Gold is ripping, but it’s not about inflation. It’s about trust - or the slow erosion of it. Mark Rzepczynski returns to map out the shifting terrain as central banks quietly step away from sovereign debt and build reserves in metal, not paper. Niels presses on what this says about safe assets, liquidity, and the narratives we’ve long taken for granted. They unpack the rise of short-term options, the distortive power of retail flow, and the fragility buried inside modern plumbing. And as trend followers chase edge in crowded markets, Mark offers a glimpse into what comes next: networks, feedback loops, and systems that learn - until they break.

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Episode TimeStamps:

01:34 - What has been on our radar recently?

05:43 - Is this time different for gold?

14:13 - Just a gold story?

16:38 - Should we redefine the definition of safe assets?

19:45 - The Fed has to change

26:08 - An overbearing uncertainty

30:25 - Our thoughts on meme stocks

35:30 - Not every innovations are good

39:02 - How narratives impact how products are sold

46:21 - Industry performance update

49:39 - Alternative vs traditional assets

01:00:43 - Every CTA is a short term trader

01:05:59 - The power of seeing the connection between markets

01:14:32 - What is up for next week?

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Intro: 00:00:24

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

Niels: 00:00:24

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 pulse of the global market through the lens of a rules-based investor.

Mark, it is fantastic to be back with you this week. It feels like it's been a while. Can't remember when we last spoke, but how are you doing?

Mark: 00:00:45

I'm doing well. It's fall foliage season up here in New England and trees are turning color. It's a bright blue sky. So, it's going to be a great day today. And I'm talking with you.

Niels: 00:00:58

Oh, that's very kind of you to say. I've heard, I've never been to New England at this time of year, but I've heard that it is really spectacular the way the leaves turn, with all the woods you have around you.

Mark: 00:01:13

Yes, it's great time to be up in New England.

Niels: 00:01:17

Good. Well, it's a great time to be listening to podcasts because you have provided a solid lineup of topics. It’s not that the world isn’t giving us anything to talk about, I have to say, at the moment. So, we'll be tackling those, some of them quite big topics, I think, important ones really.

But before we dive into the main topics and actually the next section, there might be a little bit more meat on than what we usually do because I think you've got some great points also lined up for this section.

I'd love to hear what's kind of been on your radar, what are you finding interesting at the moment? And it could be quite a number of different things. We don't have to just stick to one or two.

Mark: 00:02:06

Sure. There are two things that really have fascinated me right now. One is just the issue of what is a safe asset, because we usually think of that as US Treasuries as their safe asset. And I think that the sense of what is a safe asset is changing. Now what does that mean?

In a crisis or if you need cash, most investors would buy US treasuries? Okay. But in some sense, there's no such thing as an absolute safe asset. It's all relative. And we'll sort of say that the relativity of what is safe is changing. A perfect example is, look at French debt. Would you consider that a safe asset right now? Probably not.

So, if you look at UK debt, is that a safe asset? (Because usually you think of sovereigns as safe.) I don't know, we’ve got a government shutdown in the US, we're reaching high levels of debt to GDP. Is the US a safe asset? Treasuries? That's not clear either.

And so, the reason why I'm studying this or why this is important is because we've also been thinking about gold. You know, we've reached $4,000 an ounce in gold. You'll say, well, why is this gold going crazy? You know, some would say, well, it's just a bubble.

And they'll say, well, gold shouldn't be going up because inflation seems to be tamed relative to what it was two years ago. So, there's no rational explanation for why gold should be going higher.

But then once you look at it, what are the central banks doing with their reserves? They're actually buying up a lot of gold right now to increase the reserves in their foreign currency reserves.

erent than what we saw in the: 1990

Now, we know that safety, empirically, you'll sort of say it's uncorrelated with risky assets and you know, that does better in a crisis to some degree. It also is a good inflation hedge. But more importantly is that if you think that the traditional assets are less safe, then you're going to look for some other alternatives to diversify into. And that seems to be gold. It's very liquid. It may have as much liquidity as the treasury, at times, in the cash market.

And so, we'll see that relatively intelligent buyers, central banks, are buying gold. And what we actually see is this speculative exposure and the commitment of traders from large speculators, their long positions have actually been declining over this period.

So, you can't sort of say that there's speculative excess from large buyers. It actually is from other groups. And I think it's a different perception of what role gold will serve in a portfolio.

Niels: 00:05:45

Can I pause you here and just maybe ask a few questions around that?

When you go back to the, say the ‘70s and you just look at a chart and actually this was something I picked up this morning from an article that the Wall Street Journal had about gold. And they have this long-term chart of gold going back to the 70s.

ignificantly. One was sort of: 1978

And then of course, we have now, again, where gold prices are really moving higher.

So, my question to you is, is there anything that you can think of that is kind of the common ground between those three periods? I.E. Is it just ‘uncertainty’ that drives prices of gold? Is it something else? Is it a weak dollar?

I haven't looked at the charts of the dollar, what it did during these periods of time or is it something else? Because I think then that begs the question, is this time different?

Because both after the massive surge from around US$600 all the way up to 3,500 or thereabouts back in, in the ‘70s, you know, prices came down subsequently quite dramatically actually, all the way down to, I think, US$500 or something like that, which is of course around the time when the central banks were selling gold, interestingly enough. And then it goes up again. We reach around US$2,500, US$ 2,600 during the GFC. Then prices go down again, not as dramatically, but pretty, pretty meaningfully. And then, of course, we have this big run-up.

So, I think a lot of investors are now thinking, okay, we have a great run-up, but if history is any guide, is this something that is just temporary, and we might see a massive correction again in gold price.

I'm just trying to tie these things in together to see whether you feel or think, or if there is something that makes this rally different from the other ones we've seen of this magnitude.

Mark: 00:08:48

I'll answer this in two ways. First let's look at what is the relationship between fundamentals and gold. And the reality is that we find, you know, expect, if real rates are higher, gold price should go down. Okay, that works sometimes, but not always. We expect that this is supposed to be an inflation hedge. It is sort of, but then the link between when inflation occurs and when gold goes up is not that strong.

So, the link between uncertainty, we find that if uncertainty goes up, maybe led by the VIX or some uncertainty index, gold will also go up, but it's not always as strong as what we would like. So, it seems as though that the characteristics of what the factors are that drive gold is always at a state of flux.

So now what does that mean for today? It seems as though there's a strong demand for gold. Is this a bubble? Hard to say. You know, a 20% move in, let's say, the last couple of weeks seems truly abnormal. Should the price of gold come down later on, or are we in a fundamentally different era? That's harder to call.

Now, the reason why is because there are structural changes in the behavior of the gold market than what we saw prior. Okay. One is that we have now the central bank buyers and central banks are sort of not price sensitive. They're doing their actions for other reasons other than profit motive. Okay, so that's taking out a lot of gold.

There are certain countries that want to hold gold because the safe asset, US treasuries, may not be safe if, let's say, that you're on the wrong side of geopolitical issues relative to the US or Western governments.

Okay, so if you're, you know, Russia, China, some other countries, you want to buy gold, because you certainly can't say, well, I'll put some of my reserves in treasuries and keep them at the Federal Reserve bank of New York.

And then, finally, we'll sort of say that there's been more of a financialization of gold. What I mean by that is that it used to be that you could, you could maybe hold gold cash, in the actual bars, but that was really expensive. You had gold futures, but most investors were not able to buy gold.

Now we have, ETFs available in a number of different forms. Some, you know, you actually have gold certificates as opposed to gold bars. But what you're finding out is that it's a lot easier for people to use that. And if you buy it in ETF form, you can use that as collateral, which is key to being a safe asset.

Also, the CME, for example, allows for gold to be held as collateral for margin. So, if more institutions allow for gold to be used as collateral for loans, then it has more characteristics to the safe assets. So, there's a structural change to this market that's going on that impacts how people will use gold in the future.

Niels: 00:12:21

Yeah, I think that's right. And I think that one of the topics that I think we'll come back to in a second, that I find personally to be probably quite important in this respect, and that's this whole thing about ETFs, right.

You and I are old enough, in this industry, to remember that when, back in the ‘90s, for example, the way people reported on the managed futures CTA industry was this monthly printed magazine called MAR, Managed Account Reports, I think, yeah. And then I also remember, and this was like had a green color and it was something you look forward to. And this is also where you could see the performance tables. They were not available on the Internet. You had to wait for them like two or three weeks after month end to get the performance numbers of the competition.

But I don't know if you remember, Mark, but suddenly Lois Pels, who was the editor, they started publishing a new magazine called ETF, Exchange Traded Funds. And I just remember back then, I thought why are they doing that? Why are they spending time on this? You know, managed futures is much more important.

And boy, was I wrong. I mean the whole ETF world is just incredible. And I think, this is where I find it interesting because here's the other thing. So, let's talk about gold. It's up, when I looked at the screen, up 46% this year. And you think, wow, that's great. That really must be one of the best performers. Then you look at platinum up 77%, palladium up 63%, silver up 59%. Okay, copper not bad, 22% up.

So, my question to you is, is this a gold story? Is this a metal story? Is this the ‘beginning of another commodity super cycle’ that we thought would have come or experts thought would have come a few times by now? Is that what's at play here or is it just uncertainty? People are not sure about the safe assets.

How do you think about that?

Mark: 00:14:44

Well, I think we're going to talk about this a little bit later when we talk about complex adaptive systems and connection and networks. But, in some sense is that this is a gold story. But gold cannot be viewed in isolation. You have to sort of say that it is connected with other stuff.

And in some sense you could sort of say that, well, you know, if gold gets expensive and people view that it's, let's say, higher than what they think is appropriate or fair value, then they'll say, well, maybe I should look for a substitute. Well, the substitute might be platinum, palladium or silver so that there's spillover effects in others.

Let's say that you could have one that is your core market. And then you have satellites around the core that get pulled along by the behavior of one.

And this is constantly what we're seeing in a lot of different markets. And that's fundamental to the idea, when you think about a network of markets, that there might be a shock or a driver in one market. But there are spillover effects on others, that they get pulled along. And so, there's a pull effect which is occurring in those.

Now, if those other markets are less liquid, the pull effect could be much greater because there might be, for example, industrial uses where there's less volume of trading, so flow will matter. And so, consequently that you could have a bigger impact on some of these satellite markets relative to the core, which is still gold.

Niels: 00:16:19

Yeah, very true. Now, again, I know we're going to be talking around these topics later on as well, but just one thing before I forget it. You said there are questions about, you know, what is a safe asset? And you talked about the importance of liquidity. For example, the gold market has a lot of liquidity.

Now, of course, this is a completely biased comment, and this is something we've talked about over the years on the podcast, and that is should we actually think differently? Should we start to think differently about what does this safe really mean in a sense that instead of safe assets, should we think about safe strategies?

And does the safety of a strategy, for example, come from being adaptive instead of long only, being diversified, so it's not just dependent on one outcome; being liquid instead of being tied up in just one thing, as you mentioned, government debt, for example. I know it's a stretch because everybody can work out, listening to this, that, oh, that actually fits trend following.

So, I know it's completely biased, but I actually think there's some validity to it. That these strategies, because of the way they're put together and what they consist of, in many respects, to me, feels a lot safer than, as you said, French debt, UK debt, US debt for that matter, or something else for that matter. I don't know if you want to talk about it now but I just wanted not to forget it.

Mark: 00:18:06

So, some of the researchers who have worked on the issue of what is a safe asset have come up with an analogy. And they said that a safe asset is like a good friend. They're going to be there when you need them, okay? So, you can depend on them.

So let me put it this way, if I need safety, and I have got to get out of risky assets, then I could sort of say there's the liquidity available in treasuries that I could buy and sell what I want, at a fair price, and in that sense it's a good friend. But as we could sort of say with all of your friends, some of your friends could be fickle. They may not be there when you need them. They may disappear on you.

So, because of that, we always have a set of friends. You have more than one friend. We diversify our friends. So, just as we think about that we want to have diversification in our friends, we want to have diversification in these good friends called safe assets. We might also want to diversify across strategies to provide ourselves some downside.

Now it may be a silly analogy, but I think it's one way to think about what are you looking for from your good friend investment? You want it to stay stable when you need it most. You might not need more than one friend.

Niels: 00:19:38

Mark, well, I think it's the perfect analogy because you know what they say about the trend, it is your friend. So, there you go. I think you hit it right on the nail.

Well, this is of course tied into one of the uncertainties and why some people say gold is going up is for example the uncertainty about Fed independence, that is the Fed as a whole. And you pointed out there was an interesting speech, which I also heard about (I didn't hear the speech, I didn't read the speech) from the Dallas Fed, Lorie Logan. Tell us about that. Why is that important?

Mark: 00:20:13

So, Lorie Logan has been the president for the Dallas Fed for, not a long time, but she's been out there for a while. She came from the New York Fed where she was running the open market desk.

So, she’s probably our top expert on, we'll call it the plumbing of operating targets. So, how does the Fed do what it’s actually supposed to do. And what she said is that we're probably going to be in need for new operating targets beyond Fed funds. And in her speech she goes through that the operating targets have changed over time’ we've non borrowed reserves, we've looked at different forms of money and then we've provided different signals.

So up until: 1994

Number one is that the Fed engages in ample reserve management, there's more than enough reserves available. And because there are ample reserves, they don't need to actually sort of go out and borrow reserves to meet their reserve requirement. So, they get paid interest on their reserves that they hold in the Fed. So, they could hold excess because it's not a true cost.

So consequently, right now the Fed funds market is actually, you know, driven by some foreign banks who are buyers, and then the providers, which should be the federal Home Loan banks. So, what happens is that, as an operating target, the market has actually shrunk. It only trades about US$100 billion a day and it doesn't represent the true money market rates that people are paying.

So, she said that, well, you know, given these structural changes, the Fed is going to have to change that. They're going to have to have a new operating target. And that operating target, well it could be SOFR, which is the substitute for LIBOR, or they said that probably a better measure would be tri-party repo, overnight repo. So, it's collateralized with treasuries so it is a risk free rate.

And that using that as our operating target for the Fed, or moving to that, will better enable them to be able to manage liquidity and flows in a crisis, perhaps send better signals for what the Fed is doing, and also be more representative of where the market is trading for short-term funds. Because the amount that trades in overnight tri-party repo might be in the trillions.

Niels: 00:23:27

Would that not, and again, I've heard about this recently as well, but not in any great detail. Would that not introduce somewhat more ‘uncertainty or volatility’ into the setting of ‘the Fed funds,’ or whatever we’re going to be calling it?

Mark: 00:23:45

Well, the tri-party repo is probably more volatile than the Fed funds rate, but it also is more representative of the market. So, it will be a measure that has more volatility but at the same time, because it's a deeper, more liquid market, if the Fed says this is what we're going to use as our operating target, it will reduce some uncertainty because it'll be a clearer signal both as a receiver of the signal of where the market is at for short-term funds and as well as a sender of signal. If this is what we're trying to manage or target, then it's clear to all of those involved what that represents.

So, this gets into the plumbing of money markets and plumbing of finance. But we still have got to realize what is the driver of everything we do. And, you know, it is the short term interest rates.

So, what the Fed targets in the short-term is going to have a massive impact of what's the cost of margin? What's the cost of collateral? What's the cost that we might face? And then there's so many other interest rates that are keyed off the operating target.

So, for a lot of laymen you'd say like, well, okay, instead of calling it Fed funds, you know, it'd be looking at this tri-party repo. How does that change my life? It may not.

But for people who count their pennies every day on what their financing charge is, and the signals that they receive from the Fed are, this becomes important. And it's not something that's going to change immediately, but it's something to keep on the radar screen that structural changes are causing the Fed to change their behavior, and that's going to then impact on the behavior of other market participants.

Niels: 00:25:46

Now, speaking of other market participants, we're also going to touch on retail and what's changing in that. But is there anything else you wanted to talk about in terms of monetary uncertainty and the summary of economic predictions?

Is there anything or do you want to jump to talk a little bit about kind of what's going on in terms of the retail market?

Mark: 00:26:10

Well, there are two things I want to talk about. There’s one uncertainty that is overbearing on the market. And another type of uncertainty, that I call a little scary, they'll call it ignorance uncertainty.

Now the monetary uncertainty is that you can use the SEP, which is a Summary Of Economic Projections, which comes out quarterly, and it tells you what the Fed president or Fed banks, where they think rates are going to be in the future.

Okay, now the whole idea of providing these SEPs is that then it should reduce uncertainty because then we have a clear idea of what they think the forecast of the future path of the Fed funds rate or where the future path of rates are going to go. So, you say like, oh, this should reduce uncertainty because by giving more information to the marketplace, then they know what's going on and they know what's going on in the head of the Fed.

Now if you look at the September SEP that came out, the Fed forecast of what interest rates are going to be over the next year are all over the map. They've got people actually some raising rates, some keeping the same, some big move down lower or not.

So, in an effort to provide clarity on what the Fed is thinking, they've now told us that they have no idea what they're thinking. They have a high amount of uncertainty and that sort of has an impact on all other trading.

If you're saying the central banks have no idea what they think that rates should be or what they'd like them to be, well, then that's going to cause a lot of difference between buyer and seller opinions and it's going to cause more volume. So that's just hanging over the market.

Now the other issue that scared me is that there is an interesting paper from the IMF. Okay, now I need to get a hobby if I'm spending my time on reading some of these papers. But it's called Perceptions of Public Debt and Evidence from Cross Country Surveys.

So, what the IMF did is that they did a survey of 27,000 respondents and they were asking them some simple questions about the relationship between spending, taxes and deficits and the impact on deficits and debt.

So, they said, okay, if spending increases, what will happen to deficits? And then they asked the other question, if spending decreases, what happens to deficits? Then they ask the same question about taxes and then deficits.

And you sort of say, if I told you spending increases, all things being equal, what do you think is going to happen to deficits? You know, I'm not going to put you on the spot, but my guess is that, with almost 100% accuracy, you'll say, if spending increases, deficits will also increase. Now the scary part when you look at this, of the 27,000 respondents, just over 50% of the people got this right.

Okay, so, if taxes increase, what will happen to deficits? Again, you know, some countries are better than others because they broke it down by countries, but in many cases, you know, it's just over 50% that got it right.

So, you know, this is scary because your average person has no idea what is the link between spending, taxes, deficits, and ultimately the amount of debt do we have outstanding.

And if we don't understand those basics and then you say we've got a lot of debt outstanding, the likelihood that we're going to have a credit crisis is going to be a lot greater just because we don't have the knowledge to understand what are the linkages that drive debt in the world.

Niels: 00:30:25

Yeah, absolutely. Well, let's jump to something that became very top of mind during the last crisis and that's actually the power of retail. I think, during the pandemic we started to see the first signs of how retail investors back then, in a few meme stocks, really had a big impact in the market. But this has changed dramatically since then and it continues to change, not least with the amount of new products that are being issued.

Tell me where your thoughts are on this and I'll add a few thoughts as well.

Mark: 00:31:06

pirations, this is it. Before: 2020

So, you have this huge impact from, you know, short-term option trading. We have a tremendous amount of flows into ETF. So, when you think about it, those flows that go in can also flow out fairly quickly. So that's going to have a big market impact.

And it generally has been viewed that the retail traders or retail investors, you know, are either last to get in, you know, sort of missed market moves. Researchers would sometimes refer to them as noise traders, that they add noise to the market. And so, the question comes in, if we increase the amount of noise, how does that change people's behavior and models? How does that change pricing behavior?

We do know that the simple fact is that if you use prices as signals of value, but if noise increases, then those signals are going to get distorted. And so, the question comes in that we know this is going on, now, how do we adjust our behavior because of that? And that's an ongoing issue for research.

Niels: 00:32:55

Yeah, actually, I think this is actually very important and I think that this is a key topic that I think many of our colleagues in this industry think about in terms of the data they use, and so on, and so forth.

I was thinking about this also, in light of the recent interview that Cem did with the co-founder and CEO of Robinhood, Vlad Tenev, where they sat down and he talked about some of the new things they're rolling out.

And of course they were very much kind of in the forefront of getting retail back in the market, so to speak, with, “free commission” trading, and so on, and so forth. But of course, now they're adding other things like prediction markets, where, you know, it's not just about financial markets. You can bet on college basketball or whatever it may be.

And of course, oddly enough, being Danish, when I watch television in Denmark now, I would say about almost half the advertising on television is purely from betting firms. And of course this has been sports betting.

So, I mean, it's real. I'm not so sure it's healthy to give people too many betting tools, so to speak, but it's definitely a big part of this revolution. And as you say, it will add at least noise, if not something else. And then kind of going back to maybe the next point you brought up in your notes, which is something that Andrew and I touched on briefly, only briefly, a couple of weeks ago, which is this thing about inelastic markets and how flows impact markets. I'd love to hear your thoughts on this because we didn't do a great job in terms of going into the actual details.

We just talked about and referred to a lunch interview between the FT and the chairman of CFM, who has become a very big proponent, as I understand it, of this inelastic market hypothesis. So, you probably know much more about this than I do. So, what are your thoughts on this and how does it tie into some of the things we just talked about?

Mark: 00:35:31

Well, just to close the loop on the retail issue, it's interesting that Terry Duffy, the head of this CME, had a podcast where they talked about their rollout of their, you know, venture with Fanduel. So, the idea to get more retail investors to trade at the CME.

So, this intersection between betting markets, prediction markets, and traditional futures markets, they're getting more closely aligned. And so on one level this is part of further innovation in financial products and, what we'll sort of say is, a very competitive business. Finance has been very good at providing innovation. The issue is always that not every innovation is good. And you know, we'll sort of say that some innovation will have unintended consequences that we need to be aware of.

Now, talking about this inelastic trading, which is one of the topics for your last podcast, and I think it's very important because the idea is that from inelastic trading is markets are not efficient. That in reality markets can be inelastic or the elasticity changes across markets because of the volume that you trade or the flows that you trade have an impact on price. And that volume, in a given period of time, might actually be very large relative to the volume that you usually look at in a time packet.

So therefore, it could really have a strong impact that causes more volatility in markets. And similarly, we need to look at the actual players in the market because their elasticities will be different from player to player. So, if you take a mutual fund that has a focus in stocks, if they have flows that come in, they're going to have to invest in stocks. A hedge fund might be focused in a specific sector, so they have capital to put to use, but their elasticity is going to be based on what is their mandate or the objective of their fund.

So, if you think about it, that the market is filled with different agents or different market participants, each have different objective functions. And because their objective functions are different, they may not always be able to provide capital at a given point in time, in a way that would keep the market efficient. So, hence, the composition of the market matters. And because the composition is affected by the flow, flow matters, and flow will then affect prices.

Thinking of it from the retail perspective, if this represents a different set of flows, or the flows come at different times of the day, or represent trades based on a different set of beliefs or expectations, then that could have an impact on price, which could cause it to differ from what you might think is the efficient price.

Niels: 00:39:04

Yeah, you know, speaking about… before we jump on to something we normally get done with in the first 10, 15 minutes, which is the trend following update, but this is great, this is fun.

You talked about financial innovation, and all of that stuff, and kind of how it relates to the retail space. Actually, I think also financial innovation has been part of one of the headlines that I just caught and I'm sure other people did, which is not some topic necessarily that I know a lot about, but I do remember, and maybe this was kind of a result of hedge funds, alternative investments not doing great a few years ago, I can't remember exactly, but suddenly this thing called trade finance popped up, and oh yeah, this is great. I mean, you can invest in these funds that do trade finance, kind of like a hedge fund type strategy. And you'll get very steady, very decent, maybe double-digit returns. So, to me, you know, I feel it was mentioned as some kind of low-risk strategy. What could possibly go wrong when you loan money to people who can't get their trade financed elsewhere. But of course, this week we hear about something called First Brands and its bankruptcy.

And then you start seeing some of the fallout, for example, and again, I'm just quoting the news, I'm not making any judgment here. But there was a UBS fund that turned out to have 30% of its portfolio tied to the failed First Brand Group. You have Jefferies, as far as I can tell from the news flow, also being impacted by this. Again, maybe the financial losses are not too excessive compared to other things, but certainly reputation wise you can quickly lose out. So sometimes these things, and I think this might only be the beginning. I'm sure there are many other funds strategies that do something like this and there might be more to come.

But it just shows, or it reminds me of how these narratives can have a big impact in terms of how products are being positioned, how they're sold. But things like, again, going back to our little world, trend following, where yeah, you see the volatility every day. So, that's why people don't really like it. But it's rare that we have any really bad surprises.

I can't really think of any in the last 35 years that I've been part of this where something happened that you wouldn't expect. I mean you expect volatility in these strategies. But anyways, I don't know where I wanted to go with this other than to comment that these financial innovations are not always good.

Mark: 00:42:11

Well, trade financing or factor financing has been around for hundreds of years. It's not a new innovation. And a lot of people think…

Niels: 00:42:21

It's the packaging though, Mark. Right?

Mark: 00:42:22

Yes. Everybody thinks, well it offers you stable returns. But then maybe the next comment was well, ‘what could go wrong?

Niels: 00:42:33

Right.

Mark: 00:42:34

So, banks were very much involved in, we'll call it, trade finance. And, to some degree, factoring this is ‘bread and butter’, you know, but it's actually very people intensive and there's intensive credit work because, if you say I'm going to lend against inventory, at some point I'm going to have to send an accountant out to some warehouse and I'm going to have to look what's in their warehouse. And in case of First Brands (they're in auto parts, they do windshield wipers), someone's going to have to count all of the windshield wipers in the warehouse. And he has to find out, is that okay, is that my collateral or did you use that collateral for five other different loans?

This has been going on with traditional futures for a very long time. Because we'll sort of say that working for the Mercantile exchange in the ‘80s, at one time, you find that there is a whole department that you have to have. It's like you have to go out to warehouses and actually check to see where do you have the warehouse receipts? Is there livestock at the delivery point? Is there grain in the grain elevator? You have to actually do all of this. It's actually very expensive to do this. And the one thing you need to remember about lending is that you need a lot of good loans to make up for one bad loan.

But the important part of futures that I think that people sometimes forget is what the tremendous innovation is that has been associated with futures markets since its inception with the daily mark to market. You have to settle up every day in terms of your margin. If prices go up, and you happen to be on a short side, you might have to be required to post more margin funds. And so, that's done on a daily basis.

And so, you know, a lot of this lending wouldn't happen if let's say that you actually had to… if we knew exactly what the collateral was and what margin had to be posted, associated with it, on a daily basis.

It's a little bit of a stretch but I think that this is important to say how markets differ structurally.

Niels: 00:45:03

Yes. And not to take any shine away from the futures markets because I love them.

But I'm sure you remember, also, that there have been occasions where, wasn't there a point (and I forget which metal it was) where they discovered that actually the metal was not in the bags in the warehouse. It was scrap metal rather than copper or nickel. Yeah, it was nickel.

So anyways, not perfect, but a lot better than many other.

Mark: 00:45:34

There was a classic case of, you know, like the salad oil or soybean oil where you know, actually what happens is that they said they had the collateral and it was in big tanks. And so, what happens is that some people would usually test for whether there was actually the collateral by dipping a stick in and sort of saying, okay, is the oil there? Well, what happened is they filled the tank with water which is heavier. So that was on the bottom. So, if you tested from the top you said, oh, there's the oil there, it's legitimately there when it didn't exist. So, there are some stories of fraud going on, even in the futures markets.

Niels: 00:46:22

Absolutely, absolutely. Okay. All right, let's move on quickly to a quick update on the trend following side.

I mean Alan mentioned, last week, that it was a tremendous month of September. We're fortunate that this momentum seems to have continued pretty strong so far this week into Q4, which I'm always thinking of Q4 as not a bad quarter for trend following. I'm not entirely sure, but I don't have any data, necessarily, to base it on. But as I said, I think, so far things are moving nicely, again, with the momentum in some of these markets we've talked about continuing.

tion of the futures market in: 1974

And it just provides a great opportunity for old school trend following to really capitalize on that. So, even these old style strategies, I think, are so relevant today, as relevant as they've ever been, frankly, in my mind.

Here’s a quick run through of the numbers. So, we are using numbers as of Tuesday, this week, the 7th because they haven't been published yet for the 8th, but BTOP 50 off to a good start in October, up 1.22% now, up 1.68% for the year, after so many months of having negative numbers year-to-date, we're now, for the BTOP 50 at least, into positive territory. SocGen CTA index up 1.19%, down a fraction still 1.54% for the year. SocGen Trend up another 1.6%, down only 71 basis points as of Tuesday. And the Short-Term Traders Index still struggling a little bit, but up 73 basis points in October, down 4.42% so far.

I will add to that, I think yesterday was a very strong day for CTAs so some of these numbers may be very close to flat if not positive by now. In the traditional world, of course, there's no comparison, I have to completely admit.

1.1% up already for the MSCI as of last night, up 19.1% for the year. S&P US Aggregate Bond index up 20 basis points in October, and up 4.5% so far this year. And the S&P 500 Total Return up 1% as of last night, and up 15.98% so far this year.

Now, we have gone quite long in our “early part” of our normal conversation. So, maybe with another 20 minutes or so left of our conversation, Mark, I will let you guide us with which of these topics, that you mentioned to me, you wanted to deal with because I don't think we're going to get through all of them. So, would you mind telling us where we're heading now in the conversation?

Mark: 00:50:11

Sure. There are probably two issues that I want to try to talk about. One is a nice piece of research from Quantica, the CTA, which it looks at alternative versus traditional assets, which is an ongoing discussion we've had in the past. But I think that they've added to the discussion. And then second, let's talk a little bit about networks and complex adaptive systems, because this is an issue that I've been spending a lot of time on and I think that I want to, if anything, maybe provide a little bit of teaser for the research I'm working on, what I'm trying to achieve, and tell you why this is a hard problem, but if I solve it, it actually could have big benefits.

Niels: 00:50:59

Okay, cool. Very good.

Mark: 00:51:01

So, let's talk a little bit about this research that I was reading about that came out in the last week or two weeks. So, traditionally the futures has been this big issue of how many markets should you trade? Should you trade more or less markets?

And so, there is probably one group that says let's stick to a core group, keep the most liquid markets. That's all you need to do to be a good CTA trend follower. And the other group has said, no, no, you want to add a lot of these, what they call alternative, which are sort of the smaller, more esoteric futures, or other markets that you could trade, because that's where the (no pun intended), that's where the gold is. These are the hidden opportunities.

And so, what happened is, Quantica did the research and what they showed is that these alternatives, for a good 10 years were adding a significant amount of value added to the portfolio, that they had high Sharpe ratios, and that they were low correlated. So that the combination of the two provided a nice tailwind for trend followers.

But now, more recently, they said that the performance of those alternative markets has been less than what we'll sort of say that of the core markets are the more traditional assets. So, the performance has declined.

And so, now it has been more, not of a tailwind, but it's been more of a headwind that having more diversification, or adding these alternative markets has had a negative impact. So, then, of course, the issue is, well, what's the optimal number that you should have?

And you know, that's the age-old question of what we're seeing. And I sort of said that they didn't really touch on this. But I think it's the issue that the behavior of money flows from trend followers to different markets will have an impact on the efficiency of that market. So, notice we talked earlier in this idea about the inelastic market hypothesis. What we're saying is that markets are not always elastic, that the flows matter.

Well, if you had, for a long period, of time more and more CTAs entering in these less liquid markets, these alternative markets, by definition their flows are going to impact the behavior of those markets such that, where they could have been profitable before, they could become less profitable now because the composition of the market has changed.

Niels: 00:54:07

So, is this what we often talk about as market impact?

Mark: 00:54:12

Yeah.

So, this is the really important part, especially as you get larger, which are those CTAs with institutional investors or even retail investors, is that some of these are becoming larger and larger. They become billions of dollars. Now, a large trend following CTA that has US$1 billion actual cash, their notional value is going to be a lot larger. So, their market footprint or market impact is going to be a lot larger.

And I probably would sort of say that when we look at all the backtesting that's done, you could have the perfect backtest, but you also have to account for your market footprint - what the impact is of what your trading has been.

And we'll sort of say that it's not the cost of the bid/ask spread, it's not the trading costs, it's the market footprint or impact that really drives performance. And so, the battle of a CTA is not now as much trying to find out what is the next model to find trends. I'm not sort of saying that that's solved, but we have a pretty good idea of how we can identify signals. We can identify what is a trend. You might sort of say that sometimes very long-term does better, sometimes short-term does better. The sweet spot is the intermediate.

You could sort of talk that there are slightly different ways of doing this. But you know, the big battle, from a research perspective, from a success of a CTA, is how can they reduce their market impact, their market footprint, while still adding more assets under management? So, as I grow, my footprint gets larger and now I’ve got to fight this growth versus the market impact effects.

So, this is what the research battle is all about right now.

Niels: 00:56:20

Now, given what you just said, and I don't know if this can be concluded, but isn't there a big risk now, with the popularity that these alternative markets attracted, not just from more managers doing it, but of course also from investors buying into the narrative, so to speak. Isn't there a chance that this has had permanent damage, that we have too much money now in those markets and they're simply not able to, on an average basis, let's call it that, cope with these much larger flows to avoid having a negative market impact? Now I'm fully aware there will be times where the trends are just so strong that market impact is overcome.

But that's why I wanted to say, on average, that at least perhaps too much money now is chasing these markets. Or is that a step too far to go?

Mark: 00:57:36

Well, you can answer it two ways. I could say yes, there is too much money following it with similar strategies.

And so a number of large brokerage firms, you know, some of the French banks for example, now have CTA trackers. You know, large investment banks also have trackers. What they do is they sort of run trend following models and then they sort of look to see where are the big flows going into.

So, they anticipate where flows are going into. So, it's almost as though we know that you have a big footprint. We know that you're disturbing the system. So, what we're going to do is track you so we can then be able to anticipate that and then be able to trade either with or against it. So, there is that.

Niels: 00:58:31

In the old days, Mark, in the old days we called it front running, didn't we?

Mark: 00:58:36

Oh, heaven forbid we would say something like that. But I had an interesting discussion back at John Henry, and it was sort of a cheeky comment. John would go, “Why are all these brokerage firms, why do they want to come down here and want to have see our business? Why do they want to have us trade with them? And why are they willing to do this at just such low prices?”

Now, he knew full well what they were thinking. Well, they wanted to see our flow because then they can sort of say, well, if I have that I wouldn't break the law. But, it gives me a huge advantage if I see when large CTAs would be coming in with large orders. And even if I don't profit from it, if I know that the freight train is coming down the track, and I know this step off the track for a while because they're going to get hit by the train, that is a tremendous advantage you could have vis a vis the other competitors who might be trading in the marketplace.

Niels: 00:59:45

Yeah, and of course, I mean, the fact that data, ordered data, whatever it's called, is sold and firms today are profiting from buying that data from various platforms. It's a real thing.

And of course, you and I know that in the press relatively often you're going to see these articles where so and so investment bank is out saying, oh, if the S&P does this, then CTAs will have to sell US$80 million worth of equities, you know, whatever. So yeah, it's definitely a thing.

And, as I'm sure people know from listening to me in the past, I'm not a great fan of the shops that we place our trades with, whether or not there are Chinese walls or not, that they are so public about these things.

Mark: 01:00:45

Well, the important part in this one is that we spent a lot of time talking about, okay, that the sweet spot, for most trend followers, is sort of an intermediate trend, you know, a couple weeks. Long-term is also very good too, but short-term not so much.

But I would sort of say if you're a larger or even if you're a smaller CTA, all of the research, or we'll say that every CTA is a short-term trader. What I mean by that is that how you actually execute your orders, so how you allow your orders to enter the market, how you trade, how you sort of impact or try to minimize your impact on flow will have an appreciable impact on your performance.

Now, when you think about it, CTAs will have great double-digit years. There are other years in which you're going to have single digits or you'll have modest returns. If you can be able to cut your market impact costs by 1% to 2% that, in some years, could represent a significant portion of your overall returns.

And this has an impact even though people will test models based on, okay, I'm going to execute market on close. Well, market on close still has a market impact because it is a market clearing price and you get the price on close. But that doesn't mean that it doesn't have market impact relative to what the price may have been a half hour earlier.

And so, I would probably sort of say that when you're doing some equity trading, we spent a tremendous amount of time looking at shorter-term trading, like, what do you do in the first 10 minutes of trading? What do you do in the first half hour? You know, how do you VWAP the trades? What happens half hour before the close? What happens 10 minutes before a close? What happens at the close? So, we could spend a complete podcast on just the microstructure of markets and how you have to behave, even if you're a trend follower that's looking at longer term trends, on this topic.

Niels: 01:03:15

One thing I want to clarify, you talked about how a lot of people think, I don't know if it was your opinion or whether just your general observation, that a lot of people think that medium-term is kind of the sweet spot for trend following. All I just want to say is that that's not what our research shows. And so, I just want to make that clear.

I think it's a common understanding that oh, well, maybe short-term is a bit too short, so you have too many transaction costs. So over time you can see that short-term trading, you can just see it the SocGen Short-Term Traders index, I mean, it hasn’t made money for a long, long time. And then you can look at sort of longer-term trend following. And yes, it's been the most profitable in our research. But of course, there's also a cost to it, maybe a little bit more volatility, sometimes higher drawdowns. So, that's what we our data finds.

But I just want to say that these things change over time and there certainly was, up until the last two or three years, some nice opportunities in the “medium-term space” when, when we look at it. But the last two or three years probably medium term has been the hardest hit of these kind of different speeds of trend following.

And I think from my recent travels last week, I think a lot of investors are waking up to that, that and maybe you shouldn't pick a manager that is too focused on, and too set on a specific time frame. But actually, being adaptive, even when it comes to speed, is quite important. That's a side topic. So, I don't want to go down that road.

Mark: 01:05:02

I was going to say that you're absolutely right. For a long-term high return performance, the longer-term trends do better, albeit you're going to have to take some more risk to do it. But the key point that you make is that no one strategy, in trend following world, always does wealth. So, if ever there was the reason for diversification, it's because nothing works all of the time. So, as we see with this alternative versus traditional assets, alternative does very well. Now, it's not so well. So, that's why I always think in terms of this sort of a three dimensional diversification. It's style, timing and markets. You got to sort of say, how do you make sure you fit over different time horizons? How do you fit across different markets, and then slightly different styles? You’ve got to diversify.

Niels: 01:06:01

Yeah, you’ve got to diversify. Okay, so the last topic we're going to get to is what you mentioned you wanted to spend a little bit of time on as well.

Of course I should have my buddy Rich here for anything that mentions the word complex adaptive systems. That's kind of his, one of his pet peeves that he loves to talk about, and knows a lot more about than I do. So, tell me where we're going with this because, as you said, it is potentially something that is very, very important.

Mark: 01:06:37

Well, we'll sort of say the, the tremendous benefit but then the tremendous, we'll sort of say, potential problem with trend following is the fact thattrend following is very good about isolating exactly what it looks at and then sort of throwing out all of what they consider extraneous information.

What do we mean by that is that you don't care about what the fundamentals are. All you care about is price signals. The big issue in finance is always what we call now causal inferences. What are the causes for why markets move? A trend follower says, I'm not interested in causal inference. All I care about is the prices are going up or down. I'm a reactive, I'm not looking for the fundamentals. Okay?

And finally we'll sort of say the trend follower says, like, you know, if I'm putting a trend model (and there are variations, so, I'm not sort of saying this depicts everyone), if I'm looking at the trends in gold, I don't really care what happens to the dollar at the same time. I don't sort of say like, well, what happens to the dollar will have an impact in how I trade gold. I sort of say, you know, I, I isolate this, and I look at it as an independent market. I isolate and forget the fundamentals. I isolate and say, I don't look about causal inferences. I just do what I do very well, which is just to pick up the signals and then execute on that.

Okay, that's the reason for being and why it is successful. So now the question is, but can we improve and make this better?

So, the whole idea of thinking in terms of a network or a complex adaptive system is that, well, if I'm looking at the gold market, doesn't the dollar have something to do with what's going on in gold? So, if there's a trend in dollar, that it may tell me something or have an impact on what will happen to the gold market.

So, let's go back to our idea of flows. Flows out of the dollar may flow into the gold market. Okay, the behavior of the dollar market may have something to tell us. It may be sort of causal prior to what might be happening in the gold market.

And so, if I look at this as a system, as a network of markets, that those markets may be interrelated. And the influence of one market, because of its flows in and out, because of its behavior, because of its volatility, will then have an influence on another market. So, we have to think of this as a more richer, complex system. This is not an easy problem to deal with.

So, I'm not saying I solved it, but I think that that's what we want to try to say is that if you could sort of find those connections and realize that they're nonlinear, they're episodic. So, they don't happen all the time. Which means you're going to need a lot of data and a lot of computing power.

You're going to have to use some sort of, let's say, complex sort of machine learning techniques to extract this information. But if you could do that, then you can create an edge that may not have existed before. So that's what we think that we're trying to look at.

And I want to leave the listeners with the idea that, should you look at markets in isolation or should you sort of see like what is the connectedness across markets? And then if you think that they are connected, which I do, then you say, is there a way that you could maybe find a way to exploit that connectedness?

Niels: 01:10:36

Yeah, but just to be clear here, Mark, I mean isn't that something we've always known and a lot of people… I wouldn't say a lot, but there are certainly managers out there today who do not just generate their signals based on an individual market move. They will do cross sectional momentum analysis, or whatever we define it as. Maybe the challenge is still to find something that we can… Because these relationships change. So again, that's part of the problem.

So maybe we can become better at it, more precise at it, know when these connectivenesses are changing or breaking down, etc. But I don't know that it's new that there are relationships that can be exploited by CTAs because I think some people do that. We don't at Dunn we don't. But certainly… And also this principal component analysis type stuff that might have an influence as well.

Mark: 01:11:46

You're absolutely right. This is not a new problem. So, I don't want people to think that, okay, I'm the first person to discover this. We do this with some time series when we look at whether markets are co-integrated. So that's one simple way to do it, and that's, are two markets related, or are they co-integrated. Okay, but we're sort of saying that we're not looking at just the co-integration, we're looking at the entire system.

And second of all, most CTAs will spend a lot of time looking at what is the correlation across markets and do I need to have both of those markets in the portfolio? So how do markets cluster? Or you could sort of say its principal component is cluster analysis, hierarchical clustering or how markets are connected. But the problem comes, or what we think is the problem is that is part of the portfolio construction optimization problem.

What you want to try to do is, is think in terms of not correlation but causal relationships. And also, you want to think about how you integrate predictions with the optimization. So this is an area that's, you know, somewhat obscure. People have been writing about it. This is what they call ‘decision focused learning’, or what they call… We generally look at smart prediction and then we optimize. But we need to put the two of those together and sort of think in terms of how we optimize and predict at the same time.

So, this is the problem, you know, if someone has solved this, more power to them. But you know, this is what's keeping me up at night.

Niels: 01:13:42

Sure, well, that's perfect, Mark. Thank you so much for really a wonderful bouquet of topics that we covered today.

And if people listening, like myself, really appreciate all the time and work you do in preparing for these conversations, do head over to your podcast platform of preference and leave a rating and review and show your appreciation for Mark and all the other co-hosts, by the way, that show up every week to hopefully produce some useful and educational conversations. You can of course also share the podcast with your friends. I think I created a Link once called toptraders.com/share, that link probably will allow them to sign up and listen to it.

Now, next week Alan is joining me, but we will be joined by a special guest, a previous guest, and I'm sure we'll get into some topics that we have touched on before, of course, but in much more detail. So, I'll leave you a little bit in suspense to find out who it actually is. But I think you're going to love him and if you.

I was just going to say if you have some questions for Alan and I and the special guest, but it's not really meaningful because you don't know who the special guest is. So let me skip that and just say that we love you coming back every week listening to us.

And of course, you can also sign up for some weekly and monthly trend following updates from me and, and from Rich. So by all means head over to the website and see what's available.

From Mark and me, thanks ever so much for listening in this week. We look forward to being back with you in about a week's time. And until next time, take care of yourself and take care of each other.

Ending: 01:15:37

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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And remember, all the discussion that we have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also, understand that there's a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Thanks for spending some of your valuable time with us and we'll see you on the next episode of the Systematic Investor.