Shownotes
Nigol Koulajian, founder of AlphaQuest rejoins Niels and Alan for a conversation about markets shaped less by fundamentals than by perception. As political influence deepens and volatility is managed rather than discovered, traditional risk signals lose meaning. Sharpe ratios climb not through edge, but through exposure to hidden fragilities. Diversification is narrowing. And while systematic strategies continue to hold their line, the forces around them are shifting - slowly, structurally, and with consequences. This episode is about recognizing imbalance in real time, resisting the comfort of consensus, and asking whether today’s apparent stability is masking tomorrow’s risk.
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Episode TimeStamps:
00:32 - Introduction to our special guest
01:57 - How did the economy end up the way it is today?
09:15 - Is it just a cycle?
19:46 - What is the end game?
23:47 - A short masterclass on skew and convexity
31:45 - How trend following has changed over time
39:18 - Should you optimize your portfolio from a short or long term perspective?
45:19 - How Nigol navigates the strong headwinds for CTAs
53:04 - Turning the risk of pod shops into opportunities
56:06 - When will we revert to a more "normal" environment?
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Transcripts
You're about to join Niels Kostrup Larson 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.
Speaker B:Welcome or welcome back to this week's edition of the Systematic Investor series with Alan Dunn and I, Nils Kast Larsen, where we each week take the pulse of the global market through the lens of a rules based investor.
Today is a very special episode as we are joined by Nicole Kolachian, who is not only the founder of Alphaquest, but actually also one of the very first guests we had on the podcast more than 10 years ago. So, Nicole and Alan, it's really great to be with you both here today. I'm going to start with you, Nicole. How are things in New York this morning?
Speaker C:Excellent. A nice sunny sky, mood is good. Yesterday we had the Robin Hood conference. All the big players were there getting their viewpoints.
Yeah, another great day in Magaland, as they say.
Speaker B:Fair enough. What about you Alan? How are things in Dublin?
Speaker D:All good here. No bright sunshine here. It's pretty gray and overcast. But that aside, it's probably not unusual to report that. That aside, all is good here.
Speaker B:Yeah, it sounds a lot like Switzerland at the moment.
I have to anyways, we've got a solid lineup of topics and since we have Nigole here, I think I'm going to change the format a bit to just focus on some of these bigger topics that are so important instead of the sort of longer trend following update that we normally do at this stage. But just to mention that, you know, all is well in trend following land with all the soc gen CTA indices posting gains so far in October.
But there are, as I mentioned, quite a lot of things we want to talk to you about, Nicole, but I think it's important maybe to build a little bit of a foundation and why some of these topics are important and I think would be a good place to start kind of reviewing in your, in your view, kind of the road to where we are today and maybe also for people to better understand what, what may not.
I mean, may not be different per se, but it certainly feels different to many people in terms of where we are, how the markets operate and so on and so forth. So can you take us back a bit and maybe start from there and then we'll slowly get into all the details?
Speaker C:Sure, Niels, I'll try. Although I'm not an economist nor historian, but I'll tell you a little bit of my Experience?
Speaker B:Yes, please.
Speaker C: s and:And there was another layer of, you can call it political interventionism in the markets. And then finally you had the gfc, which was quite an intense event where the Fed and the treasury had to intervene even more in the markets.
And what you see since then is that the political influence on the markets are becoming stronger and stronger. Now to give that context, where the Buffett ratio. So if you see the importance of the stock market and the US Economy is becoming bigger and bigger.
So if you think of the Buffett ratio, which is the size of the stock market relative to gdp, long term average for that ratio is that the stock market is about 70% of the size of GDP. Today we are over 200%. So effectively the stock market has gone from becoming the tail of the dog to becoming the head of the dog.
So the US economy is actually driven by the stock market. So 1% return in the stock market is giving you 2% of GDP in new liquidity. And that's very, very, very influential.
Now this is not like the timing of the injections of liquidity and the influence of the Fed. And in today's case, you see Trump being very active that the rates have to come down.
Even in a strong economy with full employment, the timing of the influence and the pressure is even more significant because it's happening whenever there's a correction. So the stock market has gone from being the risky asset with high returns to effectively becoming a new fixed income.
In the US no one speaks about equity risk. It's effectively what are you missing out when you're not in the market, when you're not taking market risk.
So it used to be that as you're getting closer to your retirement age, you would be more into fixed income. Today it's basically the fear or the sense of any type of risk in the market is gone. Market is today risk free. You listen to Warren Buffett.
I would say he's the main cheerleader for the stock market. And if you're wise and you have a long term perspective, you can be rich by just holding the market.
And that we don't look at the corrections and that's the message. Don't look at the daily ups and downs. That's quite meaningful. Right?
So the Fact that everyday retail, I mean the ownership in the stock market has increased substantially in this period as well. So as the US Stock market as a percentage of global stock market, the US is about 60% of global stocks. Today, very few stocks are 50, 60%.
Effectively technology, the max 7 are about 40% of the market cap. So effectively there's a concentration happening the US part of the world.
The US stock market as part of the US economy and all that is basically supported by the political apparatus of the U.S. and the central bank. In that context, trend followers have had a headwind. Obviously trends are very quickly reversed.
And typically the trends that you see when there's uncertainty, in particular when the market is going down or you have inflation, all these things are basically being controlled and suppressed by the political system. You know, the idea today is you can create as much economic growth as you want without any inflation.
That's the conclusion that we can reach based on the last 40 years of market history. And the data set proves this. Right?
So if you're only looking at the last 40 years, you say this is true, we can just print money and there's no consequence anywhere. As you know, financial history goes further than back and there are consequences.
And today the debate is slowly in the more elite parts of the market. You see, you start to hear that there's a debasing trade going on in the US dollar.
So you cannot create this type of environment without an effective devaluation or effectively a massive tax on wealth, which is what's going on. So in the hedge fund world, there's a lot of, let's call it, value creation that investors perceive there's a lot of alpha.
In particular, the large platforms seem to be creating very high Sharpe ratios on hundreds of billions in assets that alpha, I mean, I'm sure we'll get into it. For us, the surrogate factor that explains all these alphas is is not skill, but tail risk exposure.
So although these platforms are allocating to very diverse PMs, and these PMs are highly diversified and they have standalone very high Sharpe ratios, the reality is that all these alphas locally look uncorrelated and they look like alpha. But in reality, when you take Taylor's into account, you will see that they're actually all highly correlated to each other and to the market.
So the trade is not only the market going up. So the S and p has analyzed 16% a year over 16 years and 25% over the last three years.
It's that mean reversion is the real bubble I would say that there's the confidence to buy the dips or to trade equity long short that everything is going to mean revert and everything is going to converge. We're in an equilibrium which is stable forever and the market are, are priced as such.
Speaker B:I am, I get everything you said.
I completely see these things and, and observations and even to me, and I think the three of us, I, I wouldn't say we're the same age, I'm probably the oldest of the three of us but it seems to me that a lot of people have, you know, the experience that you just described. However, if we zoom out a little bit further, I wonder again if this intervention that we see whether it really is that unprecedented.
It's unprecedented in the sense that now we're seeing it and maybe it's coming from a specific source but I wonder if we haven't seen this before, if we went back further in history and politicians getting involved with central banking and all of that.
So I'm not dismissing that this is what's happening right now, but I wonder if it's just part of a bigger cycle and we have to, as you may also believe at some point we have to kind of clear the air and we can start again.
n in like as you mentioned in:But you also mentioned the word, the word Sharpe ratio and I love to pass it on to Alan actually to, to ask you a little bit about this and some of the other metrics is that, that you find to be relevant for the discussion, both those that people shouldn't rely on and those people should, should rely on a bit more. So if you don't mind Alan, jump in here.
Speaker D:Yeah, sure.
Well, you mentioned the very high Sharpe ratios in the POD shops and obviously they post a high Sharpe ratio in aggregate and then at the individual level as well as you're saying and it's definitely something I see as well. Speaking to investors, I might show them a quad macro Strategy with a 0.67 sharp.
It looks very respectable and they say, yeah, that's not that interesting. We typically look for one sharp and above as a minimum.
So there's kind of this baseline expectation now that anything below that is uninteresting regardless of the correlation profile. So maybe talk to us a little bit about what's the shortfall of that thinking for a start. And then maybe secondly, you mentioned tail risk exposure.
I mean, so maybe just to elaborate on that a little bit more, why Sharpe is obviously not capturing that tail risk exposure.
Speaker C:Yeah, thanks for the question. So Niels, 100% that this is not like an end of the world scenario, it's just a cycle.
And the current investor mindset is that this is the full market cycle that we were seeing. In reality, we're not. That's the only question.
Which means the tilt of risk and exposure and leverage that they're allowing themselves to have is just different than if you took the whole market cycle into account. So typically out of this situation, it's not the end of the world. It's just an inflationary cycle that comes and it comes 100% of the time.
There's no way you can have this amount of debt and not end up and continuing to print money without inflation as a stabilizer. So how does this relate to Sharpe ratio?
If investors are becoming greedy in terms of the quality of the returns that they're getting and they're rewarding high Sharpe ratio strategies by allocating to them so effectively, investors are not only chasing high returns, they're also chasing high Sharpe ratios. What that encourages managers to do is to expose themselves to more hedged components of risk. So the trends are typically in the delta 1 markets.
And if you take the delta 1 markets and you hedge more and more principal components of risk, you will end up with things that have less trends but are more mean reverting in nature, that are less liquid and require more leverage to achieve a certain level of volatility.
So if Delta 1 markets on trend following gives you a sharp ratio of 0.3 or 0.4, you say, instead I'm going to be trading spreads on these markets and interrelationships. You're removing the trend component. The trend component is at the highest level, the most macro.
Now what that gives you is say, hey, you know, I'm going to actually remove or maybe 50% of my portfolio is going to be hedged. And in the macro world it could be that you're, you know, two times long, two times short.
In the fixed income world you had the situations of, you know, the LTCMS where you were, you're, you're basically 100 times leverage but very, very with very accurate hedges and you think risk is zero and VAR is very, very low. Today the same type of scenario is happening in the single stock world. So PMs that are required or are indeed encouraged to achieve.
High sharp ratios are designing strategies where they're hedging 70, 80, 90% of the volatility of their book and effectively are exposed to very, very distant alphas. Right?
So these things that look like very uncorrelated to anything, that seem to be purely noise, without any trends, are amazing markets because they're uncorrelated. And in everyday life you seem to be trading, you're creating new source of liquidity, it seems by hedging 90% of the risk.
So what ends up happening is if you want high Sharpe ratio, you effectively need to have high leverage.
And today if you go to the large brokers, I won't mention any names, but you can get 30 times leverage on single stocks because the hedges are so accurate and that's the expectation from the platforms.
They basically create these independent entities that are fully leveraged and 30 times is available, but they're typically more like 20 times leverage. The cash is kept in house and the PMs are able to have these extremely levered portfolios with very, very independent risks.
Now the danger of that, as you know, is that the slightest change in volatility, the slightest change in correlation will lead to very quick changes in liquidity as well. You don't have banks there anymore that are committed to providing liquidity. The liquidity is provided by other PMs.
The liquidity all comes in at once and all leaves at once.
So you see platforms that have zero correlation to the market, you know, Citadel, Millennium, Balasny, and then you see that in everyday life, amazing sharps. But then you have a situation such as Covid and all of them are down 20, 30, 35% in Tramonth, although they're uncorrelated. How could that be?
Right, so the sensitivity to leverage is very, very high. And this, the risk of this market regime is that it creates the incentive to take these massive amounts of risk that are not captured by volatility.
And there's a self reinforcing cycle, there's a reflexivity in the market where because the high sharp ratio attracts capital, you go on and you add to your current position. So if you're 10 times leverage, every dollar that you make, you have to go on and put on $10 of new positions.
You're creating a self reinforcing cycle in mean reversion or in convergence.
And if the Fed is there to provide the safety net the market put, you don't have to pay for that hedge, then your convergence trade is highly profitable for a long period. Of time. And it becomes you're taking massive risks without being aware of the downside.
Now in the context of the economy you're effectively, you can make more money playing the markets than trying to be productive in the economy. Right. So it becomes, hey, like why should I work?
I can make more money being long Bitcoin or you know, buying hedge funds and trading or shorting options. As a matter of fact, it seems like money is coming out of nowhere and that's where we are.
Speaker D:It's interesting.
Covid and as you say in March: We had SVB in: Speaker C:Those were more organized and gentle corrections that happened over time. Covid happened almost too quickly for these firms to adapt.
And then remember in: a short period of time as in: adily increasing means versus:So the status quo is not really a status quo. You're actually increasing risk as you continue to make these high shock ratios.
Speaker D:Yeah, I just wanted to ask in relation to what you said at the outset about the Fed port and I mean we have seen a shift in markets in the last few years. It was a kind of a demand constrained economy. Now it's more supply constrained and fiscal dominance. You mentioned the debasement trade.
So that wasn't there a few years but now it's more fiscal dominance.
As you say, the financialization of the economy has got even greater, which would argue in favor of, like, if the stock market falls 20% now, as you say, it has a huge impact on gdp. So the Fed has to react to that. At the same time, you've got fiscal dominance. So it's kind of hard to see, okay, what's the end game?
It's just runaway inflation. Is that the end game?
Speaker C:The end game, historically, if you look at the market cycles of all the big empires, the end game is always to try to give people paper in exchange for physical things.
So you try to keep the physical commodities in your pocket and give other people paper, and then you try to impose the paper with the strength of your military on other countries that you invade type of thing. In today's world, the US doesn't have much room for expansion, right?
I mean, you got Russia and China and India that are quite strong countries from a military perspective. It's unlikely that we're able to expand into their territory to effectively sell paper to a new population.
In the US if you look at the size of commodities, let's say the Goldman Sachs commodity index relative to the S and P, it's at the lowest level it's ever been. And it's been at that level for about 25 years at this point. So very close to that low.
What could happen is you have AI being 40, 50% of the economy right now. AI depends on energy.
And if the AI market cap is 50% of the stock market and you don't have the energy supply for that, sooner or later all these players, as the projected earnings go into real earnings, actually have to go and build all these massive platforms. They will have to get the energy. And the energy, unfortunately you cannot print.
You will actually have to buy real commodities or whether it's uranium, whether it's whatever it is, there's going to be a real world infrastructure to support AI. Where today AI is more of an idea and of a projection.
And the reality in the real world and how it's actually implemented is not really fully taken into account. So you can very easily see that the AI demand for energy will trigger a massive inflation in certain limited assets.
And once investors see that, you can have returns by investing in nuclear energy or in certain energy sectors, you're going to have a massive flow because it's a diversified return source. Today you're already seeing a massive boom in these nuclear stocks. You're also seeing gold almost doubling in price in a couple of years.
You're seeing very abnormal price moves. I would say it's the tip of the iceberg relative to the move that has happened in the AI stocks.
But that's typically the natural step, both historically and if you just look at the present moment, it's a natural. The demand of AI is going to become an energy demand and there's no one there to be able to supply it. So we're going into very far away.
We're speculating on energy stocks that with new technologies at a very massive scale. So there's an incredible dependence and a vulnerability to any type of surprise.
If these small nuclear reactors are not what we expect, then AI has to basically collapse. 70, 80%. The valuations would have to collapse.
Speaker B:Yeah, I mean, I think we should maybe continue a little bit down the road in terms of, okay, so we have the shop out there, but actually you're looking at other things that you think are better ways of looking at risk. Maybe you can expand a little bit on that. And also the words skew and convexity.
From the very first conversations we had, Nicole, I think there is a bigger audience who understand it, but feel free to just give a short explanation as you move through this topic, because it is important for people to understand, especially when we talk about the risk of convergent portfolio construction and so on and so forth.
Speaker C:There's an incredible opportunity in the market today, bigger than the mortgage crisis of the gfc. The fact that convexity and skew are not in everyday language and volatility is effectively, people are measuring risk in one specific way.
Really, the risk is not there. Volatility today does not measure risk. So standard deviation of returns.
If I tell you that there's a stock which is going up 5% a day, and there's another stock which is going up 1% a day, volatility of both is actually zero. There's no difference in the risk.
Where obviously, for example, the risk of the stock which is going up 5% a day, is higher than the risk of the stock that's going up 1% a day. So there are major, major blind spots in the main risk metric that people are using today. So where does skew and convexity come into play?
If you're a PM and you're designing a portfolio and you're designing a hedge, your volatility cap, your volatility budget is dependent on standardization of returns and correlation. Low volatility and high correlation between your longs and your shorts creates an opportunity to basically leverage, as I said, 30 times on stocks.
When you look at the option market, there's something very different The Buffett ratio. So when the stock market is large as a percentage of the economy, the skew of the S and P becomes very negative.
The skew means the volatility on the upside versus the volatility on the downside are very different. If you look at the skew, the rolling skew of the S and P today, it's the most negative ever.
So the options market knows that when the market starts to go down, the liquidity is going to dry up faster than ever before. Volatility is going to go up faster than ever before.
Yet this is a fact which is disregarded by the majority of hedge funds, by their risk managers and by the investors that are allocating into hedge funds. So the perception is you're generating alpha and this alpha is based on skill.
The reality is we have shown in our research that alpha and high Sharpe ratio are 80, 90% correlated to negative skew.
So the more imbalanced your volatility is, if you're willing to underwrite to make less money on the upside and lose money faster when you're losing, you're able to create a high Sharpe ratio strategy very easily. So the market is skewed. It means downside volatility is higher than upside. Convexity is a measure of non linear risk in both directions.
So you can have something effectively you can be long options both on the upside and the downside convexity is effectively volatility is going to go up faster on the downside versus upside or upside versus. So it's an asymmetry and volatility. Both are in a market where the Fed has provided the Fed put are ways to create alpha without any perceived risk.
So what happens from here the opportunity is if people are willing to underwrite tail risk in order to generate alpha and in order to generate high Sharpe ratios, investors are willing to reward you for high Sharpe ratios because the risk is delayed. Everybody is going to do that.
Then there's an opportunity to go out there and to take almost, I'm going to say to arbitrage the different measures of volatility and be able to be long volatility while actually generating returns.
So if the market is willing to look at volatility to the measure of standard deviation of returns and another measure of risk is standard deviation of price. So the stock which is making 5% a day is a much more riskier stock than a 1% stock.
You're able to basically find places in the market where you can actually be long insurance benefit from the tails by trading short term breakouts. In places where the different measures of risk are pointing in different directions.
So when volatility is low relative to the other measures of risk, effectively trade short term breakouts.
And that's something we have done and we've been able to generate very substantial alpha to the S and P and to the CTA index over the years by just not only trading momentum, but trading momentum in fault compressed regimes or in fault compressed markets. So it's a counterbalance. The benefit of this strategy is there's enough inefficiency that you can actually make money while you're buying insurance.
And this is even in the market where there's been no major corrections.
Now if markets were to go back to their long term means in terms of Buffett ratio or in terms of volatility in terms of tail events relative to everyday events, then you would have a massive shock and rebalancing in markets where you could make a lot of money using this strategy.
So this is, this is the real imbalance, I would say the real arbitrage in the market today is the ability to buy insurance not through options, but in delta one markets trading short term breakouts when the volatility measures are not aligned. So ATRs versus standard deviation.
Or it could be that you can see that a market volatility increases when the market is making new highs and new lows versus another market. The volume compresses when it's making new highs and new lows.
So there's all these different nuances within risk that can be measured and it's an opportunity to generate alpha with returns. There's no skill required in this. I would say that we do it, I mean we've done it for 25 years.
But just through the descriptions I just gave, anybody could go and replicate a good component of this alpha.
Speaker B:There's no doubt that, and you alluded to it early on that, that you know, the environment has changed in, you know, in the last, call it 10, 15 years maybe. And we can all speculate as to why that might be. I'd love to hear your thoughts.
But you also mentioned that say strategies like trend following had been challenged during this period.
And of course if we broaden it out a little bit, we could say that probably all CTA strategies, whether you're short term, medium term, long term, have been challenged, but at different times because you operate in the short term space.
And you mentioned short term breakouts, but I think also your firm is evolving as the environment is changing, as we have these new players in the market.
I was going to ask you whether you could talk a little bit about first the changes you've seen from your lens, but maybe then we can also go into why you think those changes have occurred and maybe that ties in a little bit more to the, to the pod shops or something else, so to speak. But I'd love for people to understand because it's so easy for people to throw out. Oh yeah, it's been a difficult, you know, period of time.
Question is, you know, has it or why has it?
And, and what are the small differences between whether you're a short term breakout manager or whether you're a long term trend follower and so on and so forth.
Speaker C:So there's a large dispersion of returns within the CTA space. The you can look at the short term CTA index. It's been losing money effectively since it was created.
On the other side, very long term CTA is more like the benchmarks and the even the AQRS. Some strategies such as 12 months price momentum and longer term strategies have actually managed to generate money.
So if you decompose the returns today, the majority of the assets in the CTA industry are allocated to very, very long term CTAs with biases that reduce their ability to make returns during equity corrections.
Effectively over the years the CTAs that have done well have attracted capital and they have continued to grow and they have continued to style drift into strategies that are more risk parity like.
And those are the ones who although they're CTAs effectively by being very long term they've had less trades and they've maintained long positions in fixed income and in equities. Those are the strategies that have done well.
Other CTAs that have done well are CTAs that have supplemented their momentum strategies with long equity positions or they have supplemented their momentum returns with the volume pression or basically volatility selling as a way to diversify away from pure momentum. So if you want to have a clear, I would say surrogate factor again for the quality of the returns of a cta, convexity is the right benchmark.
Effectively the more positively skewed the strategy is, the lower the Sharpe ratio in the last 15 years, the more negative is skewed or the less capable a strategy is in hedging equity returns. Typically the higher the Sharpe ratio.
So today the mass of assets in the CTA industry have slowly drifted towards longer term, I'm going to call them diversified or style drifted CTAs and those are the ones that are More risk parity.
Like they're the ones who have more carry trades, they're the ones who are selling volatility, they are the ones who are buying dips, they're the ones who are trading spreads and the mean reversion of spreads. Those are the ones that have attracted assets. So there are many dimensions you can look at.
Time frame being short term, you're more long convexity and you're very vulnerable to short term noise. And that hasn't worked effectively. Being long volatility has been a horrible strategy in the last 15 years. And so that's one factor.
Let's talk about government intervention in the 70s. After the inflation of the 70s, commodities became subsidized in the US so farming and the oil industry have massive tax benefits.
And in order to suppress the moves in commodities. When that happened, then FX in the 80s had big moves. And then in the late 80s of course you had the suppression of volatility.
And countries used to prop their economies by lowering the value of their currency. Then currencies became effectively more controlled and the move then went into fixed income. So first Commodities got pinned.
s and early:Now that fixed and then fixed income now is a little bit, has the boundary of inflation heading against it. So we're seeing signs of inflation. So there's less room to operate in the, in the fixed income world to propel the economy finally.
And the final barrier is of course stocks, which is where governments are effectively acting. You know, stocks have become risk free.
So that progression has led to style drifts in the CTAs with the ones that are looking to make money in the short term at the expense of being able to hedge equity correction.
So the more you're trying to have a high Sharpe ratio today, the less you'll be able to handle the full cycle or the market correction when the market mean reverts to its long term average in terms of valuation, et cetera, et cetera. So the sector allocation is a style drift, the timeframe is a style drift.
It means CT's have a more and more long term CTAs have also if you look at the returns of CTAs 80, 90% are from the long side. Effectively the short side doesn't make money very often. And CTAs that have been successful have also style drifted into long only strategies.
And you can replicate easily and you can see which ones have Done that.
Which ones have not so long versus short long term timeframe, the asset class style drift and then the long volatility versus short volatility style drift. Right. So should you be mixing mean reversion with momentum versus not?
So that's a little bit of the kind of the dimensions or the factors as I see them, that explain the differential or the dispersion in the returns of CTAs. But if you want one factor, you're not into all these different things.
Look at the convexity or the amount of the skew of your CTA and it's typically going to tell you how well they're a complement to your portfolio, but also what their sharp pressure should be in the recent environment. In the full cycle, a skew is not a predictor of returns. In the full cycle.
In the short term cycle it seems that negative skew is a predictor of returns. And that's a big confusion and that's a very, very big risk when it comes to research.
So the intelligence, the data that's coming in, all the new data sources, the alternative markets, the ability to optimize way more than ever before, have all been justifications for CTAs to drift into negatively skewed strategies in the name of diversification. In reality, CTAs have gone from being long, long term tails to effectively being short tails in many, many different areas.
So if you look at the rolling skew of the CTA index, it's actually flat. CTAs are no longer a diversifier for portfolios.
Speaker B:Now, I'm not an expert in SKU like you are. However, I've got just a couple of things that I wanted to try out, let's call it that.
Firstly, I completely agree that in my career I would say managers and by the way, I think we do need to sometimes distinguish between, as you rightly say, CTAs that have broadened their product with other types of strategies.
And then there is a small minority now which I would call kind of pure trend followers who are kind of living the way we did back in the 70s and the 80s and the 90s. And I think it's very important for people understand, understand that there is a difference. So I appreciate you highlighting these things.
However, and it is true, I think that let's just focus on the trend followers because I think it's too difficult to when you get into diversified strategies and all of that.
I think it is true that we have become more long term, but my point would be that we should, because we are adaptive and we don't sit down, we may be back in the 70s, the 80s, 90s, you would sit down by committee and say, oh, we should be, you know, 25% short term, 50% medium term and 25% long term. It's not how it's done anymore. It's all data driven. We want to use the data to tell us what, where to select the parameters and so on and so forth.
So I personally I'm not so concerned about the fact that we are more long term because the data is telling us to be that of course if it changes and suddenly shorter term horizons become more profitable. As you rightly pointed out, the Short Term Traders Index has not made money for 15, 20 years, however long it's been around.
So there would be no sense in a trend follow to be a short term trend follower. I just don't think that works. It's different what you guys do. I don't see you as a short term trend follower in any way, shape or form.
So, so I'm not so concerned about the fact I'm also, and this is where I'm really out of on my, on, on deep water here because as soon as you start talking about skew, I know I'm not at your level, but I wonder if this change in when you calculate the skew of CTAs and let's just call it the trend following index.
I just wonder if the fact that maybe the equity market, the way it has moved for such a long time, basically going up for 20 years, essentially whether that's part of the explanation as to why the skew number looked different. And then maybe you say okay, trend following skew has to be measured against a much longer term horizon today than otherwise.
These are just my thoughts.
Speaker C:These are questions that we have to ask ourselves every day.
And effectively what you're saying is should we optimize over the recent market cycle and over the factors that have made money recently versus keeping exposure to factors that have not made money in the short term but make money in the long term.
Speaker B:How do you define the short term here, Nicole?
Speaker C: In reality, CTAs just before: So from:So the question is a Philosophical question is should you optimize based on the factors are working now or should you optimize on the 100 year cycle or the 50 year cycle? And effectively that's the choice. And that's why when we talk about skew, I'm saying skew is the most differentiating factor in the last 15 years.
Whether you're long skew or short skew is going to be the difference in your Sharpe ratio. So we use Sharpe ratio as a predictor of asset flows and we use Sharpe ratio as a predictor of market regime shift.
What you're saying is that the market regime shift doesn't happen. We're saying the market regime shift is happening all the time.
When you look at Factors, short term PMs are chasing the factors that have worked recently, the platforms are allocating to the PMs that have made money recently.
And there's a major, there's a cycle, there's a short term cycle in the market that has become very intensified by effectively we try to allocate to the factors that have underperformed on breakouts when they start to do well. So effectively we're saying if value hasn't done well and the value starts to do well again, we're going to buy the breakout in value, for example.
So it's a philosophical choice, but there's always a side the choices that we're making today based on the well performing factors. That's not a long term optimization, it's an optimization for the short term, some people believe. So there's a risk to that.
Speaker B:Yeah. And I just want to clarify, I'm not suggesting that you should optimize or the trend followers should optimize to the short term.
I'm just saying that at least for those who are price based only, we will pick up a change in market regime at some point if we are data driven. That's all I'm saying. We're not making a prediction as to when this regime will change or anything like that. But anyways, too much from me.
Alan, I'm sure you want to. This is not really where we thought we were going to go Alan, so bring us back to the plan just.
Speaker D:On the short term, the breakout.
s, in the:I suppose the justification for that is, you know, markets have become more efficient back in the 80s, you know, people didn't respond as quickly to the news, so fast breakout did work then. So I mean, do you accept that narrative or not? I mean it's not just since the gfc.
ongoing trend since maybe the: Speaker B:Can I add one thing to that before you answer Nicole, and that is because you've been able to deal with this change, which I think we probably all agree on because we could see it in the numbers. What were the things you saw and what were the things? Without giving any secret sauce away, which direction did you go?
You already mentioned analyzing return streams rather than price. I mean, I would love to hear more about how you've been able to navigate something that has been a headwind for other short term managers, frankly.
Speaker C:Well, the main choice that we have made is that the way our factor exposure takes into account the long term cycle rather than the short term cycle.
Effectively we're still trading commodities, we're still trading effects, we're still trading fixed income equities all the same way with the same risk allocation as opposed to a lot of manners say hey, FX hasn't made money in the last as much in the 15 years.
I mean, of course you had the dollar yen trade recently, but we're choosing to allocate based on the factor exposure of the long term cycle as opposed to the short term. That's basically it. Now what is happening in the short term space is more intense than what you see in the CTA index.
Daily options has created the opportunity for people who are not convexity conscious to make a lot of money.
Speaker B:Right.
Speaker C:So effectively, if you're underwriting daily options, you can make a very, very high Sharpe ratios in this regime. There's many nuances to that.
If you look to at what happened in India with Jane street, the accusation is that Jane street was basically manipulating the cash market to have big moves because that triggered massive option purchases by the retail investors who were trying to have leverage plays into the market. And effectively Jane street was selling daily options to the retail market that was buying whenever there were daily moves.
And effectively they're saying Jane street was creating artificial moves in the daily market in order to trigger levered plays by the retail, by the retail market in India.
So what has happened in the short term space is that in the very short term space there's very high volatility and very high degrees of mean reversion. So if you look at the mean reversion models on the S and P, so if you trade the inverse of a volatility breakout, if the market is up a lot, sell it.
If the market is down a lot, buy it based on daily returns. It's completely out of line with other markets. So there are very specific things that are going on.
Distortions that are short term in nature that are happening today. And there's ways to, you can get hurt by those or you can take advantage of those. But again you have to balance the short term with the long term.
But I'm just giving you these are very extreme.
There's ways to make massive money basically being short daily options on the S P because it makes you effectively more aligned with the market makers. For, for us we don't make those adjustments, but we're trying to.
Now at this point we're doing research on why should two systems that are short term with the same time frame, with the same skew, one is losing a lot of money and one is making a lot of money. So there's very specific patterns happening in markets.
So as you know, there's a massive amount of coal selling on the S and P. So people say I don't, I don't care about making 15% a year. I'm happy to make 10% but I want to have an extra 3% a year guaranteed by basically underwriting coal. Now that creates the, a certain type of mean.
Effectively the S and P cannot go up as fast as it wants. It has like a massive, a price pinning mechanism and it has an effect on the upside volatility.
So the upside volatility is suppressed because of people say hey, I lose nothing. I'm not taking risk by underwriting calls.
So there's weird distortions like that going on and all of these distortions have long term they're going to mean revert.
It means if everybody's selling calls effectively buying calls is you can go long insurance and actually get paid because the coal implied volatility at this point is too low. So I'm giving you market characteristics. But this has implications for learning or for research for CTA or that are purely quantitative.
There's no right answer. The market regime shifts are harder to catch than we think. The adaptations, the vulnerabilities are sometimes take years to show up.
One very important thing to understand the real vulnerability of long term CTAs is to look at the returns without fixed income. Effectively, fixed income has provided a huge amount of positive skew and positive returns.
And if you remove that from a CTA replicator, you will see that the changes that long term CTAs have made are actually much more meaningful on the convex city than we would think.
And it's highly likely that if there is a big, you know, a large inflation regime, that fixed income will not be the positively skewed positive return contributor that it's been for the last 30 years.
Speaker B: be a nice contributor like in: Speaker C:So those are long term CTAs. Now these long term CTAs have long bias, right? And long cds have bottom picking bias.
Speaker B:Yeah, different. I agree.
Speaker C:Yeah. There's different degrees of skew that we're dealing with. Yeah, it's very interesting.
The choices or dynamics, and these are not skill based dynamics, they're philosophical choices and optimizations. Optimization choices for which cycle we want to, we want to be how optimized we want to be for the recent cycle versus the long term cycle.
Speaker B:Yeah, no, absolutely. Alan, maybe I have one more thing that I just wanted to pick Nicole's brain about.
And then if you have one final thing as well, just in, in the interest of time.
But I mean we've touched a little bit around it, but I do think it's a fascinating area and I don't know much about it myself other than I can say, see the observation about all the money flowing into these pot shops and they're certainly not flowing into to the CTA space at the same degree. How can you turn that into an opportunity?
I see some risks, but as Alan pointed out, they have been through a couple of risk off events and they've come out of it so far. But how do you think this might or how are you thinking about turning this new platform player in the markets into an opportunity? Can that be done?
Speaker C: think of them as the LTCMS of:Literally they're the ones who are underwriting massive amounts of tail risk with massive amounts of leverage in order to achieve short term, very short term, high sharpe ratios.
So the opportunity set is to actually look for places in the same way that we looked for volume compression in the futures markets and we traded breakouts and we generate both alpha and positive convexity relative to the CT index. There's a way to do this in the single stock world and on single stock factors.
So looking for places where there's been abnormally high Sharpe ratios, basically replicate as much as possible of the single stock factor universe and look for places where the Sharpe ratios have been abnormally high and bet on their mean reversions. Because the platforms have a very specific mandate and it's to cut off PMs that are losing money and to add to PMs that have made money.
So effectively the factors that have done well are being reallocated to and it's creating distortions in the market.
What we will do is look for high Sharpe ratios on a time series perspective or cross sectionally and cut a short the high Sharpe ratios once the turnaround happens.
Because we're short term traders and we're relatively small at 2 billion, we can actually trade in a timeframe which is not available to the large platforms and we can actually trade against them. So if the platforms have created self reinforcing cycles of volume compression in specific factors, we're looking to short that.
So to me that's the opportunity to make money even when nothing is going on, but also to make a lot of money in case the market regime shifts. And the perceived alpha of these platforms is not purely skill based. It's heavily, heavily convexity reliant, which means it's highly unstable.
And the, you know that the allocation is based on Sharpe ratio.
Speaker D:I think you mentioned reflexivity earlier at some point and obviously you're talking a lot about feedback loops.
You know, obviously strategy is doing well, attracting more capital, then the strategy is then getting, deploying that capital, which is a feedback loop.
I mean, I guess the question is with any reflexive process there's an error that the market is making, there's something that they're missing and at some point they identify and then you get a reversion. So I mean in your mind, in your kind of big picture framework, what is that and when do we revert to a more normal environment?
We talked a little bit about inflation. Typically it would be a liquidity adjustment.
Do you think it's that type of scenario again or problems in the, or is it over leverage that just creates the problem in itself?
Speaker C:The human apparatus is not designed to be efficient in the decisions that it makes when it comes to investing. So the Things that we, in everyday life, we go and we learn, oh, this type of behavior is positively rewarded in the markets.
You're creating imbalances, that's why you have inefficiencies in the market. Our brains are not designed to have a long term perspective. They have short term memory.
And so these inefficiencies that we created can be, for them to be taken into account in our investment process requires data and requires data which is longer term than what most people look at. And it also requires a certain degree of self awareness.
If you're the type of, you're ambitious and you want to prove that you're the best PM ever and you want to raise money like right now, you're going to make decisions which are less optimal for the sake of a short term gain.
And so effectively, in the same way that Warren Buffett has said, hey, buy and hold the US stock market and don't look at the returns, every quant researcher has the ability to look at the long term cycles and take those into account as opposed to more optimized on the data set which is available, which is much more in the recent years. Right. The data of the last 15 years. Every year we're exposed to exponentially more and more data. Right.
So it takes a certain amount of understanding of what is my thinking doing versus what is.
So I mean, you know, I meditate because it allows me to experience life not through the lens of my intellect, not through the lens of my convictions and my beliefs, but in a way which is much more stable, although it doesn't agree with what I see every day. Right. So the crowd is a very safe place to be emotionally for humans.
So if everybody at a party is talking about what you're talking about, you feel better about yourself and you feel safe, yet you're in a very dangerous place. And that is the cycle of counterbalance in the market.
And that's what, as a long term investor you have to be able to understand yourself and understand what is driving your perception of the world as you see it and to be able to neutralize the imbalances that your intellect gives you.
Speaker B:I think that's a very good place to, to stop kind of and, but also a very good place to bring you back at some point and, and continue because that is obviously very interesting and not something you, you come across with too many people in our industry. Nicole, this has been fantastic and we very much appreciate you doing it.
And I would encourage everyone listening today to, in order to show appreciation to Nicole and Alan for the time they spent in preparing for these conversations. Head over to your favorite podcast platform, leave a nice rating and review. We so appreciate this. Next week I'm going to be back with Rich.
So if you have any questions for Rich, then you can send them as usual to info toptraders unplugged.com and I'll do my best to bring them up. But from Alan, Nicole and me, thank you so much for listening. We look forward to being back with you next week.
And in the meantime, as usual, take care of yourself and take care of each other.
Speaker A:Thanks for listening to the Systematic Investor podcast series. If you enjoy this series, go on over to itunes and leave an honest rating and review.
And be sure to listen to all the other episodes from Top Traders Unplugged.
If you have questions about systematic investing, send us an email with the word question in the the subject line to infooptoptradersunplugged.com and we'll try to get it on the show.
And remember, all the discussion that we have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance.
Also, understand that there's a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Thanks for spending some of your valuable time with us, and we'll see you on the next episode of the Systematic Investor.
