Markets continue to evolve, and so do the strategies designed to navigate them. Alan Dunne joins Niels Kaastrup-Larsen to explore why changes in market structure may have permanently altered short term trend following, and what that means for systematic investors. They discuss a fascinating new research paper on market microstructure, the changing role of liquidity, the rise of high frequency trading and why faster no longer necessarily means better. Along the way they examine the Federal Reserve's evolving communication strategy, the outlook for commodities, and why regime change continues to create both risks and opportunities for trend followers.

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Episode TimeStamps:

00:00 - Summer reading, Jeremy Grantham and lessons from early quantitative investing

05:22 - Shrinking retail products, smaller futures contracts and the rise of retail trading

12:18 - First half performance review for CTAs and trend followers

15:36 - Commodity markets, Middle East tensions and the AI driven demand story

20:09 - Kevin Warsh, Fed communication and a new era for monetary policy

30:34 - Why regime change strengthens the case for trend following

38:34 - The research behind the decline of short term trend following

46:44 - Tick size, liquidity and what changed in market microstructure

49:43 - Alternative explanations for why fast trend has struggled

55:35 - Execution, market participants and the future of systematic trading

01:00:45 - Final thoughts on the next evolution of trend following

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

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

Welcome and welcome back to this week's edition of the Systematic Investor series with Alan Dunne and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor. Alan, it is wonderful to be back with you. I know you just told me it is nice and warm in Dublin. The summer has arrived, it seems.

The summer has arrived for sure. Yeah, we're getting some good sunny sunshine. Not quite as bad as continental Europe, but it's definitely been warm the last couple of weeks. And in my attic office here it's definitely been hitting some records this week, 29 degrees or something like that. So, a little bit cooler today. So, hopefully I'll be okay for the next hour at least.

Exactly. I was just telling you that I sit in a basement where I do my recording and that actually is quite nice in the summer, not so nice in the winter, but it's really nice at this time of year. Anyways, we've got, as usual, solid lineup of topics, a couple of new papers, actually, and one of them in particular, I would say, quite fascinating and we're going to get into all of that. But before we do, I am very curious to hear what has hit your radar in the last few weeks. Anything exciting?

Well, it's that time of year, everybody's heading off to the beach and looking for recommendations for summer reading. So, I've been reading a couple of different books but one that been very interesting is the book about Jeremy Grantham, the Making of a Perma Bear, or something like that. And it's written with Edward Chancellor, who's been on Top Traders Unplugged.

So, I think Edward Chancellor has written it but he worked, co-wrote with Jeremy to write it. So, I'm kind of only probably about a quarter of the way through it but already a lot of interesting little anecdotes. And I mean I've always read Jeremy Grantham's investment outlooks. And the Last Dance was a famous one he had there a few years ago.

But I was reading it for about probably 10, 15 years, but didn't really know that much about him, and his background, and how he kind of managed his portfolio. I always assumed he was kind of a fundamental bottom-up kind of stock picker, fundamental value. His letters were always kind of about fundamental valuation and he was always bearish.

But a few things that I've learned, which were quite interesting from reading the book, is one of the him and one of his earlier firms, not GMO, were early proponents of passive investing. So, this is going back quite a long time. And they were also early pioneers of quant investing. So that was news to me. I didn't realize he's a quant basically or he spent a lot of his time doing quant.

And also, that they used momentum and trend type strategies as well and were quite good advocates for them in that they saw a great complementarity between value and momentum. And they were kind of early pioneers in terms of quant investing. And there's a couple of interesting anecdotes about their kind of quant experience. One where they build an early kind of quant equity model based on a couple of fundamental factors for a client. The client was the IMF, and didn't do very well. And then it kind of was parked, and came back to it, made a lot of improvements, and then it did very well, and they were happy with it.

And then, over the course of the next 10 years, they spent 10 years tinkering with it, trying to enhance it, all brought in modifications, all that they felt were valid and made sense, and they couldn't improve it. So, it's just kind of an interesting anecdote. Obviously, this is the kind of challenge that we hear from managers all the time. You come up with enhancements, new ideas, but beyond a certain level, very often, it's difficult to kind of improve on a model.

And another anecdote he had was they found this other factor, he called it the neglect factor. So, if a stock was kind of neglected by the market, so, didn't have a lot of analyst coverage, was, I suppose, small cap without analyst coverage, something like that. They did research and found this was a very strong factor that they were going to combine with value and with momentum, and they had done the research, and they implemented it and as soon as they implemented it didn't work for six years or something, and then they had to park it. Again another experience that you hear with quant managers of doing the research, it all makes sense and then you put it on and it doesn't work.

Yeah, I mean, that's actually very interesting indeed. And it sounds like Alan, you should reach out and get him on your series for sure. But joking aside, and I certainly remember a little bit in the same vein that during that (and I don't really like the term), but the “CTA winter”, then everybody knows which decade I'm talking about. I certainly remember going out to a lot of meetings and people were kind of expecting, oh, so what changes have you made to the model, and we were kind of thinking…?

Well, we haven't really made any changes to the model because we don't think there's anything wrong with the model. It's just that at the moment, there's just not a lot of trends. So, I fully understand this thing about where you spend a lot of time, but you realize that there's not a lot you can do to really move the needle in terms of that, which is hard for people to believe because they think, oh, with all this new technology, clearly there are ways you can just keep improving, but maybe not always.

Now, I know you had something slightly different on your radar, which we're going to come to in a second, but on my radar it was a little bit related, because I saw a story this morning on Bloomberg. I thought it was quite funny that some of the really big retailers in the US have started offering their popular products but in smaller size, not in bigger size, but in smaller size, so that it actually becomes a bit cheaper for people to buy. Obviously, I'm sure that they're actually getting a bad deal or worse deal, I'm sure of that.

But when I think about the US, and going there as a kid, and all of that, I was always impressed about the huge size you go into a McDonald's, and I mean your drink, you could hardly carry the drink. It was so big. But now, apparently, it's going the other way around and maybe that's the shift we're going to see.

And I guess it's also, in a sense, a sign of the fact that there are lots of people who are struggling who simply can't pay normal prices. So, quite relevant. We don't need to go into the whole inflation point right now because I think it might come up later. But the other thing, which oddly enough is also something that is relevant for our discussion later today. And I don't know if you saw this, but I think it was yesterday or maybe this morning, in the Financial Times, that it was announced that the CME Group is going to now offer a different new contract for oil and it's only going to be based on 10 barrels instead of 1,000 barrels, meaning the tick size. I guess the contract size would be a lot lower and this is, I'm sure, in order to drive more retail money into that where they can trade these things. But the challenge I have, there's going to be another angle to this in a few minutes when we talk about one of the papers today. But the other thing I was just thinking of was, is it really a good idea sometimes that we just want to get more and more retail money into some of these markets where you can really get burned if you don't know what you're doing? And I'm thinking specifically about the craze around silver, last year. A lot of people got in quite late. I have a feeling it wasn't the professionals that bought the highs, and you often hear about that. So, is this surge in retail products a good idea?

I know it might sound a little bit biased because I come from the “professional world” where we traded in our business. So, it's not to exclude people but sometimes not all, I think, financial instruments are meant to be traded by everyone. I don't know if you have any thoughts about these things or what you see.

I guess the CME is trying to compete in the new environment. I guess you could say it's not all bad. I mean, obviously, we've had micro contracts being available on different markets, certainly S&P, and then they brought in on the yield curve, and stuff like that, and a gold as well - there's a 1 ounce contract.

So, I mean it certainly helps, even if you're kind of a semi-pro and you're trying to run a small portfolio. It's definitely helpful from that perspective. I mean I think retail can find ways to speculate on these markets somehow. You had the oil ETF (I can't remember exactly what it was called) that ran into challenges, obviously, when oil went to negative.

Isn't that the one that went negative?

Yes. So, I mean, equally you can trade on spread betting, obviously here, with smaller amounts. You can speculate on oil anyway, even if you can't directly trade a contract. So, I guess CME is recognizing that it is a segment of the market now and they want to offer product for that segment.

Yeah, yeah, I'm not surprised that they do it. It's just sometimes… But you, you're right. I mean it's probably inevitable.

What's also inevitable is that we going to talk about trend following and CTAs right now because, I mean, we are about a week into the third quarter, but I thought it was probably makes sense to hear your thoughts a little bit about the first half of this year.

My trend barometer, yesterday, closed at 50, which is a decent strong number. Even though, I will say, the first week or so of July has been quiet to a little bit soft for managers. And obviously, the last couple of days we've had some reversals now, again, given the renewed bombing campaigns happening in the Middle East. So, there’s definitely been some changes in some of the directions, especially in energies.

But overall, not a bad first six months for the CTA world but with some dispersion. And not that I have a fully clear picture of the situation as of yet, it looks to me that people who did non-trend stuff inside their strategies probably did a little bit better. Some of them somewhat better.

But, on the other hand, people who traded alternative markets which obviously became very popular a few years ago, they struggled and a number of the names came out negative with very few exceptions such as Isam, who did well, but some of the others, big names, not so well.

So those are kind of some of my takeaways. You sit on the allocator side, you monitor it from a different vantage point. What are your takeaways, Alan?

I mean looking at the year to date, it's definitely been a good year so far. I mean, solid kind of returns. Obviously if we were to go back to the middle of May, it looked even better. We've kind of had a little bit of a drawdown since then. My sense was kind of, across the managers I was monitoring in June, I thought they were generally a bit more negative than the index. I think the index is down less than a couple of percent and my sense was across, obviously, more negatives than positives.

So, I think certainly June was interesting from a dispersion perspective. As you say, non-trend may have been a factor. I think we had a lot of reversals in commodities in June. Obviously links to the Middle East, the change in tone there was one thing, but equally metals, aluminum, copper, and then also markets like soybean oil, which were kind of also related to that. And then in kind of late June and July, things like corn rebounding.

So, I mean, in the commodity space, I think there's been good opportunities earlier in the year, particularly in precious metals, and as we've seen kind of later in the first half of the year, maybe some challenges. So ,I think net/net it still feels like a good environment. Plenty of direction, movement, plenty of volatility. It was looking like a very good year at one point, but still certainly better than average year to date, I would say, looking at the returns year-to-date.

So around sort of March, April, that's where all of this was taking place. And some of the markets, especially the metals, the base metals, were surging and then it all collapsed. And I'm kind of thinking, hmmm, the last month or so, you’ve kind of seen, more or less, the same picture in the commodity space.

Yeah, I think a couple of things. I mean, I think when the conflict kicked off in the Middle East, and in March everybody was scrambling to understand the Strait of Hormuz and how significant is this? And I think I listened to a lot of podcasts around that time, our own, other ones, and there was a general sense on that this is a big problem and that this problem is looming in weeks if this isn't solved.

That was my takeaway from listening to all of these, and that maybe the relevant parallel was something like COVID, that this is coming and when it's going to come, it's going to hit. Clearly it wasn't the case. So, it's like, well, what happened?

And I mean, obviously after the fact, we got explanations around Chinese oil demand declined because they were able to tap into their own reserves and some of the oil flows were able to be rerouted via pipelines, etc. So, the market was able to withstand this for a matter of weeks or a couple of months.

So, I mean, that narrative is still out there that the disruption persisted, that there's still a problem. But it did make me think, certainly, that the predictions were pretty pessimistic at the time. That's not to say they were wrong. I mean, they were wrong in a sense that the problem did go on for a couple of months, and we never hit that point of really big spikes. So, maybe it was just a warning shot.

Maybe those fundamental challenges are there. In another scenario, maybe China wouldn't be in that position to release its own oil supplies, although it has them, and maybe domestic demand might be stronger. So, yeah, that was my kind of big takeaway from that period.

But equally, it's not just the Middle East. I mean, it'd be interesting to hear what Adam has to say, in your podcast, because obviously copper is a good reflection of the AI theme, and that trend, and that's not going away. And the CapEx plans of the hyperscalers, and all of those people investing in data center buildouts are just escalating from here. So, that's a demand-side as opposed to supply-side story that hasn't gone away. So, I think it's not just supply disruptions. There is a big demand story there too.

Yeah, I completely agree. And that's the beauty of what we do, Alan, is we don't actually have to predict what's going to happen. Anyways, we'll follow it closely for sure.

Now, before we move on to your topics, let me just quickly run through the data here. This is as of Tuesday 7th July, BTOP50 down about 23 basis points in July, still up 7.5% for the year. SocGen CTA index down 46 basis points in July, still up 8.9% for the year. The trend index, pretty close, down 58 basis points in July and still up 8.5% for the year. And the Short-Term Traders Index down 0.42% but still up 4.65% so far this year.

In the traditional world, also a little bit of softness. MSCI World Equity index down 27 basis points as of last night, up 9.65% for the year. The US Aggregate Bond index down 56 basis points for the month, up only 0.25% or so this year. And then the S&P Total Return is down 21 basis points, up about 10% so far this year.

But again, when I look at the price action for the past week, there's been a couple of decent moves, but it's mainly been something like cocoa that keeps sort of surging now, suddenly, after it was in a big downtrend for a while. But the energy markets also seem to have had some decent moves but not crazy moves, I would say.

Anyways, I kind of alluded to it that you had kept something away from me, namely the story that you were meant to talk about under your radar, we've moved that to the macro view. So, I'm excited to hear what's hiding in the macro view.

Well, maybe we'll get to that in a moment, but I just wanted to talk, within the whole macro we always kind of take a few moments to talk about what's interesting from a macro perspective. And the thing I wanted to focus on this time was really that obviously we've had a change at the Fed, and Kevin Warsh has now come in, we had his first news conference, press conference, which was interesting, and we're already seeing a few changes. I think at the Fed. We had a shorter statement after the June meeting. We had a different type of press conference. He didn't really say anything of substance about his view on the economy. He was very much was evasive on that and he didn't, obviously, submit a dot into the dot plot.

So, we're seeing changes there already. And I think it's interesting he has commissioned these task forces, or he's in the process of doing so. And one is around communication, and this seems to be a big issue for him, communication. He's not a fan of forward guidance. He doesn't like it. He thinks it can kind of put the Fed in a bit of a box. The markets have become overly reliant on it.

And it's interesting, you know, Alan Greenspan passed away there recently and Warsh does seem to be a fan of Greenspan. And obviously Greenspan was famous for kind of not giving much away. And his quote was something along the lines of, if you think you've understood what I've said, you've misheard me. So he didn't want to be kind of pinned down, he wanted to be kind of evasive.

And at the press conference, Warsh mentioned this idea that he wants the markets to draw their own inferences about the data, as opposed to the markets being totally consumed with trying to anticipate what the Fed is doing and forgetting about what's the actual data. He wants the markets to guide the Fed.

And it's actually an interesting idea, and it goes back to that Greenspan era. I remember, when I came into the markets first in the ‘90s, there was this idea that sometimes the Fed might raise rates or cut rates and people would say, well, they're just validating what the market has already priced.

You know what I mean? That very often you would get a move in bond yields or whatever and reflecting the fundamentals, and the Fed, would effectively validate that. So that's kind of the idea he's getting at. So, it's worth considering. Where did this idea of transparency and forward guidance come from in the first place? Why was it a thing before?

At that stage they didn't have the use of tools like QE. So, they were very conscious that the Fed could control short-term interest rates, but not necessarily long-term interest rates. So, the use of communications was seen as part of the tools that they had to try and influence long-term rates.

So, if anybody in the markets at the time would remember phrases like when they were about to raise rates, they might say they were going to be patient in raising rates, or if they were on hold, code was developed that they would say things like rates would be low for a considerable period. So, the market came to understand what this meant.

But the overall objective was to try and use communications to influence long-term rates because obviously at that stage they weren't doing QE. There's also a sense that more shocks created more volatility, which was seen to be a bad thing. And then certainly, as we got into the kind of the financial crisis era and post financial crisis era, the whole point about committing to keeping rates low for a long time was a key part of the arsenal of their unconventional policy tools.

So, you could say maybe the world has changed now and maybe that Warsh is justified. That a different era now justifies a different approach. What he wants is obviously the market to make its own inferences about where rates should be going based on the economic data.

I mean, it does create some questions, what might that mean for us? What might it mean for the markets for investors? Simplistically it would suggest more volatility because there's going to be more uncertainty. The Fed's not going to be telling us, weeks in advance, that it's likely it's going to be raising rates. For a long time, in the last couple of years, it was kind of leaked to Nick Timiraos, at the Wall Street Journal what was going to happen and the markets could digest it. That era seems to be over now. Can the markets infer from the economic data alone? It remains to be seen. A lot of people have grown up now in the markets just listening to the Fed and operating on what they say.

It could be good for trends is another factor. Because if you think about it, if the Fed starts a tightening cycle and then they put it into Sep, where we think rates are going to be at 1% higher in a year's time, the market kind of factors in a full tightening cycle straight away. Whereas, if it's going to be more incremental, it's going to take time for the market to infer the extent of a tightening cycle. So, that could be, if information is digested more incrementally, you might see a bigger term premia on bond markets as well because of this, because of the uncertainty.

And while there are good aspects to it does also create a little less accountability. We won't get to hear exactly why the Fed has done everything. We may not hear the full debate. I mean, they're reviewing everything. So, certainly the impression from the last press conference was, don't expect as much detail from Warsh as we were used to from J Powell and his predecessors.

So, I think it's interesting. I think it could mark an era of, as I say, more volatility and potentially good for trend. I mean, the other factor, just in relation to Warsh at the moment, that's interesting. He spoke at a European conference, and I think the initial impression was he was hawkish at the first meeting. Then when he spoke in Europe, he said the inflation risks are coming down.

And this is what Warsh is talking about. And he's saying, well, we believe that we'll get a disinflationary impulse down the line, but we don't know when it is. So, it is quite an interesting dilemma. Do you raise rates now to kind of cool the demand from the AI CapEx boom, even though you think it's going to be disinflationary down the line? I don't know. I think the market is kind of going with the hawkish narrative, but we'll have to wait and see.

I think I'm kind of a little more skeptical on that. I'm not sure maybe that Warsh is as hawkish as the market inferred from his first press conference.

No, I think that definitely remains to be seen. And of course, Bernanke may have started this thing about narratives, and so on, and so forth, discussion about narratives. But of course, there was also a book written by, I think, Robert Schiller called Narrative Economics, about 10 years ago. Because narratives have become super important.

Yes.

And speaking on the whole inflation point, I mean, not a very nice present he got from Apple, raising their prices 20%, 25% in a day. I imagine with their size, it's going to be showing up somewhere in the inflation numbers. So, interesting times indeed. Thanks for that.

And I agree with, I mean, I think for me, maybe the more interesting part about the changes, maybe not so much this thing about the narrative side, whether they give long press conferences or not. I'm actually quite interested in what are they going to change in terms of the economic data they want to publish, because I think a lot of people are kind of reliant on certain data and may even have built models based on certain data. So, what happens when you can't get that or it's completely restructured and it's calculated in a very different way.

That's going to be interesting as well. What is also going to be interesting are the other three papers we have time for today. Two of them we've kind of lumped together; one from our friends at Aspect and one from Systematica. And then the third one is from a number of people, but I think, I don't know if all of them are associated with CFM, but it's a very interesting papers. I think we may spend more time on that than we will on the first two. Nevertheless, when good people put out papers, we want to highlight them.

So, tell us a little bit about what you found interesting in the Aspect and Systematica papers and maybe set kind of the tone for what they're actually about.

Yeah, so I mean, there are two papers that are basically making the case for trend and trend strategies, but from, I guess, different perspectives. I mean, the Aspect paper is about the changed macro world, changed macro regime, which we have spoken about before. But, I suppose, re-emphasizes many of these themes that the last 25 years were effectively an anomaly in terms of kind of abundant energy and the peace driven from globalization, etc.

And now we are seeing kind of structural breaks in markets, such as bonds are less reliable diversifiers for equities, store of value (such as the dollar) being reassessed and redefined, obviously surging demand for gold from central banks, and I suppose commodities as much more strategic assets. And then given that backdrop, trend following has been a great way to kind of reflect and play on those themes as a diversifier, as a strategy that is adaptive for regime change, as a strategy that gives access to commodity exposure in a managed way. So, I think they were all important points.

I mean, one thing that got me thinking on this paper is everybody kind of looks at these supply shocks and talks about, oh, if we get shocks like in energy. People always think it's an energy shock and that would be bad for bonds and equities and it's that kind of scenario that you might need other things in your portfolio.

But it's not just an oil shock that we need to think about. There are other kinds of shocks. We could have a shock in other commodity markets, such as the copper market or in food prices, etc., that could be disruptive and be negative for traditional assets.

I say that because a lot of people say, well now the world has changed, we're not in the ‘70s anymore or we're not as reliant on oil and we had what we had in Iran and it didn't get as so disruptive for oil. So, the point is we're not just talking about oil, we're talking about commodities more generally.

And we could have shocks elsewhere. We could have a fiscal shock or a fiscal problem in the bond market that could impact bonds and equities. And where else can you find sources of diversification in that stage? Or in currencies, we could see a huge dollar decline or a huge dollar rally, which could be disruptive for traditional assets as well. So, I think all of those are relevant when thinking about these kind of supply shocks.

The Systematica paper makes the case for trend from a different perspective. It's along the lines of the total portfolio approach; what we're hearing a lot more about now. And this is, again, recognizing, I suppose, the failings and the drawbacks of strategic asset allocation and particularly in the current environment, again where bonds are less diversifier.

And in this paper they kind of highlight the shift in the stock bond correlation. But also that many other hedge fund strategies give you a lot of equity risk and as does private equity. So, it's about finding the true diversifiers. The likes of equity market neutral is a good diversifier, but it's unlikely to give you that convexity. So, the trends can.

In terms of diversification and what they call dynamic risk management, they're making the case for trend as complementary to equity market neutral in terms of building out portfolios that are more balanced from. From a risk perspective.

So, I think the two papers are good in terms of summarizing those points. They are probably about things that we have spoken about before but, really, I may be restating those points with a different lens.

Yeah. So, when I think about… I mean obviously, these, as you say, these are not necessarily new things that has come out in these two papers. But when I think about it, maybe I think about these things a little bit differently in a sense that when you look back, and we always talked about the 60/40 portfolio (60% equities, 40% bonds). And the way I thought about sort of portfolio construction was more about maybe the assets you should own, so to speak.

What I think this narrative, not just these papers, but generally where the discussion seems to be going is not so much which assets you should have in your portfolio, but more about kind of the behavior you should own or have, kind of the exposure, not so much the underlying asset. I know, obviously, you like the talk about these sort of behavioral exposures regimes.

So I think there'll be more of that, and I hope that investors and larger investors will start thinking more about that so they're not kind of stuck. Which I guess the total portfolio approach is kind of also a way to get away from the silos where you could only stay in a very narrow lane. Now it's much more about kind of the impact that, say, a strategy has on the total portfolio, not so much about how it does relative to a few other similar type strategies.

So maybe we just need to get used to talking more about… which would be good for us because we've always argued that there is a behavioral element in why trend following works, so to speak.

Okay, let's move on to maybe the feature of this conversation, so to speak: Is Trend Still Your Friend? (is the paper) - A Microstructure Account Of The Demise Of Short-Term Trend Following. Now, it's definitely a detailed paper. It is by a number of people: Judah Kuth, Zoltan Eisler, Adam Ray and Jean-Philippe Bouchaud - well known to many people, Chairman of CFM, previous guest on the podcast and highly respected, of course.

Now what I like about this paper, and I admittedly have not sort of studied it probably as detailed as you have, but what I like about the paper overall, and why I think it's such an important paper is that it puts validity and depth to something that certainly we've talked about on the show for many years, namely this very simple observation that short-term trading doesn't seem to work as well anymore. But not really being very specific about it, just noticing that yeah, short-term managers haven't done that well. Some have gone out of business.

And if we look at our own models and signals, we've certainly noticed that parameter settings have probably become longer, slower systems have done well, all of those discussions we've had. So, that's the interesting thing that we finally have something that is well done, well researched, that kind of dives into this and tries to explain what it is we've been observing why that could be the case. So, if I can tee it up like that for you, Alan, and maybe you can tell us much more about this wonderful paper.

Yeah, it's definitely a really interesting paper and, as you say, it's getting to the heart of something we've been looking at and debating in markets for a while. Not just you had the kind of the more sluggish performance of trend generally for a period. And then also the challenges for fast trend as well. And we've talked about some of the explanations and some of the potential explanations and, I guess, what's interesting in this paper is they also look at some of those ideas as well and are dismissive of them as well.

And maybe we should talk about those.

I mean, the classic ones are assets. We remember we used to hear the industry has gotten too big, so, that was the source of the degradation in return. That's not consistent with the evidence in terms of AUM stagnated for a few years in the industry. And actually, with the growth of liquidity in futures markets, the CTA footprint would have been declining over time. So, that's not true.

And then also the electronification of markets is another thing. And if you look at, say, the electronification of futures, interest rate futures markets, has come along and has had no impact on the profitability of those markets. So, I mean, what they are proposing or what they're suggesting is actually that it's the volatility adjusted tick size, that that's a key variable for how conducive a market is for fast trend following.

So, the size or the value of a tick is small and even people probably trade it even less than that. Whereas, in the bonds it's much bigger, the interest rate markets it's much bigger. And in certain commodity markets it's bigger as well.

So, I suppose the intuition behind this is that in the small tick size markets you tend to see less liquidity. The liquidity is there, but it's not necessarily apparent at the kind of representative bid offer. Whereas, maybe in the past, before you had the advent of high frequency trading, you would see a large volume at the bid offer. So, the point that they're making is that in the past you had a transmission mechanism for fast trend following whereby a trend follower would trade a decent size in these markets and then that would kind of set forward a series of events where the person who receives that trade then trades in the market and that creates momentum in itself.

So, the way I think about this, because I started in foreign exchange markets in the ‘90s, and the way the markets worked back then was, if you were, say, a CTA going to buy dollar/yen, you called up Bank of America, or whoever it was, and give me a price in dollar/yen, or whatever, but let's say if you wanted in dollars, or US$500, that was a big amount. Right? But they would quote a price for that.

So, you could actually get a big trade on. You might not want to because you might say, well ,the spread's going to be wider, but the big banks would quote you a price for that. So, if you go and buy a billion dollars or US$500 million in one go, what did the bank do then? Well, the bank then, they called up all of the other banks and they bought again. And what did those banks do? Well, they did the same thing.

So, the fact that a lot of trend followers would come on and execute size (big size at that price), that put in place a momentum effect. And this is the thesis of this paper. That momentum effect, that comes from the actual trading, is a key part of what drives trend following returns.

Now, they acknowledge it's not the only part, but it's probably the most relevant part for fast following. They also touch about how behavioral factors like the speed of adjustment for different participants in the market and underreaction initially and then overreaction later. These are the typical explanations of why trend following works.

But they're proposing another explanation that a big part of it was that for fast trend to work, you had to be able to get big trades on at a reasonable cost. And then for them, those trades to, I suppose, encourage more momentum in the markets, which I think makes sense. I mean, as I say, from my experience in FX markets, that's what you would have observed.

And also, it could be that CTA behavior has changed as well. If you think about it, if all CTAs suddenly said, okay, we're not going to trade at the offer, say we're trying to buy the market, and we'll be very slow in putting our trades into the market, that creates maybe, arguably, less momentum itself. So, they look at the different explanations.

What they find is, interestingly, that the variable, as I say, that explains the degradation in returns and fast trend following is this volatility adjusted tick size. From the perspective that if you look at the performance of fast trend following, it's deteriorated in certain markets but not in all markets.

In the large tick size contracts, fast trend following does seem to work. So, actually the title is nearly a little bit, not quite, misleading. But actually, that was one of the interesting aspects of the paper ,when you get into it ,is that actually it's not saying that fast trend following doesn't work at all, it's just that it doesn't work in these particular markets, particularly equities and currencies.

And they've also found another interesting feature of this research, they found that counter trend trades have become more dominant in the markets in the last while. And that's interesting because you might remember when we spoke to Toby Crable, a few weeks back, this is something that he said as well. He wrote this book called Opening Range Breakout and he was saying that you used to see a lot more follow-through when you get a break in markets, whereas now you tend to see a new low and then a reversal. So, markets seem to be much more mean reverting at short-term times horizons.

Now, if you delve into the paper, actually there's an interesting chart. If you look at the performance, I don't know if you have it there in front of you.

I'm looking at Figure 10 at the moment.

Actually, I was going to talk about… Let me pull a figure 10 because I was looking at figure 10 as well. And it's kind of striking. If you look at figure 10, what it shows you is this degradation for fast trend following, which is the red line there, when people go and download it.

So and actually if you look at the large tick, there's no evidence of a CTA winter there at all for any timeframe. Things just kept working well for the whole period. So, I think it's interesting, I mean one thing that strikes me. What does it mean for CTAs? I mean, it means quite a few things. Does it mean that CTAs have to penalize the small tick contracts and be cognizant of this effect if you're going to trade faster? That's one thing.

Some people will argue, okay, yes, the returns in fast trend following have deteriorated but there is still a value for it in terms of convexity and skew. There have been papers from Man around this. Yes, it hasn't been as good but still, from a crisis alpha perspective, it can still have a merit.

But I think certainly the idea of adjusting exposures, people obviously have done it for liquidity reasons before. Obviously, when CTAs build portfolios they do penalize certain contracts from a liquidity perspective. So maybe the next thing is penalizing from a tick size perspective.

I mean, more broadly it's an interesting hypothesis that trend following works for two different reasons. One is the behavioral reason and the second is this momentum effect created by the trading itself. And if the conditions, if the market microstructure is such that you can't get that momentum from the execution of the trend trades, you don't get that short-term momentum. I mean it's certainly interesting. I think people will debate that, but I think it's definitely intuitively makes sense to me.

What do you think?

So, if someone came to me and said listen, we have found out exactly why short-term trend following hasn't worked for the last 15 years plus, I would not have thought about something as unsexy as tick size. Let me just say that is not what I would have expected. Could there be something about it?

Now I'm not going to argue against people like Jean-Philippe Buchaud because he's much smarter than I am, but I want to offer, at least, some other things. So, first of all, if this is the case, we could run our own simulations based on markets with small tick size for the contracts and markets with large tick size. And, keeping the model consistent, we should see the same pattern that they found. So, maybe that's something we should all do. Okay. Especially if we're involved in short-term models, that would be relevant.

Now, the other thing that I can't help thinking about is one, the environment. Right? Did the environment change after ‘09? Maybe, because we had a big global financial crisis that ended in ’09, and we know that central banks got much more involved, and so on, and so forth. Yes, it is true as well, the market participants started to change as well.

And correct me if I'm wrong here, Alan, wasn't ‘09 also where they changed banks not being allowed to trade a lot on their own book and actually you had to outsource it. So, you could argue that market participants perhaps change as well and that has an effect.

And finally, I would offer a third thing that could be relevant here, but I have no data on this, and that's actually the rise of these multi strat pod shops because my impression is that they are much more short-term. Maybe not necessarily only in their holding period it, but certainly also in the way they manage risk. I mean, you're down a little bit, you get caught; you're down a little bit more, you get caught.

And I happened to have lunch with a super interesting guy, who is from that space, this week, and he was basically saying (I don't think I'm saying anything confidential when I say this), he was basically saying, if you're one of the pods, and you get a call on a Friday afternoon that you need to cut your risk by 50%, they give you two hours to cut that risk. Right? So, I can't imagine that the rise of the AUM in these pod shops has not had an effect on the short-term microstructure of the markets. So, I would offer that as another explanation.

I can't say that tick size is not part of the explanation. I think managers probably, if they're interested, should test it. And I think it's obviously a convincing piece of evidence they put forward. I just think there might be more to it. That would be my…

Yeah, I think, I mean, I think that they're fair points. I mean the other thing I was thinking about, I mean, because obviously they're saying, just to be clear, like would for fast trend in general, I mean, it's kind of equities and currencies are the two that have struggled. I mean, it's not just they assign it specifically to the tick size, but in general that's what it shows.

I mean the other thing we've had in equities has been zero DTEs, more volatility selling. So, the market microstructure has changed in a few ways. As you say, more pod shops but also new products and structured product vol selling.

Can I offer one more thing?

Yeah.

I mean if we think about it, let's just say that this is done using simulation. Right? Let's just say that that's what you do. Clearly, I mean, if you take a contract like we talked about in the very beginnings, now the CME Group is coming out with a contract that's like significantly smaller. Well, I have a feeling that when you bring out a futures contract, I haven't fact checked this, so don't take it as 100% sure. But I have a feeling, oddly enough, that the fees that you pay to trade those contracts are not going down. They're just the same. Right? So, you get less exposure but you pay the same transaction cost.

So, clearly, if you want to have the same exposure but you choose to trade the small contract, you have to trade a lot more contracts. That means your commission costs go up significantly. Now, wouldn't that erode your performance? Of course it would.

So, I think there are lots of moving parts in this that, as I said, I haven't read the paper in detail so I'm not familiar if that is already addressed and accounted for. But clearly if you just say, yeah, we're just going to switch to smaller contracts but we're going to take the same transaction cost model. Yeah, that's going to have an impact.

Yeah, just one other point that they say in the paper, I mean, they kind of slice it a number of different ways. They also look at high volatility and low volatility and they actually find trends are better in low volatility. But then they also look at kind of big one-day moves and small one-day moves. And what they're saying is, what's been eliminated specifically is trend followers ability to profit from margins, directional kind of one-day moves. So, when something big happens, trend followers used to be able to get in on big size on those moves, and get executed, and profit from them.

So that speaks to the liquidity, right? That speaks to the liquidity of markets.

Yeah, but then they did look at liquidity as a variable itself and that didn't explain it cross sectionally. So, it's kind of a combination of liquidity and the contract characteristics is what they're suggesting.

I mean, without digging too big of a hole for both of us here, Alan, certainly for me, I'm kind of thinking here, okay, let's just say that you have a firm that needs to execute a billion dollars of something, right? If you think about it, whether you trade with 10 people or you trade with 2 people, the loop it creates, the follow through it recreates, whether 10 people have to go out and get a market. I mean you would think that pushes the price. Right? Or whether it's 2 people doing it.

I mean intuitively, to me, I don't know if that makes a big difference. It's the same order size. So, the question is not how many people do you trade with? To me, it's more like how big is the size that you're trading vis a vis the total size of the market. But maybe I'm completely wrong here.

Yeah, I mean that's why I think people will debate it. I mean maybe the argument is that you can't get… I mean they do say that there is a suspicion that CTAs have actually disengaged from short-term trading. Which is actually, which is true. Which is the anecdote most people are saying.

Most of the trend followers say, well, we don't do much short-term because the evidence shows it's been deteriorating for a long time. So, I don't think it's necessarily been a big driver of returns. Their point is that the ability to capture those moves. But the trend signal have…

So, what we could say, maybe what we could say is that in the short-term timeframe the participants have changed a lot. Meaning you used to have more momentum type participants. Now, you may have more mean reverting type managers, like high frequency or whatever, who is basically just trying to make a bit of money on the spread or whatever they're doing.

So, maybe that's part of the reason as well that, in the last 20 years or so, the way, specifically, the short-term timeframes are made up in terms of who's doing the trading has changed dramatically.

Yeah.

Maybe CTA… I mean, they do allude to fact that CTA behavior may be changing too. I mean if you think about it, if CTAs are kind of all very focused on, well, obviously everybody's focused on best execution. But if you're passively buying as opposed to crossing the spread, I mean, and they do touch on this as well, you're kind of going to miss the big kind of breakout moves because you're passive. And then obviously, if you want to execute, it's going to be expensive. So, I mean that's another dimension to it that they allude to as well.

And then finally, maybe before we wrap up, I would say the final thing that I would have noted that's really changed in the last 15 years is actually how we execute. Right? In the old days we would print out tickets, we would look at them, and then we would work the order kind of during the day or whatever. Nowadays some people just go straight from the, from the signal to the exchange and they incorporate some kind of algo to do the actual execution.

And these algos definitely behave differently than what an individual trader would do because they are not emotional, for example, and they have patience, and so on, and so forth. So, I think this is a very interesting topic and it's a great paper. I think there's more to it, but again, I'm not a quant, so, it’s easy for me to say. But really appreciate you digging into this and really, really appreciate all the authors for putting this out there.

Absolutely, it's definitely one of the more interesting additions to the whole debate around us.

Yeah. Anything else you want to add before we wrap up, Alan?

Not that I can think of now, no, unless we want to get into the football or something.

Well, as long as Switzerland is part of the World Cup, I'm definitely happy to get into football. But if they leave in the next round, maybe we won't talk about football anymore. Who knows. Anyways, this was great. Really appreciate it.

And of course to everyone listening, please show your appreciation for Alan and all the other co-hosts by going to your favorite podcast platform, leave a rating and review because it really does help more people find the podcast. If you have questions, as usual, for upcoming episodes, you can email them to [email protected] and next week the one who will be answering questions, should they arrive, will be Yoav, along with a few other papers that he found that we will be digging into. So, stay tuned. And that's going to be another very educational conversation.

From Alan and me, thanks ever 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.

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