think they went into is like how do different styles blend with equities or blend as part of a bigger portfolio. I'd be curious to see that result. And obviously, and also the skewness was the other point I had. Yeah, exactly.

Katy: 00:34:32

And also the skewness, You know I love skewness, yeah.

Alan: 00:34:34

years,: 1994

So yeah, I think the debate will rumble on. Any other takeaways? I mean, would it force you to reassess your perspective on constant re-vol sizing your book?

Katy: 00:35:13

No, I mean I think it just, it rhymed very much with a lot of philosophy and things I like to think about when it comes to trend is that you know, sort of the tradeoff between sort of position sizing versus capturing those trends I think is something that all managers have to think about. It just was a really eloquent way to discuss that topic and it also got me thinking about like extensions of it and I think that's great.

So, applause to them for a great paper and also for sending it out, what was it, Wednesday night or something. I said, you know, a couple days ago and I was like Alan, this is great, let's read it. So yeah, so something fun for us to read, you know, before the holidays.

Alan: 00:35:53

So yeah, and I mean you touched on the point about long volatility which is, you know, it's always a topic that comes up in conversations. And then you've got kind of, are you long implied vol or are you long realized vol, and variants like that? I mean is that a topic when that you get those questions from investors, are people seeing that as a favorable thing or not?

Katy: 00:36:16

rote a paper for CME Group in: 2011

But this paper kind of hints at the point that, you know, depending on your position sizing approach you might have more or less of that long vol exposure. And so, it depends on what the objective of an investor is.

If an investor is looking for risk mitigation, and they're looking at sort of like, the first one, your example, they want returns when maybe they can get more correlation to the long vol, if they have the static, if they're willing to understand the risk management implications and think about global Sharpe more than say local Sharpe. Or maybe they need a mix of the two, which is what I was saying - a little bit of both, to kind of balance those two risks.

And on the other hand, as you move to more aggressive position sizing, you're capturing that, but in a more better risk adjusted way. So, I think that kind of answered a question for me that I explained in that paper 15 years ago, but it was much more explicit and showed it in a neat way. So, I would love to ask them about that.

Alan: 00:37:43

Yeah, and on the concentration issue, I mean, you know, there is also the point if you're a discretionary macro manager, like concentration is a good thing sometimes. If you have a high conviction trade, you know, you just lever up, you know what I mean? You don't want to have a balanced book with 10 positions. If you have a high conviction on the dollar, that's where you want to have your risk. But obviously quants don't necessarily approach it the same way.

What they showed in the paper, you could have quite a concentrated position in a sector or market, obviously, by just leaving the position to participate in the rising volatility. But equally, I guess even if you're vol sizing, you can be concentrated on a risk factor sometimes.

Inflation was a big driver effectively. Most CTAs kind of were effectively short bonds back in ’22, as the main risk factor. So, how much has been heavily concentrated? You know, how much of a concern is that?

Katy: 00:38:47

So, this is a really good philosophical question because I think that one of the big challenges… Trend following, I think, as a strategy, one of the big challenges is that when you look at it across a portfolio, it's really exposed to prevailing market macro themes. And so, endogenous in this is, you know, the correlation structure of those themes and sort of the stability of those themes.

And so, this is something that's been a challenge, especially clear to us, over the last two, three years where a lot of the overall volatility profile, correlation profile has been really focused on monetary policy. And that's why I said when changes [occur] in correlation between stocks and bonds, that's driven by sort of the fundamental relationship between those asset classes. It is driven by this overall macro theme of do we have inflation or not?

I do agree that you get a different type of concentration. The concentration you're getting is perhaps more sort of a balance of those macro themes and you're really exposed to multi asset macro themes where that's actually your position instead of individual trends themselves. So those individual building blocks build up to something that really is a macro themed exposure based purely on price movements.

Alan: 00:40:12

inancial crisis, we saw again: 2022

Katy: 00:40:35

n investor said to me, during: 2022

In a year like this year, where basically it's all about will we actually have cuts or not, back, forth, there hasn't been a lot of macro change. So, it's not surprising that hasn't been an easy macro environment, in general. for trend, especially in shorter time horizons.

Alan: 00:41:37

No, for sure. Okay, so maybe moving on. There was another paper that came across our desks that was interesting and definitely topical. It was from Aspect Capital on the whole area of portable alpha, and that's something we've been talking about on Top Traders Unplugged a bit recently. And portable alpha is the idea of combining different strategies.

So, it’s about combining an alpha strategy on top of a beta strategy such as the S&P 500, and getting the S&P 500 exposure. Well, you can get either side of it via on a leverage basis, but one way of doing it is to use futures to get the S&P and then you have capital freed up to invest in an alpha strategy. And, I mean, this is similar to return stacking. It's effectively the same thing. I mean, that's been a popular label put on it in recent years.

I mean portable alpha seemed to be very popular going back to pre-global financial crisis days and then kind of died a death a little bit. I mean, I wasn't as close to portable alpha strategies back then, but my impression is that you were combining equities with another equity strategy which wasn't very sensible. But I mean, have you had much exposure to running portable alpha or what's your perspective?

Katy: 00:43:01

Well, I mean, obviously it's something I'm quite familiar with, but you know, I generally think the framing of that question can be a little bit confusing because I do really believe that when you say portable alpha, you're kind of assuming that those correlations hold and you're kind of ignoring…

And I always love that, you know, with the APT, and the CAPM, and I used to teach those things to MBAs, and I always thought about it like, you know, when you have an alpha there's always still some residual risks. And I think that when I think about any portable alpha strategy, the concept of alpha is relative to the risk that you've removed, assuming that you caught all of them.

And so, I think that it's a great framework as a start, and I think what made it challenging for investors is they really thought, perhaps, that they were segregated and there wasn't risk in the alpha. And I think, you know, the concept makes a lot of sense, and I like the concept of, you know, using the value of implicit leverage that you get in derivatives which allows you to get sort of more capital efficient use of your capital; AKA you can get that equity return and you can combine something with it.

But what I do like with the paper, regardless of the terminology, is that, you know, I think the more and more that investors understand that managed futures and equities are just a very natural compliment, the better. But they also need to understand the risk, and what I mean by that is the correlation risk.

So, there can be periods of time where managed futures doesn't look like alpha at all, where it's actually long equities, and that would actually increase your exposure if you had a recession or a drawdown. And so, I think that if you call it portable alpha, and someone really thinks it doesn't have correlation risk, then there's risk that they will be disappointed or upset in certain periods. So yeah, I don't know, I mean you probably agree with me, but.

Alan: 00:44:58

Absolutely. I mean, I scanned through the Aspect paper. Was there anything in the paper that kind of stood out from your perspective? I mean, I think a lot of it is around what we're talking about, about, you know, that it matters what's your alpha source, what's your beta source, and, and how you blend them. That’s, obviously, the key ingredients. Any other takeaways, would you say, from the paper?

Katy: 00:45:23

Well, I just like that they're kind of highlighting the capital efficiency of futures because I think that, you know, the word leverage is often, it's seen as a bad word a lot of times, especially by equity investors because they really think about that you have to borrow something. And what's great with futures is that, implicit in that leverage is that you don't have the borrowing costs associated with it and you can still just have capital efficiency.

So, it is a way to combine, and I'm a big fan of combining equities with trend and other managed futures strategies because they naturally work well together. So, you get a package which basically is a little bit smoother as a global portfolio, as opposed to just you still get that equity exposure, but you kind of smooth the ride with something that's a little different.

Alan: 00:46:13

Yeah, I mean, there is a curious kind of topic or debate here. I mean, it's true, we all know, you know, combine equities and trend following, you get a better Sharpe. But that would suggest that, why don't trend followers just stick in a constant long, 100% S&P future and then modulate around that. Obviously, there are reasons, but I mean, that's effectively the same thing, isn't it?

Katy: 00:46:39

Well, I mean, I think we're going to see more and more product in those areas just because the question is much more of a packaging question, I think, for people. They have equities here, over on the left, and they add managed features, and so they need to do that combination themselves. But I actually do believe combining them together dynamically, just like the risk management we saw in that paper, has some concentration help.

So, making a parallel to Quanica is that if you include equity exposure, I think the challenge is always complexity. You know, like the more complex a product becomes, the harder it is for investors to understand your performance over time, and Expectations. And so, it's going to be that as we see more of those types of products in our space, there's going to be a lot more work that's going to have to be done by people like me. So, this is fun to educate people on the benefits of combining equities with trend.

Alan: 00:47:41

Yeah. Well, one of the reasons why this is popular again, there was a Bloomberg article that I was chatting [about], with I think it was Andrew Beer, a few weeks ago around this. And the Bloomberg article was saying that part of the reason for the resurgence of portable alpha is it's hard to sell an alternative product in an environment where the S&P is doing 25% per annum, kind of on with the implicit assumption that it will continue to do that. You know, you can debate that.

But investors, you know, they often have this perception, okay, there's going to be an opportunity cost if I take money out of the S&P to put into an alternative. So, this is a nice solution. I mean, do you get that in your conversations with investors, that they don't want to go into an alternative because of that perceived opportunity cost?

I mean, do you get that in your conversations with investors that they don't want to go into an alternative because of that perceived opportunity cost?

Katy: 00:48:21

Yeah, I mean, I think that's the classic debate. I mean, I'm sure you're talking with Andrew Beer about this as well. It's like if we move from the 60/40 to the 50/30/20 or whatever, there is an implicit view from investors that, you know, there is this opportunity cost of switching to something else. And I think what's exciting about the framework of portable alpha, with the caveats that you understand that correlation risks exist, is that it's a way to kind of say, instead of sourcing from pulling out of those two classic buckets, maybe you can just kind of add something that has alternative features that is similar to that bucket.

And so that's very desirable, I think, for investors who still want that equity exposure, but want something else that maybe likes macro environments a little more. Or if they're nervous about bonds, what bond alternatives do they have, and they still stay with their 60/40, but they provide some alternatives that have similar features?

Alan: 00:49:18

There's a question that you get with this kind of product, I guess, which is, where does it sit in the portfolio? Because lots of bigger institutions will have different teams and it's all kind of bucketed off; you're the equity, or you're the beta analysts, and you're the alternatives. So, when you combine different kinds of return streams and you get a hybrid type product, where does it sit, or what's your perspective, or what would you say to investors on that?

Katy: 00:49:43

That's the precise problem. So, if you have equity plus other strategies, is it in the equity bucket or is it not, or is it closet equity in your alternatives bucket? So, you know, I think that's kind of the challenge. It's the way that people classify those investments. And so that requires a reframing for investors.

And you know, if I want to use an example that I think is really great, my favorite example is what some of the pension funds have done with risk mitigation strategies. There's an example. They created a bucket which had a specific mandate, and then they could articulate to their portfolio teams and their boards, this is the goal of this strategy. And then they were able to put something in things like trend or you know, long vol.

And so, I think the challenge with any of these combined products is exactly like you say, does it really go in the bucket or does it have its own bucket? And that creates some challenges for explanation and for attribution. And then once it's in the bucket, guess what, it gets compared to the things in the bucket. So, you know, it makes it challenging for us.

Alan: 00:50:52

the popular ones back in the: 2000

Katy: 00:51:34

I would say that would definitely be one that's a natural candidate too. I mean if you've been watching the momentum factor this year and some of the factors, I think that dispersion across equities, both globally and in the micro level, has created a lot more opportunities. So, that would be a way to kind of enhance, using cross sectional adjustments to enhance your overall beta. So, I think that is one natural candidate as well.

Alan: 00:52:01

Yeah. And I mean you touch on the risks of this approach and obviously one of the risks is that, with trend following, adding it to equities you've got equity positions in your trend following and, you know, at certain points in time, I guess at the moment trend followers would generally be long equities. Which is not a bad thing because you're capturing the trend. But at some point there will be a turning point.

I mean, so it also lends itself to the question, and I know some managers have done this, of tweaking then the trend following program. If you know this is the objective is to blend it with equities, would you tweak the trend following program either to cap the equity beta or to be faster to turn down in equities, or what are your thoughts on that?

Katy: 00:52:46

Yeah, I've done a lot of research on that and there are definitely several different methodologies you can use. I mean one is sort of the sizing of trend can also be something that's dynamic.

So, then it's a portfolio question, right? Like how correlated is trend in managed futures? You could think about that. Other managers have looked at things like beta capping, equity exposure. There are a lot of things that you could do to try and optimize that relationship if you wanted to. Or you could just kind of accept and clarify that these things are moving independently and occasionally they'll be in the same positions. And I think there's a range of different approaches to that.

Alan: 00:53:27

Yeah, yeah, I mean I think that it comes back to kind of the investor utility function and if you're willing to, because obviously you will get some months where both equities and trend following have a tough month and then you're going to have a particularly tough month with a portable alpha strategy. And so yeah, I guess that just comes with the territory. You have to be able to live with that kind of volatility.

Katy: 00:53:52

Yeah, I mean, I guess it's about communication, understanding the product. Again, where I pointed out that complexity makes more work for us to make sure that everybody is really clear of the risks.

Alan: 00:54:09

So, I mean just before we're coming up to close here, before we wrap up, obviously it's year end, and you're looking ahead to next year. I mean, any thoughts? I mean we did touch on it a little bit earlier on in terms of some of the themes.

e in year’s time, reviewing: 2025

Katy: 00:54:50

So, when people have asked me what are the biggest concerns I have going forward, or the biggest risk that people are underestimating, I've generally said the volatility of inflation, not just the level of inflation, but really just this idea that we think that it's gone, and that it comes back, and that's why this month has been interesting to me. And I think really nobody knows yet, especially for the US, what is this deficit situation and what are these policies? What is going to be pro inflationary and what isn't? You know, where is the ballast going to swing?

burned from what happened in: 2022

Bonds are hard. They used to be the favored child of managed futures for decades, and now they are sort of the least favored child, I would say, from my perspective. Bond have no natural predators except for inflation. And now we have inflation that's kind of coming in like the coyote, chasing after your bonds.

And so, I think that's an interesting one to watch next year. And I think everybody's going to be watching also… I'm just interested to see how does this pro US theme, can it keep going? I mean, how does China pivot and sort of adjust to it? How do other regions kind of navigate?

I just find it so fascinating. The US is the slower one to cut rates. They're usually leading and now they're lagging. Right? And they're being slower because there's just such a different macroeconomic situation in the US versus others. And we haven't had this divergence in most of our careers. Right. So, it's an interesting time.

Alan: 00:57:10

Definitely, and we have the uncertainty of tariffs. Will we get them or not? And then the additional, you know, what impact it will be? Will they add to inflation or not? I mean, there are lots of different views on that.

'm sure if you go back to the: 1990

But as you say, on inflation as well, we had the inflation numbers out this week and still kind of showing a little bit of stickiness. I mean, not running away to the upside, but certainly being slow to converge on the magic 2% level. So, I think that's definitely important.

interesting, at the start of: 2024

I mean, it's interesting times, but hopefully it'll be volatile, volatile in a good way.

Katy: 00:58:41

I hope so too. I mean,: 2025

Alan: 00:58:47

Well, good stuff. Well, great to chat with you. I enjoyed speaking with you today.

efore we're back to normal in: 2025

So, we should probably wish all our listeners a Happy Holiday Season and we'll talk to you in the new year.

Ending: 00:59:28

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.

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