Today, we explore what it means to invest in a world defined by volatility, uncertainty, complexity, and ambiguity (VUCA). We discuss why geopolitical shocks... especially supply-driven ones... are creating persistent trends across markets, and why trend-following strategies are thriving despite strong equity performance. The conversation dives into how investors process information (or fail to), the limits of central bank responses to supply shocks, and why markets may not be fully pricing in current risks. Mark also shares new research comparing hedge fund strategies under different volatility regimes, highlighting why managed futures stand out as a robust diversifier. The episode closes with a forward-looking discussion on AI, replication strategies, and the growing role of narrative versus data in investment decision-making.

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Episode TimeStamps:

00:00 – Introduction: Preparing for the unpredictable

00:36 – Entering a VUCA world: volatility, uncertainty, complexity, ambiguity

02:00 – “Uncharted territory” in markets and beyond

05:30 – Central banks, leadership changes, and policy uncertainty

07:16 – Oil markets, OPEC shifts, and geopolitical tension

10:16 – Trend-following performance update and market context

14:06 – Reverse engineering CTAs and the role of AI

18:42 – Replication strategies vs. true alpha

22:41 – Trend-following performance metrics (April update)

24:43 – Supply shocks and why they’re harder to manage

28:53 – Are markets underreacting to geopolitical risk?

31:53 – Information overload, ambiguity, and trend persistence

34:54 – Why more data doesn’t mean better decisions

38:34 – Government intervention vs. market-driven trends

40:30 – Pandemic policies and unintended inflation

43:00 – New research: hedge fund strategies vs. volatility regimes

47:16 – Why managed futures stand out as diversifiers

51:11 – Narrative vs. data in investment decisions

55:36 – AI, sentiment analysis, and the future of models

58:46 – Simplicity vs. complexity in strategy design

01:00:49 – Bundling vs. unbundling investment strategies

01:03:18 – Momentum crashes and new research directions

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Welcome to Top Traders Unplugged. In markets success doesn’t come from predicting what happens next, it comes from being prepared for what you can’t predict.

In each episode we go deep with some of the world’s most thoughtful minds in investing, economics, and beyond to understand how they think, how they prepare, and how they decide, and the experiences that shaped how they see the world. No noise, no short-cuts, just real conversations to help you think better and invest with confidence.

Welcome and welcome back to this week's edition of the Systematic Investor series with Mark Rzepczynski and I, Niels Kaastrup-Larsen, where each week we take the polls of the global markets through the lens of a rules-based investor.

Mark, we've got a pretty good, very solid actually lineup of topics that you kindly brought along. It'll be exciting to get into that. And before we do so, I'm always curious to hear a little bit about what's kind of come across your desk in terms of maybe other topics. we're not going to talk about. Is there anything you found interesting in the last few weeks? I've got a few observations, but I'd love to hear whatever has caught your attention.

Well, you know that I've talked to you in the past about being in a VUCA world. You know, it's volatility, uncertainty, complexity, and ambiguity. And we're living in a VUCA world now. And I think that's going to be what our discussion for the most part is, that we're living in uncharted territories.

And the question is how do you navigate that? Especially if you might be a quant investor, how do you navigate this kind of environment? So that's what has been the focus of my attention, especially for the last couple of weeks.

Okay. So, I'll throw in a few observations, myself, that I’ve noticed, let's put it that way. But they're kind of on the same line, in terms of uncharted territory, when you mention that word. One thing that caught my attention was the new record set in the London Marathon; less than two hours.

I mean, I don't know if you've seen the guy running that, and anyone who was close, but they run so fast. I mean, literally, they're like sprinting. In my world it's like sprinting, and they do it for two hours. And I think even the guy who came second, he was like a world record, but he only got second place. Which is kind of crazy to think about.

When you really think about it, are there bounds by which we could behave, let's say physically, mentally? And it seems like we're constantly challenging those outer bounds.

Yeah. I mentioned to Cem last week, when we were on, in ‘what's been on my radar’, I mentioned actually that there was also, now, a record in terms of a robot now running a half marathon quicker than any human, which is also kind of uncharted territory.

Right, right. I've seen those…the dancing robots, and the robots chasing boars. I think there's a meme out there that we want to show robots as becoming more and more human.

Yeah. The other thing that's somewhat uncharted was just a headline. There's no focus, specifically, on the firm. And so, maybe I shouldn't mention the firm, but there was, I think, the biggest redemption (at least that I'm aware of) in the hedge fund world, very recently, where there was a client who redeemed US$6 billion from a hedge fund. And the name will remain unmentioned, but I mean, that's a massive redemption to receive on your fax one morning, I imagine.

Well, I think that, as investors, over the time that I've been working in the investment world, investors have become more and more sophisticated, and as their sophistication has increased, they demand more from the managers that they invest with.

And so, you know, I think that there's competition across firms, but then there's also the competition of just meeting the expectations of investors, and it's pretty high because they're fairly sophisticated themselves.

It is a very interesting precedent because usually, if you're done being chairman, you might still have extended time on your appointment, but you don't go back to being just a member. So, this is somewhat unprecedented. Most people sort of say I should just resign now.

I think that while everyone focuses on Powell, and this won't be the focus of our discussion today, probably my discussion with many smart investors has been what kind of Chairman Warsh will we have? Are you going to have the Warsh that's sort of following a Trump lead of lowering interest rates?

Or are we going to have the Warsh of the past who has been somewhat negative about quantitative easing and thinks that the Fed balance sheet should be shrunk? That makes a huge difference on what kind of Warsh you're going to get and it makes a huge difference on how markets will behave, if we really have a Fed Chairman who believes that the balance sheet is too large and is going to have to be shrunk.

Yeah, absolutely. I guess the final thing I noticed, that I guess you could also say is in uncharted territory, was the fact that the UAE left OPEC. That's kind of an interesting development as well because they're not a small member, so to speak. So, does that mean even more volatility in that sector? I don't know.

That, again, is a very dynamic environment. They do have a pipeline that avoids the Straits of Hormuz. It can handle up to, some people say, 2 million barrels a day. That has been reported to be a little high. It might be about, you know, 1.5 million barrels, but that's a big number. And so, they're going to say we're going to push out as much oil as we can, while this crisis is going on. Because we can.

Yeah, exactly. I think that that's what the speculation is, that if they're not a member they can even put out more. However, they still need to get it out physically, so to speak. So, if the limitation is the pipeline, then I'm not too sure how much more they can pump. But I'm not an oil expert, so I will leave it with that.

Speaking of oil, Mark, let's get into some trend following update. You and I are speaking on the last trading day of April, and if all goes well for the next eight or ten hours or so, it looks like it's a pretty good month for trend followers and CTAs. In fact, and I haven't checked this, I would not be surprised if the SocGen Trend index makes a new all-time high. I would not be surprised if a lot of CTAs are going to end the Month at a new all-time high.

So, among all this turbulence, among all this uncertainty, even though it also is a very strong month, as we will learn in a second, for equities, these strategies are coming out pretty strong after of course, March, which was, you know, a correction month because of the “surprise attack” in the Middle East.

But I guess it just reminds me that sometimes, you know, people want to pin down the strategy as something like, oh, it's a crisis alpha, or it only makes money when everything else goes pear-shaped. But you know, we should stop and also just take note of the fact that even in one of the strongest equity months we've had for a long, long time.

Actually, it's also pretty strong CTA month and, of course, performance which, at least from my vantage point, looks pretty broad-based in terms of sector participation, despite the fact that we can't get around that the energy sector is most likely going to be dominant. And of course, there are some complete outliers in terms of people with massive oil exposure who are up significantly this year. But as an industry it looks pretty good.

What have your observations been so far?

Well, you know, we've often talked about the Goldilocks conditions for trend following in the sense that you can't have it too short, it can't be too long. But what we do find, from all the research we have, is that the more that you have a length of some type of crisis, the longer the length on the crisis, the time that we're in crisis, the better it’ll be for a trend follower.

This is now playing out as we move through time. This crisis lasts longer and longer. Then it allows more for the price behavior to be displayed in trends so that the trend follower could take advantage of it.

Yeah, what's interesting to me about it is that yes, March was certainly a month where we had to trim equity exposure because of the reversals. It probably, for some managers, meant getting out more or less completely.

It also meant, maybe for some getting slightly short, but also for the many longer term trend followers they remained long. There are a couple of things that I noticed. One is that there has been a flurry of predictions, let's call it that, by the investment banks.

And I have to say, I mean Goldman Sachs has been quoted a lot about this, and that is about these, you know, all CTAs are going to buy US$86 billion worth of equity exposure in the next week, or they're going to sell. I mean, all this speculation about what managers are going to do.

When I see them come out, and maybe they're not the ones putting them in the media but they are producing these observations in the first place for the media to distribute, guess. It kind of boggles me, a little bit, that there is so much attention on it and often it's not very accurate, at least when I look at how we are changing our exposures and positioning. So, I don't think it's very useful information. But it certainly is something that has caught the attention of many.

What has got my attention is more, actually, the changes within, I think, the CTA space and that's to do with fixed income. It looks to me like fixed income positioning did change in March to the short side and that we've kind of been building on that and with, you know, recent expectations to an ongoing conflict, you know, inflationary pressures are mounting. Maybe we'll talk about that later as well.

But I think that's been the big change. Maybe, to some extent, also the dollar exposure might have changed as well, but certainly fixed income. And fixed income has been difficult for trend followers for quite a while. You know, long/short exposure, changing every sort of six, eight weeks. So, not an easy sector. But we'll see if this one is going to stick around for a little bit in terms of more downwards pressure on fixed income prices and upwards pressure on interest rates.

Now Niels, this whole issue is very interesting because, I guess, one of the problems with aging is that you remember from things from the past in your career. And I will sort of say that, you know, prime brokers, brokers in general have, for decades, been trying to reverse engineer trend following programs in an effort to sort of say can I understand what they're doing or when they're going to enter the market or when they're going to exit. So, this is nothing new.

What is new, and I think that is important, is that people are now using more AI to help them with this reverse engineering. In particular, there's been some recent work, it was an interesting paper called Mimicking Finance.

And what they did is they said that it took a lot of portfolio managers and they said, well, I'm going to sort of create agents, AI agents to try to replicate their behavior. And what they find out is that oftentimes they could get about 70% plus of the behavior of managers by using some AI agents to describe training strategy and behavior. What they find is that even though they could replicate it fairly closely, their performance is generally under the best managers.

And what they find is that the best managers are fairly dynamic, or that they have, they have rules or behavior that is hard to mimic. So you can mimic the average, but generally, you're going to underperform, but you can't mimic the best managers.

Well, the last line kind of goes to a point that I respectfully made to one of Andrew's colleagues who was posting about their returns and comparing that to (I would say not very that super relevant, but I'm biased, let's remember that) not the best indices that I could think of. If you want to compare yourself to that - some Morningstar type trend following systematic.

It's not really the indices that I would compare to. But anyway, I mean, the whole thing about replication, I wonder do you really need an AI nowadays to do that? If you can just look up the replicators positions in the ETF space every single day, do you really need an AI for that?

I know why they're trying to do it, but it's kind of funny. I mean, wow.

Now part of that is that you actually bring a good point. And this has been another ongoing issue, do we need the added complexity? And you actually had this in one of your past TTUs. What happens when we add more complexity to models? Do we really get an advantage?

So, with hedge fund replication, the idea is, since AI agents can actually sort of be used to include non-linearities, include other behaviors, can you improve it? The question is, how do you compare that against hedge fund replication or replication strategies that are simpler?

In general, because I've worked in this area a little bit in terms of research, the hard part for replication is capturing the non-linearities associated with trend following behavior. And what do we mean by nonlinearities?

If I'm looking at some replicating a moving average strategy, I'm not saying it's easy, but it's relatively easy. The hard part is that, when you think about a lot of managers who use breakout systems, a breakout system is somewhat nonlinear in the sense that you're dormant until you see a move in the market, and then when that move reaches some threshold, then you'll kick in with positions - somewhat non-linear. The non-linearity is the hard part in hedge fund and, we'll call it, trend following replication.

Yeah, I mean that brings up a good point. Not that it was one of the points I had expected to discuss with you today, but I mean, as you know, I voiced my concern about the narrative about replication being simpler than what we do. On the other hand, I completely agree with you that, in my opinion it's not quite the same that they capture.

But I mean, it is interesting what you mentioned because I don't know that many CTAs of the larger ones still use breakout. Actually, I think we, as an industry, have moved towards more continuous signaling. And the reason I say that is I see some of these, you know, they're not small but they are smaller managers where I do think they use sort of breakout type style and then they also use some very different risk management techniques, much more static position sizing.

Some of them are shooting it definitely, out of the park at the moment, this year, way above anything that replication will capture. On the other hand, we obviously have to recognize that replication in the relatively short period it's been around has kept up overall performance wise and in some cases also outperform the indices, but not necessarily. And that was the point I was making to one of Andrew's colleagues.

Not all. It certainly hasn't outperformed some of the best managers. And obviously, I can just look at our own equivalent funds and there was no outperformance. In fact, there was much more downside volatility and drawdown in the replicator in comparison. So, I agree with you.

I think for me, what the conversation… (and I don't have the skills or the time to kind of dig deep enough into this) I think what the conversation lacks is that we kind of just conclude that, just because the performance looks the same, it must be the same. But this is where I just don't think that is true.

And even with a correlation of 0.75, 0.8 I still think that doesn't prove the point about, oh yeah, we can just easily replicate these managers, and we do it in a more efficient way, so we will always outperform over time. I just find it so difficult to buy into that narrative.

Well, two important points are, when I use the word breakout system we'll probably say, no one's going to walk into an office of an investor and say I'm using a breakout system. That's more of a catch-all for threshold-based or trigger-based signaling.

So, in the sense, instead of having a continuous signal, there may be some threshold by which you'll take action and then a threshold where take off action. But in a replication issue you could have a pretty high correlation but you could still have a negative beta relative to the set of managers you're trying to replicate.

So, correlation may not be the best guide for a replication strategy. And going back to basics, it's that alpha component that is the intangible that's not being picked up by some factors which you can't replicate and is also what people will be paying a premium for in terms of someone that will, they'll be willing to give money, they're willing to pay fees, and pay the incentive fee.

Yeah, absolutely. Mark, I'm going to give a quick trend following update. As I mentioned, it's a strong month, so far in April, and my trend barometer yesterday closed at 55. So, that's pretty solid and I think that reflects well the performance we're seeing at the moment, as of Tuesday, 28th April.

And by the way, I think yesterday was another positive day. Maybe not a huge day but a positive day. We have the BTOP 50 index up 1.84% in April, up 9.46% so far for the year. SocGen CTA index up 2.31% in April, up 9.92% for the year. SocGen Trend, very similar, up 2.45% for April, up 9.71% for the year. And the Short-Term Traders index up 56 basis points, and up about 5% so far this year. The British Alternatives (which is a flat fee trend following index of fewer managers) up 4%, as far as I can tell, in April up 12.39% so far this year.

MSCI World, as I mentioned, it's a great equity month, up 8.35% as of last night, up 4.59% for the year. The S&P US Aggregate Bond index pretty flat in April, and pretty flat so far the year-to-date, only a few basis points. And The S&P 500 Total Return up a whopping 9.37% in April and up 4.63% so far this year.

All right, Mark, we are now at a point where we're going to talk about your very long list of topics and I'm completely at your mercy where we're going to go with this. But it is somewhat geopolitical in its flavor, as far as I can tell. So why don't you take over and, and tell us what we're going to learn about today?

Well, it's geopolitical in its flavor only because geopolitical events are what has been driving the markets. Obviously, we just talked about the performance of trend following and we see that as this geopolitical event in the Middle East, as it extends, then what we're going to see the chance that dislocations are going to have stronger effects, longer effects, and is then going to be displayed out in prices.

So, a perfect example is that we had a shock to oil prices. There are some reversals at different times based on comments that were made, but surprisingly the markets have stayed higher. If you got long early in March, even though you're facing more volatility, you've done reasonably well.

The other thing that's important about this particular event is that it is a supply shock. And we'll sort of say that the global economy has difficulty with supply shocks over demand shocks. And the reason why is that with a demand shock, central banks are pretty… the playbook is pretty well scripted, we lower interest rates, boost demand, we could then be able to reverse the problem. It could be on the fiscal side, certainly on the central bank, monetary side.

But if you have a supply shock, what do you do about that? It becomes a little bit more difficult to deal with because, do you accommodate a supply shock which would then add to inflation? I know we just had Eurozone inflation. It's coming in at about 3%. We'll say US inflation, a new Fed chairman might have a different way to view it, some untrimmed mean inflation, but we're seeing that it's persistent at above 2%.

So, you have a problem that the central bank doesn't know what to do, or central banks don't know what to do because of what we see as a supply shock. So that gets us into more of a ‘70s kind of world. And if you have a 70s type world then you could be able to have extended price trends across many different markets. The other thing we forget about this geopolitical is it's having an impact across all commodity markets, some of which we haven't seen yet.

Take for example fertilizer. A lot of fertilizer comes out of the Middle East. So, the Strait of Hormuz is closed, you know, fertilizer is not available for plantings.

I think we're seeing that there are shortages of propane, butane, and other refined products, especially in Asia. Which means some restaurants are closing down, other businesses are closing down. So that's going to have real effects on equity markets and in the macro markets.

So, we're going to see that this is going to have long ranges of effect. Now, the interesting part is I always go back to Sherlock Holmes and remember this story where he said, the dog that didn't bark. So, the real question comes in, with all of the shock that we've seen, surprisingly, equity markets have held in well.

We've seen some movement on fixed income. We've seen the behavior in energy, but it seems as though that there has not been the proper discounting of this large event. And what I mean by that, when you say a market is not discounting the markets, it means that you have an opinion.

But you know, Niels, I'll ask you, if I told you you're going to have this kind of energy shock and then said, tell me what you would have predicted would happen to equity markets, what would you tell me?

I think it's often the case that people think that okay, higher inflation means higher interest rates, means lower equity prices. But as far as I know/remember, I think that actually plays out a little bit later. Meaning the initial inflation period is not necessarily bad for equity.

I love it when you ask what do you think happens? Because you know, I have probably no clue.

We'll take you as a representative, an intelligent Investor in. And I think that when you sort of say that, yeah, I don't really have a clue. But you'd sort of say, well, it must have been that equity markets are forward thinking. They must have discounted, you know, the chance of war. And the answer is they didn't. You know, they are completely surprised by the war.

And I think that there are issues where you could say, are we going to be surprised in equity markets by what's happening in the Middle east ,or have we not discounted the fact that it gives me some pause. If you look at the VIX index, the VIX index has actually fallen. If you look at some of the uncertainty indices, they're still fairly high. Some of them haven't come out for the last month because they're only produced monthly. But the data suggests that we have relatively high uncertainty. But it seems to have peaked.

The daily uncertainty indices have been very volatile. But VIX volatility or stock volatility has actually declined over the last month. It's probably a little bit higher than the median, but we'll say it's certainly not elevated.

And if you said that they were going to have a war in the Middle east like this, again, I think that if I asked you, as an ‘everyman’, what would you think would happen to volatility?

Well, the thing is we get… I mean I think the answer is, you know, self-evident. But, I think also, in a sense, unfortunately it reflects that we are kind of getting numb to all of these messages coming out, left, right, and center, even though some of them are horrible.

Yeah, right. And even when you get… So, we're almost like numb to the information that comes. But even if you get inundated with all of this information, it would seem as though, and we'll call this the Inundated with information with Conflicting Signals is a form of ambiguity. Okay? It's ambiguous about what is going on.

And in an ambiguous world, a world with high uncertainty, the normal expected behavior, which is going to be good for trend following, is that everyone is going to slow down with their decision making. If you're going to make a decision, and you had better certainty, you would act fast or you would be decisive.

When you feel that there's more ambiguity about what signals you're receiving, if you see that there's greater uncertainty, you might dollar cost average, you might hold back your behavior, you might wait before you take action.

And all of that behavior should lead to more price trends. That is what we're seeing. And we're seeing that's one of the reasons why trend following is doing well.

You know what's fascinating about that, and I think this is something at least I hear from people (maybe it's something you want to bring up later, so I apologize if I skip the queue here a little bit), we're now talking a lot about AI and all of that. But leave that aside for a second. Clearly, one of the things that has changed in our careers, let's put it that way, is the introduction of the Internet. And with the Internet, and what followed, was this information flow that became instant. We all knew what was going on at the same time.

And I certainly remember, from decades ago, talking to people about it, where they were kind of questioning, well, how is trend following going to cope with the fact that now we all have the information at the same time. And so, what's interesting about what you're mentioning is that information, even though there is a limit to how quick it can become in terms of distribution, let's just say that it's pretty much instantly distributed now. You would kind of think, well, that must mean that shorter-term timeframes, shorter-term models should be doing better, they can navigate this quicker.

But as you rightly mentioned, what has been clear, not just this year, but generally in the last many years, is that it's the opposite. It's actually the slower systems, the slower models that are better at navigating the environment. That's kind of interesting and a bit counterintuitive in my opinion.

Well, I think you're touching on one of the fundamental issues of how markets behave over the last few decades is that there's information reaction. So, information is now more readily available than before, which means that the markets should become more efficient because you get the information right away and you can act on it. But the real issue in where you make money is what is your ability to process that information?

Our ability to gain information is better than ever in the past, but our ability to process that information may not have improved. And so, consequently there could be more uncertainty that leads to behavior, or that leads to behavior that leads to trends, that last longer than expected.

Now, can I form a direct hypothesis about this? Can I be able to find a testable… Yeah, that's a little bit harder. But we will sort of say that the people who are very high frequency traders, or those who react immediately to new information, they have an edge. But those that actually sort of allow for the human behavior and that processing is still difficult also have an edge. And those are for trends that are longer, not shorter.

Yeah. By the way, the whole supply shock and where you said it's actually harder for the economy to deal with that, is that part of this “newer inelastic” market hypothesis that people are talking about? Is that part of the same argument?

Well, inelastic is not so much to do with the behavior and flow of markets. I think that the supply shock problem means that governments who can actually arrest trends, you know, don't know how to deal with it. When you think about it, the worst fear of a trend follower is that the trends start to occur and then government policy comes in and arrests the trends or tries to reverse it. So, let's say that you have a market is moving into recession. If we move into recession, you'll see equity markets decline. You're going to have a reaction in commodity prices. You're going to have a reaction to fixed income market. So, you start to see that market behavior is sending signals that'll tell us what our trends are that are associated with recession.

Well, what is the worst thing that could see happen if you're a trend follower? That the government comes in and then says well, if the market is declined, I'm going to try to reverse that flow. So, if the equity markets are declining, I'm going to do something that's going to reverse that flow.

So, then the trends are going to reverse. You're going to actually sort of be hit with losses. You might then see a drawdown, a supply shock environment. What is the proper response by government? It's not clear. So, that means that prices are going to be primal, prices are still going to be driven by market behavior, not by the behavior of governments.

Well, we’ll sort of say that a corollary to what I'm saying is that, okay, let's go back to the pandemic, which was a government induced supply shock and we'll sort of say, not the pandemic itself, but the response. Okay, well then the government said well, now we induce the supply shock. But now what we've got to do is we've got to do something to offset the supply shock that we generated. So, what we're going to do is increase fiscal spending. We're going to keep interest rates extremely low. We're going to flood the market with liquidity. And then, lo and behold, what do you think happened? You actually got inflation. Okay.

So, their response to this supply shock was to say, how do I offset the supply shock? But by offsetting the supply shock, then they actually created a bigger problem which actually led to inflation, which then led to advantages for trend followers.

Indeed. Indeed. Well, talking about trend followers, I noticed in your notes that you have a point called my current research on a different hedge fund strategy sensitive to risk volatility shocks, but there are exceptions. So, is that where we're going to head now?

Let's talk about this, and I think that it's always good to put this in a discussion of trend following or in the context of how it fits within all other hedge fund strategies. I think that, when we look at the institutional investor, he doesn't think in terms of, am I going to choose trend following? They're going to say, how do I choose trend following vis a vis all the other types of hedge fund strategies that might offer diversification? Which one is better? So, you're not competing against other trend followers, you're competing against all other hedge fund strategies.

So, one of the things I wanted to look at is that when you think about it we've looked at hedge fund strategies beta and how we can be able to classify them. And the standard argument is that the beta for trend following is close to zero. So, it's a very low number. Other hedge fund strategies still have positive beta. So, okay, if you really want to have, you know, strong diversifier, by managed features, what you find out is that some of the other strategies have higher alpha. And this is by just looking at a simple regression of looking at systematic risk and measuring alpha over time. They might have significant positive alpha. If you look at trend following it’s not so much the case. You're going to find out that the alpha is close to zero.

So, you get this diversification benefit on your beta side, but you're not getting a lot of alpha. So, you have a trade-off. I said, well, let's take a look at different hedge fund strategies, how they behave with respect to risk. And we'll call it risk regimes and then risk shocks.

So, what do we mean by risk? We can look at the VIX index which is a perfect example of risk. And the VIX index is different than the systematic risk that we see versus the stock market. So, we ran, and found out, and looked across all hedge fund strategies, and said well, how sensitive are you to sort of the risk regime?

And what we find out is, actually, we standardize what the VIX index is. If there's a low-risk regime, hedge funds generally do better. Okay, so low-risk, they do well. So, when we see high-risk and… sorry, Niels, I have got to ask you, as my ‘everyman’, what do you think hedge fund strategies, how their excess returns behave during high risk environments?

Oh, I'm sure they're not as great as trend following.

Exactly. So, what you find out is that in high-risk regimes well, the coefficient is negative which tells you is that high volatility, a lot of hedge fund strategies don't really do that well. So, even though they may market themselves that we have manager skill, and our skill is that we can be able to risk manage better than other types of managers, surprisingly they have a negative coefficient to the risk regime.

Now, when you look at managed futures, they're actually insensitive to the risk regime. So, whether it's high risk, or low risk, that coefficient is not significant. So, it tells us is that a trend follower is not dependent or is not affected by the risk regime, which is very interesting.

So, if you're really worried about risk in your portfolio, meaning the volatility as measured by the VIX, managed futures will be a better choice than many of these other strategies that may generate alpha, but that alpha is actually dissipated once you take into account the risk regime you have.

So, in particular, then we looked at what is the alpha for these different hedge strategies in different risk regimes by partitioning, you know, the VIX into low, medium and high? And we'll sort of say that if you're looking at what happens to alpha in a high-risk regime, it actually turns negative.

So, if you have alpha and you sort of say like, hey, I'm a good manager and I show skill in a low volatility environment, in a high volatility environment, I don't show it. On the other hand, managed futures, again, it's invariant or independent of the risk regime.

And then finally what we did is that we said, let's look at this in terms of risk shocks, okay? And in particular you'd say what is a risk shock? Which would be the change in the VIX index. So, it's maybe not the risk regime, but we'll say it's not the regime, it's the fact of whether I have a big shock to volatility, either positive or negative, that matters.

And again, most hedge fund strategies don't really do well with positive risk shocks. On the other hand, managed futures, again, seems to be invariant to risk shocks. So, in some sense, you’ve got the advantage of a low beta. But more importantly, you're not sensitive to the type of risk environment, in terms of regime or shock, where other hedge fund strategies that might purport that they're offering diversification just don't do it or don't offer that advantage.

But I just wanted to mention that we, just last week, updated this study with more data. And for those who want to receive, not necessarily specifically about Dunn, but about trend and, and high volatility trend in particular, I'm going to publish that, on a regular basis, as part of my Sunday email updates. And people can subscribe to that on toptradersunplugged.com/ Sunday. So, just if people want to see this, there is definitely something that I can share publicly on that. But it's a slightly different way of attacking the same kind of question: How do these strategies actually perform and which are the most valuable alternative investment strategies, because I think there's a lot of confusion about that.

And this doesn't dissipate, you know, the conversations and all of the research and work about, you know, crisis alphas. But we want to try to… and I think, as a group, you're going to talk about trend following and managed futures. We want to get beyond just the crisis alpha story.

Yeah.

We want to try to sort of say, are there other ways that we can be able to look at data, in a very systematic way, to be able to sort of say, is there something unique about managed futures versus other hedge fund strategies? And so, you say like, well, what are people most focused in on and where do they really worry about? You sort of say, yeah, they're worried about what's my overall portfolio beta or not.

But I think in reality, if volatility is high, or volatility is increasing, I want to find strategies that actually will protect me against a high volatility regime or do better in a perfect world. Reality is it's hard to find strategies, and that doesn't mean that you won't find individual managers who do well. But it's hard to find hedge fund strategies that do well in a positive risk shock or a high volatility regime. But you do have some exceptions and that's managed futures. You also have global macro does similar. But then you could say global macro and trend following are also similar strategies. One’s systematic, one’s a discretionary representation of a large set of markets.

But you could sort of say there are unique characteristics that are associated with managed futures that you don't find with other strategies that offers benefits beyond just the fact that it's a low beta strategy.

Yeah. Is this part of your kind of putting context to different types of analysis, storytelling versus narrative?

The context issue is something that I spent a lot of time with because when you think about what we do when we sell strategies or actually develop strategies, we always talk about context or narrative. And in some sense, I'll talk about two quotes to set this up. And this is from Daniel Kahneman. So, you know, Daniel Kahneman, the Nobel prize winner or finance guy. But he said, “no one ever made a decision because of a number. They need a story.”

And then he also said, “the confidence that individuals have in their beliefs depends mostly on the quality of the story they can tell about what they see, even if they see little.”

So, in some sense, that’s one of the constant challenges for managed futures, if you say, okay, what do you do? (And I'm making this overly simple.) I follow trends. Well, what does that mean? Prices go up, I'm a buyer. Prices go down, I'm a seller. So, that's it. What do you think about the market? Tell me what you think about what's going in the Middle East. I really don't have an opinion. If oil prices are going up, I'm a buyer. If they're going down, I'm a seller. And I think that is a classic conversation that you would have with a trend follower.

Yet, in reality, the investor is saying, like, gee, you know, I want to hear the story, give me the story. Then the next global macro manager or some other manager comes in and he says, well let me tell you about what's going on in Iran. Let me tell you about the pipeline that's going from the UAE. Let me tell you about the number of ships and how we look at geopositioning to find out what the ship traffic would look like.

And I said like wow, that's a very smart manager. And it's because he gives context or gives a story or narrative. Now I'm giving one example of story and narrative as persuasion. But I think that context matters for our trend following behavior. The question is how do we add context in our modeling? And we'll start out with what started our conversation. We talked about geopolitical risk and then we said about how this plays out in and price shocks, and if markets dislocations extended for a longer time then it's better for trend following. That provides context.

Can we be able to use different tools to provide context to add value to our models? And that's an ongoing issue of how do you best use AI? And this is where we're actually seeing more AI being used in two areas. One is in natural language processing to come up with sentiment measures. I think that that's becoming a very interesting area of research for quantitative analysts. And then for large language models, LLMs, because how do we process a lot of Information, some of which is non-numerical in a way that we can then be able to convert into signals.

Now perfect example is that for natural language processing we could take earnings calls and we could be able to use what is called a bag of words and then be able to try to figure out the sentiment that's occurring in the marketplace. This is proving to be very profitable and being used by a lot of firms. The question is how do we use that for a trend following model? And I'll sort of say that the jury is still out. Not that there has been negative work, but the work hasn't been done yet.

Yeah, it is interesting. I mean, it always in my mind comes back to this thing that a lot of this sentiment, and so on, and so forth, should all be reflected in the price. And the price is the only truth that we have.

And I'm not suggesting that things won't change in the future, but I'm also noticing that for so many decades, with so many different changes in the world, in the technology, and so on, and so forth, those managers who've just stuck with using price have actually done very well. Even though there is a difference, for sure. There is. You know, now we hear something about economic trend. Well, that's maybe giving context in another way. Right? But I just don't see it necessarily as being better. And I'm happy to see that classical trend following, using price is, is still very potent.

This is, again, ongoing research, and I think it's important to try to test different hypotheses. You may come to the conclusion it doesn't add value, but that doesn't mean we shouldn't try to look at this.

Now what we found is that, in some of the research that I've been looking at, for example, for a lot of LLMs, they'll use multiple agents so that you come up with an agent and an agent has a very specific task in a process. So, what they find is that if you have a model that has an agent, one is following technical signals, another one that's looking at fundamentals, another one is looking at sentiment. And then you sort of ensemble all of those agent behaviors, you actually get better Sharpe ratios than if you use a coarse model which only uses one agent.

So, what would be the analogy is that you could have a trend following agent in some type of AI model, but then you also have other agents, that do other things, that are coming up with other forecasts, and you blend them together, can you actually do better?

Now is there a real life analog for this? We do know that when you look within, we interchangeably use the word trend following versus managed futures. We do know that finding a pure trend following manager, there are fewer of those, and more of them try to mix and match sort of other types of strategies within, that that may be changing. Again, they may go back to pure trend following. But when you think about a manager that uses a number of different strategies, he's acting like a multi agent LLM.

Yeah, I mean again it's, it's interesting and, and I hear this narrative that using more things is potentially better. I just think it's an easy narrative.

Right?

Because it could also be much more confusing. I mean you could have strong GDP data, but the markets could still be going down and so on and so forth. So, I get it and I know we're heading in a way where people will innovate, and they will use things, and combine things, and that's great.

I just personally think that it's also great to see that just sticking with kind of a more narrow set of information, and in this case where it all started, namely price, seems to at least continue to work well for now. And we'll see. But I think your other point about, you know, there aren't that many pure trend followers left. And so that's also maybe just part of the evolution that maybe there will be even fewer of us left in five year’s time because people will have added more things to their strategies. I don't know, time will tell.

And that gets down to one of the classic issues, when you pick strategies, hedge fund strategies, should you want to have a pure strategy, and then be able to find another pure strategy of someone who's doing someone else, and then you as the investor, you could blend whatever you want. So, for example, and I'm not saying that people would do this, I have a manager over here that is a, we'll call it, carry expert. You know, he's Mr. Carry in terms of all different forms.

And then I have another manager that I'm looking at that's a trend follower. Now, would you prefer to have a single manager who does both together in the same fund or would you prefer that they say you purely follow trends, the next person follow carry, and then I as the investor will figure out what the weights are that I want to have for my portfolio. And that's an ongoing issue of finance, should you buy it bundled or should you buy the component parts?

Yeah, yeah, we see that as well with portable alpha. Right? I mean, more or less everybody can create their own portable alpha product. But of course there's been a huge market where they success successfully have, you know, bundled it together. And maybe it's easier sometimes to give the investors what they need in a package that they want. And maybe that's the answer.

In driving in very simple terms, the behavior of multi strats, they're saying we have, maybe, hundreds of pods. What they're saying is that all those pods are supposed to be orthogonal. They're all supposed to have slightly different strategies. They say, well you could go find managers who are like a given pod. But what we're going to do, our value added, is that we could bundle all of those pods together in a better portfolio than you could. We could then react, from a risk management perspective, faster than you could.

So, say this is our value added statement. So we'll say Wall Street is constantly focused at trying to figure out how to bundle or de-bundle different risk premia, or different products, in an effort to serve clients. And the investor is constantly having to sort of say, do I do the bundling, or do I let someone else do the bundling? And this is going to be the age-old problem.

Wall Street has always been good at bundling. Do you remember when they bundled together really bad loans and it became a not so great solution for the investor?

Yes, there's good bundling and bad bundling and sometimes we may not know what is good or bad bundling until after the fact.

That is very true. Anyways Mark, I know you have a hard stop today, so should we leave it here? Is there anything else you want to just mention?

Well, the one that I'm going to come back to is that there's been some interesting research on, we'll call it, bimodality and deep momentum. And if you look at momentum you actually look at separating winners, look at winners, past winners or past losers. That also goes on for trend following and it's cross sectionally.

But what they find out is that, within the set of past winners or past losers, there's a lot of “noise,” but you'll have some past winners that continue to win, which is what you'd expect in momentum. But then you have some past winners that lose really bad. And they use that as an explanation for why there could be momentum crashes.

And I think that this is another area of research that is very insightful. If we go into the details of what's going on in marketplaces is that we can uncover some new relationships and I think that this is going to be important work that we need to explore a little bit more from the trend following area. But we'll save that for another call.

We'll save that for another day. I mean, it's always so fun to be having these conversations with you because you never quite know what going to be in the next conversation. So, really appreciate that. And of course, you write a lot about many different interesting topics on your own blog, so people should definitely go and check that out as well.

Now, if those of you listening today want to just show some appreciation for Mark and all the work and preparation that he does, along with all the other co-hosts, head over to your favorite podcast platform, leave a rating and review because it really does help more people discover the podcast. And of course, if you want to share it you can use a link called toptradersunplugged.com/share and people should be able to sign up there.

Next week I'll be joined by Allan. So, that's going to be super interesting. I know he's up to some new stuff so, I'm sure he'll going to mention some of that. If there are some questions for Alan, info@toptradersunplugged.com is the email to use.

Now, of course there are lots of other things that we have on the Top Traders website so people should go and check that out. Weekly, monthly trend following reports, updates, blog posts, all sorts of interesting stuff, even if I say so myself.

From Mark and me, thanks ever so much for listening and we look forward to being back with you next week. And until next time, as usual, take care of yourself and take care of each other.

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