What if markets move not by logic, but by pressure? In this conversation, Alan Dunne and Yoav Git trace the invisible currents behind price formation, namely how a single dollar of inflow can lift valuations fivefold, and why that distortion challenges everything the efficient market promised. From the slow mechanics of supply and demand to the moral hazards of policy and liquidity, the discussion follows money as it reshapes narrative. They revisit research that foresaw inflation’s return, and question why QIS indices so often fade in practice. Beneath it all lies a quiet question: what truly drives the modern market?

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Episode TimeStamps:

00:00:23 – Opening and agenda for the discussion

00:01:05 – Math education in the UK and XTX’s push to fund young talent

00:03:39 – Market performance recap for early November

00:04:49 – Reflections on volatility and fixed income trading conditions

00:05:13 – Introduction to the “Inelastic Markets Hypothesis”

00:05:53 – Supply, demand, and elasticity explained in market terms

00:10:30 – Instrumental variables and how economists measure elasticity

00:14:51 – The debate: if markets clear, how can flows move prices?

00:15:44 – Why equities are more inelastic than bonds

00:21:04 – Questioning the 5x effect and how flows follow prices

00:23:48 – Policy and moral hazard implications of inelastic markets

00:26:07 – How elasticity differences shape trend-following speeds

00:29:57 – Should all markets use the same trading models?

00:36:19 – “Best Strategies for Inflationary Times” revisited

00:38:30 – Why the paper predicted 2022 so accurately

00:42:03 – The nature of trend following: slow losses, fast wins

00:44:24 – Inflation mandates and the overlooked role of CTAs

00:48:33 – Why TIPS and real estate can fail as inflation hedges

00:50:05 – Examining “Quantifying Backtest Overfitting” in QIS

00:53:59 – The 60% haircut between backtests and live returns

00:56:00 – How CTAs add value beyond bank QIS products

01:00:40 – QIS as a low-cost, capital-efficient exposure

01:01:15 – Closing thoughts and next week’s preview

01:01:59 – Outro and disclaimer

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Intro: 00:00:01

You're about to join Niels Kaastrup-Larsen on a raw and honest journey into the world of systematic investing and learn about the most dependable and consistent yet often overlooked investment strategy. Welcome to the Systematic Investor series.

Alan: 00:00:23

Welcome back to the latest edition of Top Traders Unplugged, where each week we take the pulse of the market from the perspective of a rules-based investor. It's Alan Dunne, here, sitting in for Niels again. Niels is away this week, and I'm delighted to be joined by Yoav.

Yoav: 00:00:38

Pleasure to be here. Doing fine in London.

Alan: 00:00:40

Good stuff. Great. Well, it's very mild here in Dublin for November. I presume it's the same over your side?

Yoav: 00:00:46

Yeah, actually a very mild November, no snow, no cold, very good for cycling.

Alan: 00:00:53

Good for cycling, good stuff. Well, we like to kick off with what's on your radar. Last time it was comedy. I don't know if you'll give us an update on the comedy or tell us a few jokes, but what's been on your radar?

Yoav: 00:01:05

Oh, the comedy went quite well, actually. I'm surprised you don't have a bootleg copy. But actually, I want to talk about something a lot more serious this time. What has been on my radar is mathematics in high schools and primary schools in the UK. If you have a child who is half decent in mathematics, you start worrying about it.

because there's a new school,: 1729

But it started me thinking about the two ends of how you can make mathematics accessible, especially between Key Stage 2 and Key Stage 3. So, that's between primary school to GCCs. And there's actually an excellent report, when you look at it, by the Nottingham University about the pipeline of mathematics. And they have a few really nice observations about the way that, you know, you start with 25,000 schools in England and the UK and then how, at each stage, fewer and fewer people remain in what they call the excellence stream. And they are making a few suggestions to how to increase that number, you know, increasing participations of ladies, increasing participations of students from disadvantaged background.

And then what was very interesting is that, guess what? The person who supported that Nottingham research with a great paper is none other than XTX. So, actually you can see that a lot of thought has gone into trying to improve the pipeline to get more mathematicians through school and then into university and I think that's a very worthwhile cause. And Alex, is to be commended on that.

Alan: 00:03:39

Interesting. Yeah, very good indeed.

Well, we normally like to start off talking about performance, and good to get it out of the way I think because we have a lot to get through in terms of meaty articles and academic studies. We've got three, if we have time for all of them, but I sense we might get embedded down in one of them, at least.

But in terms of where we are, obviously early days in the month of November, but slightly negative performance on the managed futures side.

SocGen CTA down 40 basis points month-to-date, and year-to-date still down 1.9% this year. And SocGen Trend down 56 basis points on the month, and then 1.44% so far this year. Obviously, we're very early in the month. We've had a little bit of a correction in some major trends, obviously in equities, gold as well as edged a little bit lower.

But from your perspective we've had a bit of a recovery in trend following and managed futures last few months and this month, starting off a little bit negatively. But any thoughts on performance?

Yoav: 00:04:49

Again, I kind of refuse to get drawn on that because I'm always a pessimist. So, I'll count my chickens at the end of the year. But certainly fixed income has been very difficult. We have seen up and down, and round we go, and of course the UK has kept interest rates at 4% as well. So, it's an exciting time to be trading fixed income trend.

Alan: 00:05:13

Yeah, very good. Well, the first topic I wanted to get into is an academic study, a research paper. It's called In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis, from a couple of academics. I mean, I won't steal the major takeaways, but the takeaways here are quite dramatic and interesting in terms of the impact of new buyers or new money coming into the equity market. So, maybe I'll hand it over to you to give the high level summary and maybe we can get into some of the implications of the research then.

Yoav: 00:05:53

Yeah, absolutely. So actually, Niels and Andrew Beer talked a little bit about it, because there was a paper, there was an article published in the Financial Times about this very paper. And the way JP Bouchaud is talking about it and supporting that paper. And the idea behind it is about supply and demand and trying to understand how elastic or inelastic the equity market in the US is to money flowing into it. But we kind of need to step a little bit back and have just a little bit of understanding about what supply and demand is and how to calibrate it. And then we can think about this paper in terms of the outcome of that methodology. But the outcome is completely astounding.

So, the punchline is that whenever there's a $1 flowing into equity market, that translates into a $5 increase in the overall valuation in the market. And the reason why this is kind of very surprising is because that breaks the efficient market hypothesis. It just puts it straight into the dustbin. And it's a big thing.

It basically says that what we're doing at the moment, what we are seeing is a bubble, and we're seeing flows basically driving the valuation and a 5x amplification whenever there's a new dollar flowing into the equities. So, it's a very, very surprising result, but maybe it is correct. Okay, so that was the paper.

But we need to think about the methodology and we need to think also why this is important to trend following. I mean, I kind of think about it and I'm trying to understand why this is important. So, what are supply and demand?

The idea is that, you know, if people want butter, and people produce butter, there will be a point where there is a demand curve. So, the higher the price, the less people would want butter because they would want to eat something else. And conversely, the higher the price, the more supply there is.

So, the way that we look at the supply, it varies with price in one direction and the demand is varying in another direction with the price. So, the two curves will meet at a point. And that will determine an equilibrium in the economy where we have both the price and the quantity of butter (which is consumed) are at an equilibrium.

Okay, and then what is a trend? A trend is when there is a shock to that system and suddenly people want more butter. They've watched Bake Off, they really want to start cooking, baking bread, or baking more cakes.

So, there is a demand shock, or potentially there's a supply shock. You might have a situation where, you know, there’s mad cow disease and suddenly we have less cows to produce butter.

So, when you have a supply shock or a demand shock, the market needs to find a new equilibrium. And the way that it does it, it does it through the adjustment in price. So, you know, suddenly if there is less supply, the prices will rise until the market adjusts, demand adjusts to meet the supply.

And the question of how much the price needs to move is important for us as trend followers. And it's called the elasticity of the market. So, if like in commodities, for example, demand is quite inelastic. Like, the amount of electricity that we use is not that dependent on the price. So, we need a big change in price to get a small change in demand.

So that gradient, how elastic, how responsive is the supply and demand to change in price is called elasticity. And it really affects the nature of trend because what you see is that the more inelastic the market, the more response we need to get in price to really drive to change the supply and demand.

And the other aspect of supply and demand, which is important to trend follower, is the time, how long does it take for that new equilibrium to be reached. Because obviously, if the market readjusted instantly, then there wouldn't be a trend. It would be just like instantly from today to tomorrow. There would be like a new price and that was it. And there's nothing more to do.

But in a lot of the markets that we're looking at, we have a much more delayed response. Like, if you are short of cows, unfortunately you can't order them on Amazon and get new cows to produce new butter. You actually have to grow them over a year. So, it's much more difficult.

So, that's why it's important for us as trend followers. But the problem, of course, is that it's very difficult for economists to really calibrate what is the elasticity of both supply and demand. And the reason for that is because every time there is a shock, you get a shock both to the supply and to the demand, and the two are mixed up. So, you're trying to solve for two variables, but you only have one observation. And that kind of makes the whole process very difficult and you get what's called a biased estimation of what's going on.

So, what are these two economies but actually I think mathematicians, so Xavier Gabe and Ralph Hoyen, from the US, from Harvard and from Chicago, they came up with a really, really innovative idea which is something called the instrumental variable, an improvement on an instrumental variable methodology.

as actually discovered in the: 1929

So, for example, in the case of the cows, if you have a mad cow disease, it doesn't affect demand, but it definitely affects supply. So, events which only affect one side of the equation can be used as a ruler to align one side of the innovation, one side of the shocks, and that allows us to solve the problem.

And what these two economists came up with is the idea of actually looking at the share of demand as a way for us to generate those vehicles. So, what’s in their model is a very nice idea, to say suppose we're consuming oil, and there is a demand shock, but it's a generic demand shock. And all countries are equally affected by that. So, the US and Europe and so forth are all affected.

So, when I look at the equilibrium, the percentage of demand in each country will remain constant. The price will change, the quantity will change, but the percentage that is being consumed by each country should remain constant.

But what happens if we observe this, like an orthogonal change, in that share of demand, if suddenly the US starts consuming more and Europe starts consuming less? That is definitely idiosyncratic shock.

It is not related to the general shock, it's related to idiosyncratic shocks in the US or in Europe. And that means that it's uncorrelated to the factor, the factor shock in demand. And that means I can actually use it to calibrate my supply. And that's a really, really impressive idea. And that was their first paper.

And on the back of that comes this paper where they look at the share, the transfer of equity, between different investors in the market. So, they're saying, if I'm trying to calibrate and see what happens if there's a dollar flowing into the US equity market, obviously the price will change. But how do I estimate the gradient?

The way I do it is I look not just at the overall value, I look at how this changes between various institutions, like pension funds, mutual funds, ETFs, and so forth. So, it's an amazing idea, really nicely done. And then you do the calculations and whoa, you get to sort of $5 per $1 flowing in.

And that's a really great paper.

Alan: 00:14:53

I noted it touched on this point in the paper, and it is something that you hear in the media as well, and there's two different views in it. People sometimes point to there's a lot of cash in money market funds. And they'll say, oh, this is bullish for the market because if this money came into the market, it'll push up the market. And I guess, if we're to believe this paper, if this money comes in, it'll push it up by a magnitude of 5, if that's the case.

But at the same time people say, no, that's incorrect because the market always clears. So, for every buyer there's a seller. So, if there's money coming in, there's money coming out. Now they addressed this in the paper, but I didn't understand their argument. So, can you explain why that's not the case?

Yoav: 00:15:45

I think the point is that not all assets are the same, have the same elasticity. So, if one were to look at the fixed income market, which is actually the money market fund, we have actually natural experiments. So, if I look at a very different market to the equity, so if I look at a period like GFC, if I look periods of quantitative easing or Covid, we have a natural experiment where the Fed comes into the market and injects money straight away. So. if I look at GFC, the balance sheet grows from US$10 trillion to about US$11 trillion. Okay, so there's US$1 trillion flowing into the market.

Now, did we see bond prices going up by 50%? Of course we didn't see that. So, we didn't see like a drop of 5% in 10-year yields. It just didn't happen.

Okay, so the elasticity of the fixed income market is much, much lower. The estimation is somewhere between 0.25, 0.5, maybe 0.75. So a much, much lower elasticity on the demand side. By the way, on the supply side as well. So, fixed income and equity markets are very, very different. They've grown. The US treasury market has grown from US$10 trillion at GFC, all the way to US$25 trillion about now.

Alan: 00:17:11

Yeah.

Yoav: 00:17:12

At the same time, the equity market has grown to US$50 trillion. So, you know, about twice the size, and the ratios remain roughly constant.

But you know, if I look at the supply side, where the price of bonds haven't moved at all, a bond is still worth a bond (like about $100, give or take). Okay, but the supply (thank you US treasury for supplying us with tons, tons and tons more of debt), that's a very different dynamic to the equity market.

In the equity market, we see about, I don't know, US$500 billion of issuance every year, thereabouts. Actually, a much, much lower level of issuance of new supply coming to the market because it's driven by real economy. There are just so many businesses that can come online in any given year. So, it's much more constrained from a supply perspective. And the way that the market has grown is actually in valuation. Which is what we've seen with the S&P. So, the idea behind…

So ,if you have a mismatch in the elasticity between these two markets, then you can actually take US$1 out of the money market fund and push it into the equity. And, lo and behold, what are you going to get? You're going to get maybe a little bit of a drop of price in the money market fund, but like a huge pickup in equities. Okay, so there is a mismatch in between…

Alan: 00:18:35

Yeah. But my point is whoever bought the equity bought it off somebody and they've sold, so they've realized a dollar. So, there's a dollar coming out of the market at the same time.

Yoav: 00:18:45

Yes, absolutely, absolutely, but there is actually, essentially… Well, the valuation will go up. I mean, it's not that there is any more value, like, there's not necessarily more value in the company. But it's just the question of the way the price will clear. The price will clear at that point.

Alan: 00:19:06

Yeah, I mean, the market always clears, which is the point. I mean, I always reconciled it in my own mind, from the perspective of the intensity of the buying and selling pressure. Because it used to be the case, when I started off in markets, you're sitting on the desk in FX, and you'd ask them, why is the dollar going up? And to say more buyers than sellers, that was always the answer.

Yoav: 00:19:26

That is the right answer.

Alan: 00:19:27

But actually, it's not right because there's the same number of buyers and sellers for every buyer there is a seller, but it's the intensity of the buying and selling pressure.

Yoav: 00:19:35

Yeah.

Alan: 00:19:35

The buyers are bidding up, and the sellers are holding back their offers. So I mean, I'm still not clear out what their explanation on that point is. And I do hear what you're saying. And they make the point in the paper that equity markets are, I suppose, inelastic because there's not… I mean, as you say, typically if the price goes up, in a lot of markets you get more supply. And you do get that, to an extent, in equities. I guess you get more equity issuance if the cost of capital has come down. But not a huge amount of that, I suppose, is the point. Isn't that it?

Yoav: 00:20:12

Yes, exactly. So, there is not actually a lot of supply coming into the market or not enough supply coming in to meet it. And by the way, the supply, it's almost independent of the price level of the equity market. So that's actually quite interesting. It is really driven by real life constraints.

Alan: 00:20:30

And the other point about equities, I mean, there's this idea in economics of, I think it's Giffen goods where, instead of demand going down when price goes up, the demand goes up when price goes up. I mean, equities are like that. I mean there's a wealth effect. So, psychology, people become more bullish when you see the price going up, but that's already in the literature. We all really know that. So, there's nothing coming…

I suppose what was different about this paper was this number, for every dollar coming in it's boosting the market valuation five times.

Yoav: 00:21:05

So, I've got to tell you, I actually don't believe that's the correct number. And let me tell you, I mean, the main criticism really is about what drives what.

So, what we see is we see for the analysis, the regression, is contemporaneous effect. So, we see US$1 flowing into the market and we see the valuation goes up by US$5. But it doesn't tell you what drove what.

And in that respect, here comes trend following. Can trend following explain at least some of this? The idea is, as you say, if equity prices go up, people will start pushing more money into equities. This is exactly what trend following is about. And if you look at the hedge fund industry, and if you look at CTAs in general, you can do the maths, US$300 billion under management in CTAs, that kind of translates into quarterly flows into equity prices going up of about 0.2% of the value of the overall market. And that's not far from the 0.6% that these guys are doing the analysis on.

And another proportion of that can be coming from, you know, mutual funds becoming, essentially, internally more trend following. They will start allocating a little bit more to equity, if it's going up. I mea,n these days nobody is like, oh, I'm going to stay out of the equity market.

So, I think there are a lot of closet trend followers in the QIS market, in the mutual funds, in the ETFs. People, like retail, will put more money in if the price of equity goes up. They understand it and they would invest.

So, it may be the case that not all of the $5 are to do with the market having to take that flow. It's actually the other way around. It's that, as a result of the price going up, we see flows into the market.

If you do the maths, I think the US$5 is actually a little bit excessive. But you know, we are seeing a little bit of a bubble in the equity market. So, maybe right now there is, actually, this amplification effect.

Alan: 00:23:36

Yeah. I only scanned the paper, so, did it talk about the time frame over which the US$1 translates into the US$5 increase? It's not instantaneous, obviously, it's over a period of time.

Yoav: 00:23:49

It's over a quarter.

Alan: 00:23:51

Over one quarter.

Yoav: 00:23:52

Over one quarter. So, the data that they use is flows of funds. They look at Morning Star data about mutual fund flows and they use the 13F filings. So, it's actually very slow moving data.

So, from our perspective, when I look at quarterly changes in active funds, both long/short equity, macro funds, and CTAs, there are a lot of flows that actually are of similar size and they will happen as a result of price change during that quarter. So, I think there is a little bit of work needs to be done on the paper. But it's a really amazing methodology and they've been very helpful. I've written to them and they've written back, and they've been very helpful in this discussion. So, a really big thank you to them.

Alan: 00:24:47

Yeah, I mean, obviously if it is the case, it would have policy implications. I mean, they talked about this… their reference in the paper, you know, central banks buying equity indices directly, like in Hong Kong, and we've had it in Japan buying ETFs. But equally, that's the whole point of QE as well, or at least it's one of the rationales for QE is that you get this portfolio transmission effect from safe bonds into riskier bonds and then ultimately into risky assets like equity.

So yeah, I mean, if it was a given that this number is correct, you would think it might caution central bankers about so much QE.

Yoav: 00:25:27

Yeah, so, absolutely. Well, I think there's a moral hazard here galore. But from a practical implementation, if you're only getting US$0.25 of US bonds as a result of putting US$1 in, it might be more effective to put US$1 into the equity market. But, you know, to me that smells of a huge moral hazard. And really, I mean, it's almost illegal in some countries, being able to run your own stock, to inflate it artificially. So, there are implications certainly. But of course there are also moral implications of doing it.

Alan: 00:26:09

Yeah, I mean, you talk about some of the kind of implications, say, for trend following, and how different markets will have different elasticity of demand and supply. So, in this case we're talking about low elasticity of supply in the sense that, as the price goes up, you don't get new supply coming in, not very quickly anyway.

I mean, we talked about bonds. I mean if the price of bonds go up, and yields go down, we have seen more debt being issued. So, there is a bit of elasticity of supply there. So, what I was going to get to is, should this impact on how trend followers think about trading different markets given the different characteristics?

Yoav: 00:26:54

Oh, absolutely. I think there are a couple of things. So, the first thing is, if the market is more elastic, it will have lower volatility. And we see that again in bonds versus equity that bond volatility is lower than equity volatility.

But I think, from a trend following perspective, you really need to understand the dynamics from the purpose of what is the delay for the market to find a new equilibrium? And here you have a huge difference between financial assets and physical assets.

So, if we look, if we look at the equity markets, we can look at the impact of how quickly does the market reach the new equilibrium and reverses? Actually, we see the rebalancing effect of that.

We can see that in the ETF market. So, if I look at shares outstanding in ETF market, you see a very strong negative auto correlation on the weekly scale. So, the idea is, the money flows in, and then there's some rebalancing, and a little bit flows back out. And that negative correlation is a very fast process in the equity market. So, equity markets maybe have a high multiplier and low elasticity, but they're very quick to adjust.

What we see in commodity markets is a complete opposite. So, we have a demand which is very inelastic, and we have supply which takes a long time to, to provide. If you need to dig more copper, if there is more demand for copper, and you need to dig it, it takes time. There are cost curves for the manufacturer and also, it's a dynamic which plays itself out over a year or even more than that. And we see that the point where the price becomes negatively autocorrelated is like a year out. Because, you know, the decision to switch from planting wheat versus rice is a decision that will play itself essentially for the next year.

So that delay between supply and demand basically means that price will have to do the work over an entire year. And that means that you are looking at a sort of a prolonged trend and that's how you should harvest it.

If you're looking at equities, you've got a lot of like intraday equity trend strategies, because that process is much quicker in the way the market finds its new equilibrium, it’s a much quicker process.

Now, I'm not going to tell you how to run your trend following, but in some sense there is a frequency, which is actually not a good frequency where you are sort of stuck in the mean reversion area of that process. And that will vary depending on the nature, the physical nature of the market. Certainly in commodities, it's really, really important.

In equities, I've got to tell you, it's a really complicated process and it also depends on what the company is and what the underlying stock is doing. So, unfortunately for trend followers, our life is not easy. Making money out of the market is never easy.

Alan: 00:29:58

Yeah, but generally there had been a sense that maybe you should have the same model in every market, and then obviously some trend followers do deviate from that, but it can be a controversial decision.

But I think there was also a research paper from the two Moritzs, a while back, looking at the cocoa market or kind of inspired by the cocoa market, and a question on this topic, are some markets slower to adjust because it takes longer to plan? In some markets, obviously, you get quick, faster substitutions, say, between soybeans and corn, etc., stuff like that, but, you know, presumably less in other markets. I mean, then, would that suggest you trade all of the commodity markets at different speeds depending on their characteristics?

Yoav: 00:30:44

So, we already do. Okay, so the mathematics of the signal may be the same. So, suppose you're doing EWMA, crossover, that should be fine. Stick with what you know. But we already trade markets at different speeds because the cost. So, normally when we look at the market, we normally look at the cost of trading and if the market is expensive to trade, we will tend to trade it slower.

Okay, so, the speed at which you trade is already a function of something in the market. And, in some sense, the liquidity is also reflecting some nature of the underlying physical market.

But I think it is important to recognize that there may be a tilt in speed that, when you observe it, it's not necessarily driven purely by, “Oh, it is completely accidental that the two week trend has historically underperformed the two month trend.” Sometimes there is a genuine reason why the two month trend actually is better suited to the underlying dynamics of the physical commodity that you're trading in.

Alan: 00:31:59

The other thing that comes to mind, in relation to this research paper and the kind of the fivefold change in value, I mean, did you talk about has that number changed over time or has it been growing, I wonder? And also, from the perspective of if and when things go in reverse and money starts to exit the market, will we have a more amplified downturn? I suppose is the question, yeah.

Yoav: 00:32:23

So absolutely. I mean, the implication, again from a policy making perspective, is that if things start going south, we are heading for a bit of a roller coaster ride. There's no question about that. The data is quarterly, so it's not like you can do a lot of variation.

start something in the early: 2000

But I think one of the key areas where, to me, is an indication of inflationary process at play is when I look at that correlation between equities and bonds. So, we talked about moving that money. And the effect, when you have an inflationary process like 5x on the equities, is actually that you can actually even sell a little bit of equity and push it back into the bond market and actually push the price of bond markets as well.

So, I think, when there is such an important asset class which is undergoing an inflationary process, I would have expected to see a positive bond equity correlation. And of course, we haven't seen it until the last two years, but we are seeing it now.

So, to me, that's also a little bit of a warning sign that under the hood there may be some process where we have a spillover of valuation from equity market to the bond market.

Alan: 00:33:58

Of course, yeah. So, I guess if the equity market goes up fivefold in value, and you have a rebalancing effect for everybody who's running bond equity mandates, they have to sell some of that equity and it rebalances the bonds, isn't that it?

Yoav: 00:34:11

Yeah, exactly. So, that's exactly the process. In fact, any rebalancing process spreads the value from, let's say, from one stock (if you're putting money into one stock) into the other stocks, which are maybe trading value stocks or maybe in the same industry.

So, that process, that RV process, pushes money; that rebalancing process pushes money to the nearby stocks, but it also pushes it onto other asset classes. So, it's kind of worrying. At the moment we are seeing the positive correlation.

Alan: 00:34:44

So, I know you've written a blog about this paper. I mean, what was your takeaway? Or I mean, in summary, what is the most relevant thing? Obviously, it's a stark number. If it's true, it really frames things quite bluntly.

Yoav: 00:35:00

So, my takeaway number is that I suspect the number is actually lower. It may be a little bit above one, but I suspect a lot of it is to do with actually prices driving flow, to my mind. So, I'm not 100% convinced that US$5 is the right number.

But I think the willingness to depart from the efficient market hypothesis, and thinking exactly about the buying pressure and the selling pressure in the market, the way that order books clear and there is a buying pressure and that will translate into what we think about as permanent slippage but they think about in terms of long term valuation changes. I think that is much closer to reality than the efficient market hypothesis. And that's definitely to be recommended.

Alan: 00:35:58

You brought a few different papers and the second one we wanted to get into was one which we've probably touched on, maybe going back a few years. But it's very interesting paper from the team at Man about the best strategies for inflationary times. Any reason this is back on your agenda at the moment?

Yoav: 00:36:21

Well, I mean I wish I knew what's happening to inflation. If the US shutdown ends and we might actually get some numbers… But I always like to look at things that actually work very nicely out of sample. (And maybe if we get it to the third paper we can talk a little bit about ‘out of sample’). But I looked at this inflation paper because, again, interest rates, we seem to have gone through a cycle. We've reached the peak, we're coming down, and to me the question about where is inflation going and have we conquered inflation or if the Fed is very happy with inflation being like where it is right now, that is of importance to me. And this paper is by a chap who I really like, and who is also a personal friend. That's because I was working with him at Man. So that's Otto, Otto Van Hemert.

is paper was published in May: 2021

So, he was talking about what strategies are good during times of rising inflation and high level of inflation. So, at the moment inflation is not particularly high. It's, of course, higher than 2% but the question is what's going to happen if inflation starts picking up again?

And he's looking at which asset classes are going to do well, equities or bonds, real assets, gold, real estate; but also which type of strategies actually perform particularly well. And again, I Think this is related to our discussion about equity and bond equity correlation.

So, you know, one of the observations that he makes in the paper is how does each asset class correspond to a contemporaneous increase in inflation. And, in terms of bonds, it's always bad. Higher inflation generally means lower valuation of bonds because the yield is to rise.

In equities, it's a much more nuanced view. So, if inflation starts picking up from a low level, that's actually quite good for equities. So, you kind of want a little bit of inflation in the system to basically ramp up yield demand and ramp up the valuation of your underlying asset. Conversely, if you start from a very high level of inflation, from above the median level of inflation, then a rising inflation is bad for equities.

So, that's actually, from our perspective, actually important at this point in time. So, if we see interest rates essentially staying where they are at the moment, and we start seeing a pickup in inflation, actually, equities are not too bad, which is quite good.

But from a trend perspective, of the nicest observation that he makes is what trend strategies are likely to do well and is looking at commodity trend (which is not surprising). Inflation and commodities are very much linked together, being sort of a physical asset. And to me, what was quite surprising is fixed income. And of course I'm trading a fixed income trend. So, I was like, oh, that is nice to see.

job going back all the way to: 1925

he got it completely right in: 2022

Alan: 00:41:08

you say, the results were, in: 2022

Yoav: 00:42:04

Exactly, and it was very surprising. I mean a lot of people write off trend because you go down the stairs when trend goes wrong, so to speak. Where, actually it's not because there isn't any trend, it's because the percentage of trends in the market is slightly lower.

So, if I think about the hit ratio of how many markets are trending well, well enough for us, as a manager, to make money, what you find is that we just need about 40% hit ratio to sort of break even and start making money. And the last couple of years have been tough because we've had a hit ratio of 30% maybe.

So, it's not that there aren't any trends, there are still trends in some markets, cocoa, coffee, gold and so forth. But it's just the percentage is slightly lower. And that has been very tough. But the way that we die is that we die by a thousand cuts.

arly well. So what you see in: 2021

Alan: 00:43:37

It's interesting, I mean, I guess for us in the managed futures industry, the kind of inflation protecting aspects of managed futures and trend following are well understood. We know about papers like this, but you know, when I speak to investors working with different groups, very often that doesn't feature so strongly that characteristic.

I mean, obviously people might allocate to trend following for diversification, for convexity, for crisis alpha, et cetera, but then they may have a real asset book where the focus is on inflation protection. I mean, what's your experience around that? Do you find investors using managed futures for that purpose?

Yoav: 00:44:26

So, it's actually quite rare. I think your point is exactly correct. And it's actually very surprising because quite a lot of mandates are inflation plus 4%. So, if you speak to sovereign wealth funds, or if you speak to pension funds, a lot of the time part of the mandate is inflation. And what they fail to appreciate is that if we do see an inflation pickup, it's actually not necessarily the tips that will give you the inflation protection. It's not necessarily real estate that will give you protection, but it's actually the active strategies that can move into that universe and take advantage of, let's say, a rising commodity. So, a CTA with a high commodity allocation will do extremely well in periods of rising and falling inflation.

So, it's inflation volatility which is important to us, and that is related to, essentially, channeling uncertainty in the market on where prices are going to settle.

Alan: 00:45:27

Yeah. The other thing I wanted to just touch on, I mean, they have a table in there of all of the different kinds of assets and strategies, and you have commodities (general commodities), commodity energies, trend, all assets, etc. Now, obviously, the one that historically has done best has been commodities - energy.

Yoav: 00:45:44

Absolutely.

Alan: 00:45:45

And I think if you were to, I mean, from the research I've done myself, commodities, in general, have done better than trend in these periods, but then they will suffer more, bigger losses in the other periods. So, I mean, trend following has that ability to do okay in the other periods and still provide the protection in the inflationary periods.

Yoav: 00:46:09

So, if you look at commodities as an asset class, it actually drifts down. There is a cost for holding a commodity because you've got to store it, you've got to finance it. So, generally, if you look at a total return of holding a commodity asset, it’s generally downward sloping because there is a built-in sort of storage yield and all of these which kinds of needs to be financed.

So, it's the same, by the way, in terms of VIX. The VIX might be oscillating but actually holding the VIX you're actually, losing a lot of theta. So, holding, just being sort of a long only a commodity, may not be the solution for an inflation product. Unless, as you say, you have a downside. And I think people fail to appreciate how beautifully trend responds to inflation.

And by the way, inflation, as a risk factor, is a much more slowly changing risk factor versus equity. So, in terms of protection, if you think about the equity protection that you get from a CTA, it's a little bit uncertain because a crisis in equity can manifest itself over two days. And if we have a trend follower who is trading on a two month horizon, you're just not going to get that protection.

It's not the first responder, it's the second responder in the equity market. But when it comes to inflation, inflation is a much more slowly evolving process and that really plays very well with the speed at which CTA's trend. So, it's not just that we are exposed to the factor, it's also that this factor is actually evolving in a speed which is much more relevant to the speed that CTAs trend. So, people kind of fail to appreciate that.

Alan: 00:47:58

that well, and we saw this in: 2022

So, even though those assets may may preserve their value against inflation over the long-term, in the midst of the inflationary episodes, they may not be optimal.

Yoav: 00:48:35

Absolutely. And that's actually the same with bonds with TIPS. So, if you have long dated bonds, they've got two risk factors built in. You've got both the inflation exposure but also DV01 interest rate exposure. And the two factors are playing against each other because higher inflation corresponds to also higher yields, which means like the DV01s you will suffer. And inflation linked bonds, they're top heavy, so to speak. Most of the of the cash flows are at the back, towards the maturity of the bond.

So, TIPS will suffer because of the interest rate exposure and housing will suffer because of higher mortgage rates that will, basically, really depress the market. So, high inflation is not necessarily alleviated by real estate holding.

Alan: 00:49:26

Yeah, very good. Well, it’s definately one of the better papers around. I think it won one or two awards, as I recall. I can't remember which ones but it definitely is a very well regarded paper. So, if anybody hasn't read it, it's from Otto and the team at Man AHL, the Best Strategies for Inflationary Time.

one came out, I think it was: 2017

Yoav: 00:50:07

So, I think one of the problems, actually, with the QIS is that there's not a lot of data out there. So, I'll tell you the story of how I came to see this paper.

So, suddenly, like in the last couple of months, I see QIS hitting me in multiple situations. So, I had one allocator came to me and says, we are thinking about this particular QIS index. Would you mind having a look, tell us how it relates to you? What do you think of that? It's a liquid trend following product and, you know, we value your opinion.

Now we don't mind doing that because we are very much at the very illiquid side of the sort of the assets that we trade. Our correlation to the liquid universe is around 25%. So, we really don't mind. We're not really competing with the liquid trend offering. So, I said, yeah, of course. I'll have my opinion, you know, it may be good, complementary to what we're holding.

So, that was my first QIS, this last two months. Another one was a consultant, and he came to me and he said, well you really need to articulate the added value. People are coming to me and saying what is the added value of CTAs over and above those QIS products? And that's a really great question. It's a really good question and I think people need to…

By the way, the third QIS incident, of course, is last week. So, let me plug in last week's TTU where Moritz and Nick Baltas, from Goldman Sachs, were talking about the QIS market as a whole. And that's a huge market, right? It's like somewhere between US$300 billion and US$600 billion, depending on how you measure it.

So, like a really chunky market. And I think it is our responsibility, as hedge fund managers, to really justify what we are doing, and what's the added value over these QIS products. And on paper, I was trying to get some data on the QIS products. And I think one of my initial reactions is it's actually very difficult. Like if I have the SocGen index, there's actually, you know, the information is out there.

If you have traded funds, if you have ETF trend following, you see the performance, you can make some judgment, you can see what's going on. With QIS products, each bank will be slightly defensive about what they are running and they will be running a lot of indices.

So, it's very difficult for us to actually assess, to make like a bird's eye assessment of that industry. It's very difficult for us. So, the only paper that I was able to find is this one, and even this one I had to ask as a favor from somebody. It took me some time. I spoke to somebody from Barclays to help me find this paper. And I was actually a little bit surprised, to be honest.

And the reason I was surprised is actually panel B, in Exhibit 3 (if you're reading this paper), which is really the haircut. So, let me tell you about the paper. The paper is looking at 200 odd beta like products.

Alan: 00:53:40

So, we're talking about carry, and trend, and, I mean, they call it alternative beta, but alternative risk premia would be more a typical name.

Yoav: 00:53:49

it going back, you know, from: 2000

And then they look at a collection of 200 funds, QIS products, classified by the type of strategy that it's running, and they look at the haircut. And the average haircut is around 60%. So, you think your Sharpe is 1, but actually the Sharpe you're getting is 0.4.

Now I've got to tell you, within a hedge fund, like when I was at other shops and a new strategy came along internally, when it comes to allocation we were equally suspicious of new strategies. So, the backtest would have been 1, we would have applied a haircut of 50% before we allocate to that strategy.

So, suspicion is a good thing. But it's kind of interesting to see that realized. The thing that surprised me is the haircut on strategies that I thought were kind of well known.

So, we're sitting at: 2017

Alan: 00:56:01

Yeah.

Yoav: 00:56:02

And I think once I've sort of ruminated on it, and I actually looked in the specific index, the QIS product that I was asked to look at, it sort of came to me because what's happening with trend is precisely because it is actually well understood that the value of the overall performance comes from the envelope around how you put that model together.

So, we all know that like the trend following, you know, it's not really in the signal. The signal is actually going to be fairly well known, and actually it doesn't really matter which particular signal you're looking at that is going to give you, let's say, a Sharpe of 0.2 in the market. So now the question comes about, how do you put together a portfolio of those? So, portfolio construction is important. How do you manage the risk of that portfolio to make sure that you do get the diversity? That is very important.

So, for example, in the QIS index that I looked at by very well respected name, and actually not a bad product at all. A really good paper, really good maths, but if you look at the returns it’s very spiky. And that, to me, is a sign that the risk management isn't necessarily like cutting edge. It may be okay, but execution, this is really important, especially in those alternative markets. But can you add value through execution?

And you have to realize that the incentive, for example, on execution is very different for a hedge fund than it is for the QIS product. Because the QIS product makes money out of flow. I mean there's a lot of good stuff that they do, but the way they make the money is they net the flows internally between the multiple flows internally. But this is important to them.

So, I think it's because the alpha is not necessarily in, “Oh, I've got a better signal than you. I've got a machine learning trend following signal.” It really is about how you put together a portfolio. This is actually what makes a fund a better product with trend following. And I think that is partly something to do with why, even for strategies which I thought were very well understood, like carry or trend following, you see this haircut in performance in the QIS products.

There's a place for everything. And QIS is a great industry. There's a lot of things that they offer that we do not offer. So, anything from very quick customization to technology. It's come a long way in terms of how well they are being put together. But we should remember that the incentives of the researchers and the experience of the researchers in putting together a fully fledged sort of product which stands on its own is slightly different from the QIS product than to the hedge fund industry.

Alan: 00:59:25

Fair enough. I mean, obviously the attraction for many people is the cost, so fees are generally lower.

Yoav: 00:59:33

Absolutely. I think that if you're trying to put together an exposure to a risk factor, and by the way, it's not necessarily static allocators, but like hedge funds.

Alan: 00:59:46

Yes, yeah, well, a lot of platforms are using these now.

Yoav: 00:59:51

Absolutely. If you think you can manage it actively and you want exposure. And it's very difficult for volatility, it’s very difficult. You have to put in the work to actually make it happen. So, I completely understand the attraction.

And from a capital efficiency, you get a very capital efficient solution because, of course, JP Morgan, or Morgan Stanley, or any of these products, they're able to net all those QIS products that they're offering and they can offer very effective margining.

So, there's a lot of good quality and good reasons why you might want a generic, you might consider it as a good like stocking filler (we're talking like you're coming up to Christmas).

Alan: 01:00:42

Yeah, yes.

Yoav: 01:00:43

Absolutely. And it's a good thing. But you should realize that, first of all, the incentives on execution are different. The alignment of their fund manager with you is different. And you know, for better or for worse.

But if you want a very low-cost solution, that may be the way for you. And it's very quick and it's customizable. You can say, I don't want ags, I don't want this. They will do it for you straight away. It's really, really good.

Alan: 01:01:17

Very good. Well, it's an interesting one and definitely worth checking out as well.

It's a paper that has been around a while if you can get your hands on quantifying back test overfitting in alternative beta strategies. So going just a bit over the hour, but Yoav, great to have you on again. Yeah.

So always interesting to see what research you're, you're reading and working on.

Yoav: 01:01:45

It's really appreciated, a real pleasure and speak to you soon.

Alan: 01:01:50

Yeah.

Well, Niels will be back next week, so if you have questions for Niels, please send them in.

But from all of us here at Top Twitter's Unplugged, thanks and we'll be back again soon.

Ending: 01:02:01

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.

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