Shownotes
Today we tackle the most important questions arising from the evolving landscape of systematic investing, focusing on the changing dynamics of asset allocation in the current market environment. Nick Baltas and Niels discuss the implications of rising interest rates and inflation on traditional 60/40 portfolios, questioning whether this approach remains valid. We explore the potential benefits of incorporating trend-following strategies, especially in light of recent market volatility. The conversation includes insights on risk management and the importance of understanding correlation, particularly during downturns. With a blend of empirical analysis and practical advice, the episode touches on the key question of how much investors should allocate to trend-following strategies from a different perspective and encourages listeners to rethink their investment strategies and consider more adaptive approaches to asset allocation.
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Episode TimeStamps:
01:28 - What has caught our attention recently?
07:37 - Industry performance update
09:02 - Reflecting on August and September
12:25 - The reversal of the short fixed income trade
17:31 - The death of short-term trend following?
21:32 - Finding the right trading speed
24:15 - Out-performing is a long game
27:47 - Its time to move direction
29:53 - Can CTA's forecast risk and returns?
33:45 - Evaluating models over a long time
39:24 - Baltas' thoughts on correlation forecasting
42:26 - Pairing risk parity and trend following
48:25 - A dangerous game
51:35 - How much should you allocate to trend following?
01:01:06 - Is the benchmark changing?
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2. Daily Trend Barometer and Market Score
One of the things I’m really proud of, is the fact that I have managed to published the Trend Barometer and Market Score each day for more than a decade...as these tools are really good at describing the environment for trend following managers as well as giving insights into the general positioning of a trend following strategy! Click Here
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Transcripts
You're about to join Niels Kostrup Larsen on a raw and honest journey into the world of systematic investing and learn about the most dependable and consistent, yet often overlooked investment strategy.
Niels Kostrup Larsen:Welcome to the Systematic Investor Series.
Nick Baltus:Welcome or welcome back to this week's edition of the Systematic Investor series with Nick Baltus and I, Nils Castro Larsen, where you each week we take the pulse of the global market through the lens of a rules based investor.
Nick Baltus:Nick, it's great to be back with you, as always.
Nick Baltus:It's been a little while.
Nick Baltus:Have you been.
Nils Castro Larsen:Yes, correct.
Nils Castro Larsen:It's been a little while.
Nils Castro Larsen:I'm very, very glad to be back.
Nils Castro Larsen:I think last time was this first week of August, very well timed.
Nils Castro Larsen:Just before my break.
Nils Castro Larsen:No, I've been, obviously, I enjoyed the summer.
Nils Castro Larsen:We got back to Greece with family and then beginning of September when schools start again, here we are so kind of planning now for the year end, a bit of travel, some good projects at work, and managing a four month old alongside with my six year old daughter is in itself, I guess, the new way of living in September.
Nick Baltus:Absolutely.
Nick Baltus:Yeah.
Nick Baltus:My travel season started as well, unfortunately, also started with me picking up some kind of bug on the way back on my latest trip.
Nick Baltus:So if I'm coughing a little bit along the way, we'll try to mute that as much as possible.
Nick Baltus:But be warned, we obviously have quite a few topics lined up, thanks to you, and as always, they're great.
Nick Baltus:But as we also do every time we speak, I'm really interested in just sort of what you are picking up on your radar at the moment, not related to the topics necessarily we're speaking about, but just sort of what you find interesting.
Nick Baltus:I've got some completely random stuff that I wanted to throw at you, but what are you sort of finding interesting at the moment?
Nils Castro Larsen:I mean, from a business standpoint, the one thing that typically keeps us on our toes, and now we also see another transition, is this kind of risk aversion that grows or falls as time goes by.
Nils Castro Larsen:And I think for the last year and a half, maybe it has been a period whereby I, the vast majority of clients and investors would look into carry opportunities, maybe with some sort of short lived breaks.
Nils Castro Larsen:I would call March last year as a good example.
Nils Castro Larsen:But suffice it to say that post August we are seeing more and more and more of this defensive mindset coming back.
Nils Castro Larsen:There is much less appetite, at least in the past one month, for Kerry trades.
Nils Castro Larsen:So in this regard, it is something that keeps us busy.
Nils Castro Larsen:And for almost like two years it wasn't really the key point.
Nils Castro Larsen:So that is something that has drawn my attention, I would say, quite substantially in the last couple of weeks, maybe.
Nick Baltus:Yeah, I mean, it's quite relevant for our conversation, I guess, people interested in something that's a little bit more defensive.
Nick Baltus:For sure.
Nick Baltus:I found some random stuff I just wanted to mention that caught my attention.
Nick Baltus:The first one is kind of related to the fact that in the month of September, despite, you could say, certainly growing uncertainty, conflict, whatever, equity markets seems to be fairly immune at this point.
Nick Baltus:And I did notice that the latest valuation for OpenAI because obviously that's the other big theme at the moment, doubled from the spring to now, 157 billion for a company that doesn't make much of a profit, as far as I'm aware.
Nick Baltus:I didn't notice that.
Nick Baltus:That's more or less the same capitalization as the firm that you work for.
Nick Baltus:And Uber and at and T is in that range as well.
Nick Baltus:So I thought that was kind of interesting.
Nick Baltus:The other thing that keeps us busy generally, is this idea of whether inflation has been conquered or not.
Nick Baltus:Clearly, central banks have declared victory recently by starting to lower rates, including in the US.
Nick Baltus:But there's a couple of things that actually did show up this week as something that could spark a little bit of inflation, in my opinion.
Nick Baltus:One is that I think last night, so overdose overnight, the dock workers that have been on strike for a few days now, they've agreed a 62% wage increase over six years.
Nick Baltus:That's pretty decent.
Nick Baltus:It might inspire other people to go on strike and try and get a better deal.
Nick Baltus:Now, clearly this is good news for a lot of people, especially those who love bananas, because apparently 75% of all bananas into the US comes through the east coast ports.
Nick Baltus:So thats obviously the good news.
Nick Baltus:Now, another strike that is somewhat in the news is of course, the strike at Boeing.
Nick Baltus:I think last time I heard they had rejected a 30% pay rise over four years.
Nick Baltus:So clearly these pay rises are meaningful.
Nick Baltus:And I just want to just put it out there as part of the conversation about inflation, part of the conversation about the dynamics and the changes we're seeing in the labor markets where historically, at least for many decades, employers were at the wheel determining terms.
Nick Baltus:And now it seems that is changing.
Nick Baltus:Another thing that could be inflationary is the fact that this morning, just a couple of hours ago, we're recording on Friday, the European Union voted to impose tariffs as high as 45% on EV's from China.
Nick Baltus:That's certainly also going to.
Nick Baltus:Hopefully not hopefully, but it's going to put some price pressure, I guess, on these vehicles.
Nick Baltus:And of course, we've seen some pretty decent move up in energy prices this week given what's going on in the Middle east.
Nick Baltus:So for me, those are kind of interesting things.
Nick Baltus:They all point in same direction, but maybe for other people.
Nick Baltus:The biggest news, Nick, that I picked up yesterday is the fact that apparently next week we're all going to find out who Satoshi Nakamoto is because HBO claim that that's going to come out in a new movie that's being released next week.
Nick Baltus:So to all our bitcoin lovers out there, that's going to be interesting.
Nils Castro Larsen:They're looking forward to it.
Nick Baltus:I am going to watch it if I can.
Nick Baltus:I don't know if I subscribe to HBO.
Nick Baltus:I have no idea.
Nick Baltus:But anyways, it'll be interesting to see what they come up with.
Nick Baltus:I did forget one thing, by the way, that also is somewhat in the news is of course, this chinese bazooka that has been unleashed, which have certainly had an impact on the markets, especially chinese equity markets, in the last period of time.
Nils Castro Larsen:And I think this also propagated in some commodity markets as well.
Nils Castro Larsen:We see things like iron ore following a year of falling prices, having a significant rebound in the last month.
Nils Castro Larsen:I would say commodities as a whole had a very strong September, but coming from very, very different regions.
Nils Castro Larsen:Whether that would be wildfires and drought for some of the ags, obviously we have the Nat gas moves and the energy moves in the broader complex here, China impact in some of those metals.
Nils Castro Larsen:As a topic, I would say September was quite interesting for the commodity complex, both on the beta side as well as the implications for some of the systematic strategies we're running.
Nils Castro Larsen:It was not a great month, by the way, in this regard.
Nils Castro Larsen:For systematic strategies on that front, sure.
Nick Baltus:Good stuff.
Nick Baltus:Well, we just opened the month of October.
Nick Baltus:We just opened the fourth quarter.
Nick Baltus:It's going to be a quarter where I guess the focus might be the US election in a few weeks, but we should still talk a little bit about what's going on at the moment.
Nick Baltus:My trend barometer at the moment, it finished at 36 yesterday.
Nick Baltus:So not a great reading, a little bit weak.
Nick Baltus:And I think that's being reflected so far in performance in October, even though it's only a few days old.
Nick Baltus:But as of Wednesday night, beta 50 is down 78 basis points in October, still up 3.34% for the year.
Nick Baltus:SoC gen CTA index down 92 basis points, up 1.56% for the year.
Nick Baltus:Socjun trend down about 1% still.
Nick Baltus:Well, I have it down as 1.17% for the year, but I think it might be up 1.17% for the year.
Nick Baltus:I think it's a typo on my side.
Nick Baltus:And the SG short term traders index down 63 basis points and down ten basis points year to date.
Nick Baltus:Contrasting that with equities.
Nick Baltus:MSCI world down one and a quarter roughly for the month of October, up 16% ish so far this year.
Nick Baltus:The S and P global developed sovereign bond index down eight basis points, up 2.34% for the year, and the S and P 500 down about 1% for the month of October, but still up a healthy 19.5% so far this year.
Nick Baltus:I mean, you mentioned, just before we jump into the topics, you mentioned a little bit about kind of performance, what youre seeing.
Nick Baltus:Obviously August and September has been interesting.
Nick Baltus:We can pack it with some of the things that you wanted to start out with, which are reflections on August, but it may also include September.
Nick Baltus:So why dont we just start with that?
Nick Baltus:I know youve been traveling, having some interesting conversations and its kind of nice to have a real time dialogue about what is being talked about.
Nils Castro Larsen:Yes, yes.
Nils Castro Larsen:So as we're preparing the agenda for today, I thought that reflections following the August moves for the, I guess for the trend world is an interesting topic, not because we're going to go through and see, okay, what happened in August and so on and so forth, more so because I'm getting interesting discussions with regards to the impact of speed or the impact of equity defensiveness, or maybe lessons learned, if there are any lessons that we learned out of it and having gone through that, do we have to change anything in the models?
Nils Castro Larsen:We've run some analysis and there are some interesting results that I wanted to more share with you, or maybe we cross check our views.
Nils Castro Larsen:I would say that August was very special in the sense that going through the downturn, and obviously with a big question mark whether that downturn would continue, we end up eventually realizing one of the fastest v shapes in equity markets.
Nils Castro Larsen:Eventually August was a positive month for equities, even if during the month, for example, Nikkei had one of the largest negative returns in history.
Nils Castro Larsen:By the way, one of the topics that has been discussed that maybe not as much in the context of trend following, we saw the keri trade unwind and some of the currencies that year to date have been delivering positive contribution, be it japanese yen or China or Indonesia currencies obviously turning the other way around and starting appreciating quite substantially in the middle of the month.
Nils Castro Larsen:Let me start from a couple of points.
Nils Castro Larsen:I should start firstly by saying that the underperformance that came from the reversion in equity markets primarily, and then some of the currencies, is something that, at least in my experiences, did not surprise anyone in the sense that it does exactly what it says on the team.
Nils Castro Larsen:You have been piling on historical trends.
Nils Castro Larsen:Year to date, equities have been rallying.
Nils Castro Larsen:There's a great performance that came up until end of July, let's call it.
Nils Castro Larsen:And then the reversion was literally the, I guess, the mirroring effect of being exposed to equities.
Nils Castro Larsen:Maybe what was a bit more, I guess, interesting year to date was that no other asset class was actually trading as much as equities.
Nils Castro Larsen:And therefore some dynamic risk scaling and maybe some conviction in favor of equities overweight the asset class.
Nils Castro Larsen:And therefore, after the fact, you had a bigger, in relative terms, turning point.
Nils Castro Larsen:So I think that was one interesting conversation that we had with Kleiss.
Nils Castro Larsen:Is it actually worth allocating more to trendy asset classes or not?
Nick Baltus:Can I?
Nils Castro Larsen:Yeah, please.
Nils Castro Larsen:That's the first point.
Nick Baltus:That's the first point, exactly.
Nick Baltus:So on that point, what I would say is, I agree with you that from a trending behavior, you could say equities has been a great sector.
Nick Baltus:But here's where some of the other moving parts in a trend following model comes in.
Nick Baltus:Because what we did see starting in, say, q two, was of course, the reversal of the short fixed income trade.
Nick Baltus:And for those who use correlations as part of their risk management, that would actually lead to the equity exposure being reversed or reduced over the summer, because suddenly you have two positively correlated asset classes being long.
Nick Baltus:So that is one thing that I just want to throw in there, and that's absolutely fair.
Nils Castro Larsen:I'm actually looking at some stats.
Nils Castro Larsen:You're absolutely right around maybe may, coming into June, we saw some relative reduction in the risk in equities, primarily coming from the rates move, which I have to say, however, I know getting closer to August and the reversion of those rates moves, you ended up reducing the rates exposure, and then just before the reversion in equities, you ended up kind of allocating a bit more to equities.
Nils Castro Larsen:I guess the important point goes as follows.
Nils Castro Larsen:The reversion, had you been quick, would have been at your benefit if the downturn was contagious.
Nils Castro Larsen:So I think there are two important points assessing the downturn in itself, but then assessing the month as a whole and assessing the v shape.
Nils Castro Larsen:So before I go there, let me give you the second interesting data point, at least as far as I'm concerned.
Nils Castro Larsen: have had so far, I believe in: Nils Castro Larsen:I don't think this is something that has been well discussed, at least in our calculations.
Nils Castro Larsen:Just to say again, so I don't confuse anyone, the FX attribution in a trend program year to date has been the most negative it has historically been across the asset classes for any other calendar year.
Nils Castro Larsen:I don't think this is very well communicated or maybe well understood, but I think it's something worth pointing out, pointing out now to get to more interesting results, at least for me, the V shape gave rise to the question, should you be quicker or should you be slower?
Nils Castro Larsen:So we've run an analysis whereby we look into very short term signals to more longer term signal.
Nils Castro Larsen:Let's call it one or two months of, let's say some rolling window or a half life.
Nils Castro Larsen:It doesn't really matter up to, let's say twelve months.
Nils Castro Larsen:What happened in August was that being faster or slower would get you better off than being somewhere in the middle.
Nils Castro Larsen:So let me explain that having an average speed, which is relatively, I guess, medium term, three to six months, will get you worse off than being faster than that or slower than that.
Nils Castro Larsen:And obviously the question becomes like, how is that possible?
Nils Castro Larsen:And this is possible because the V shape has two effects.
Nils Castro Larsen:Either you're too quick to go short, then it reverts, and you're quick to go long.
Nils Castro Larsen:So you participate partly on the downfall as well as on the recovery, or you're too slow, and then you don't really react to it, because by the time it's down, maybe your gross exposure dropped by a bit, but then it recovers.
Nils Castro Larsen:You're still long, but there is a middle point, like a sweet spot or maybe a bitter spot, that as the market drops close to the trough, you start reverting the exposure to short, and then it rebounds and you don't even recover.
Nils Castro Larsen:Like I tend to use this example whereby you have the physics 101 we did back in school days.
Nils Castro Larsen:There's a frequency at which the soldiers are synchronized on the bridge and the bridge falls.
Nils Castro Larsen:And I think this is a good example whereby we have this v shaped dynamic, and this was enough for a medium term speed of to be the worst of all the others.
Nils Castro Larsen:And frankly, when we started running the numbers, I was not expecting this result to come out.
Nils Castro Larsen:I thought that being faster would actually get you better off.
Nils Castro Larsen:But the reality is conditional upon the recovery game.
Nils Castro Larsen:Being much slower or much faster will get you in a better place.
Nils Castro Larsen:Now do we change the model?
Nils Castro Larsen:My answer would be absolutely not.
Nils Castro Larsen:Like I'm sure we can find other examples whereby one would be better, the other one would be worse.
Nils Castro Larsen:Beyond just data mining, I don't see any other value from just seeing that this v shape that happens to be a typical false positive, which however was very aggressive.
Nils Castro Larsen:I'm not sure what has been your experience and your conversations, but I think to me that was a very very interesting example of neither extreme will get you as badly as a middle point, which is typically what we would follow as a normal speed.
Nick Baltus:Yeah, I think these are definitely talking points at the moment.
Nick Baltus:And there is someone out there interested in the trend space.
Nick Baltus:He doesn't know that.
Nick Baltus:He's inspired me to look into these things.
Nick Baltus:It's just something that I picked up from conversations where they have convinced themselves that a certain speed is the speed.
Nick Baltus:And of course I beg to differ on that point.
Nick Baltus:In fact, the speed that you're mentioning as being the worst in this situation, it's the speed that they think is the absolute best.
Nick Baltus:So it just shows you that you can't really conclude that.
Nick Baltus:Now I can give you an example where longer term speeds were not great and it was actually Covid.
Nick Baltus:And what I mean by that was that that downturn was just enough like three or four weeks wherever we as longer term trend followers had positioned ourselves short equities and I cant remember long bonds and whatever, just because that was enough time for our models to react to that.
Nick Baltus:And I completely agree with your finding that in August it was just so quick that our models, yes theyve reduced risk mainly because of volume expansion.
Nick Baltus:Not so much about the signal making a change for those few days.
Nick Baltus:But of course what determined also orcas to some extent is how you had handled the yen, the Nikkei over the summer months because there were signs of a change in direction, or at least there were signs of those trends being challenged, lets put it that way.
Nick Baltus:They were not as strong as they were earlier in the year.
Nick Baltus:I agree completely with all of that.
Nick Baltus:Now it actually inspired me to get our research team to run some analysis using different fixed look back periods.
Nick Baltus:So all the way from 20 days is the shortest one to 260 days as the longest one.
Nils Castro Larsen:Then.
Nick Baltus:Okay.
Nick Baltus:And then on top of that we ran how we do it.
Nick Baltus:Actually in the model where we don't have a fixed, we have a cloud of different look back periods and the selection is actually dynamic.
Nick Baltus:And I mean to no surprise and this is very important what I say now when I talk about short term trend following and in this case we're just using 20 days, not only is it by far the worst look back period, but it doesn't mean that, I mean that short term trading can't be profitable, it's just short term trend following.
Nick Baltus:I dont think its profitable in the long run.
Nick Baltus:This is a 20 year simulation that we did and obviously this is subject to all the disclaimers that you need to state when we talk about simulated returns of course, but there were some short term managers that probably would have done better than the results I look at.
Nick Baltus:Then you see a big improvement if you triple that 60 days, definitely over.
Nick Baltus:Using this raw trend signal improves a lot.
Nick Baltus:It's actually quite similar to 130 days.
Nick Baltus:Between 60 days and 130 days, not a lot happens after 20 years.
Nick Baltus:Obviously during that period there will be a difference for sure.
Nick Baltus:But once you got, then you get longer.
Nick Baltus:So you double that again to say 260 days.
Nick Baltus:There is a big, big big improvement by a big factor actually in terms of the simulated returns that it produces.
Nick Baltus:And then as we probably will see in some of the papers as well, once you start being more active dynamic in the selection of parameters, which is how we do it on our side, you can actually make even further improvements is our finding.
Nick Baltus:So I completely agree with you on these findings.
Nick Baltus:And of course it's a choice what kind of trend following you want to do.
Nils Castro Larsen:I would say almost like paraphrasing or adding to your points that I think the choice of the speed, there's no sweet spot for me.
Nils Castro Larsen:The slower you are, the less reactivity, I guess, or lack of ability of capturing a turning point error you have.
Nils Castro Larsen:So that's the typical type one error, let's call it, or like type two in this particular case, the quicker you are then you have more false positives.
Nils Castro Larsen:Now striking a balance between the two net of costs is, sorry, gross of costs is a choice that is a pure trade off accounting for costs.
Nils Castro Larsen:The faster you are, the bigger the I guess the impact can be.
Nils Castro Larsen:So there comes a point whereby becoming even faster will get the costs eating up much more of your ability to react.
Nils Castro Larsen:And therefore you don't even have to go in that unless you have like a very strong cost control system.
Nils Castro Larsen:Now that's the first point.
Nils Castro Larsen:The second point I would put is that you're mentioning Covid and how being reactive is obviously kind of helpful in terms of turning the corner.
Nils Castro Larsen:I would even add to that by saying that looking into August on a month that the market was positive doesn't even appear.
Nils Castro Larsen:If you do your typical scatter plot with a trend following smile and the convex and so on and so forth, there comes a point beyond which you did not have trend following respond to a downturn because the downturn was so short lived, so it didn't deliver.
Nils Castro Larsen:The convexity would have done so if that was fast and the move was contagious.
Nils Castro Larsen:Now it's another discussion to be had as to whether the v shape is something we can learn from it, but it's not ultimately a downturn that you would have expected a short or medium or long attempt, trend following to deliver return.
Nils Castro Larsen:The last thing I would say maybe counter to your and my views, static position sizing would have helped because you wouldn't have reduced your equity exposure throughout that v shape.
Nils Castro Larsen:So it would look more like as a beta move more than anything.
Nils Castro Larsen:I'm not vouching for it by any measure, but I'm just saying that there are some counters and we can always find examples that, you know, one single choice justifies, I guess, a dogma.
Nils Castro Larsen:But I would not suggest that this is a lesson that I know that I learned from it.
Nils Castro Larsen:I'm just putting it out there for the benefit of the conversation.
Nick Baltus:No, I agree with you on the equity exposure, but we also have to take into account that static position sizing and all the other in the yen and all of those things would have had a negative mining.
Nils Castro Larsen:Now data mining?
Nick Baltus:Yeah, you're data mining a little bit, but that's fine.
Nick Baltus:That's fine.
Nick Baltus:Now the other thing that I was curious about as we did this analysis was, okay, but what about the protection capabilities that people want from these strategies?
Nick Baltus:How is that impacted by a look back period as well?
Nick Baltus:Just to make a long story short, what I also found was that the longer you go, you actually get more performance during those periods where there is equity crisis.
Nick Baltus:Now, of course, I have to add to this that this is based on crises that are meaningful and long.
Nick Baltus:I dont mean about a week or two week crisis, so to speak.
Nick Baltus:I think what the period has highlighted, and hopefully for investors, is that there are obviously different ways to deal with these things.
Nick Baltus:Also, if youre long only or if youre an equity investor, but it's just the price we have to pay for delivering the long term compound growth.
Nick Baltus:It is the fact that we will go through these periods.
Nick Baltus:Some of them will be too quick for us to hurt, and some of them will be just long enough for us to be caught.
Nick Baltus:And that's just how it is.
Nick Baltus:That's just the way of the world.
Nick Baltus:If you start trying to overthink your models and try and remove negative periods, because oh, I don't really like that you end up in a bad spot in the long run, is my experience at least.
Nils Castro Larsen:I completely agree and I think I've been clear.
Nils Castro Larsen:We've discussed it several times.
Nils Castro Larsen:If we really after like a daily move or a two week or two day move or a weekly move, we are not following trends anyway.
Nils Castro Larsen:By design, this is precisely the space that maybe requires some contractual protection, which by the way, it's even more expensive.
Nils Castro Larsen:I'm not saying it's nothing the right approach, then there are ways that we can combine option based strategies, buying some optionality with trend following.
Nils Castro Larsen:I completely agree with you.
Nils Castro Larsen:It is in those long term sustained drawdowns that you get the outperformance.
Nils Castro Larsen:It's not in a short lived downturn that eventually ends up reshaping.
Nils Castro Larsen:And I think testament to hopefully the amount of content and industry reports and education that people like you are actually offering to asset owners post August.
Nils Castro Larsen:We've seen none of our, I guess, business activities or if you like, discussions leading to any particular challenge or potential thoughts of unwinding a trend following exposure.
Nils Castro Larsen:It's absolutely clear.
Nils Castro Larsen:It says exactly what it says on the team.
Nils Castro Larsen:If the trend is continuing, it does the job.
Nils Castro Larsen:These are the scenarios that you would have to be exposed to for the long term benefits, right?
Nils Castro Larsen:Being defensive as well as long term sharp.
Nick Baltus:Well, this is the thing.
Nick Baltus: rs, in particular things like: Nick Baltus:I certainly feel that there are more people who are now serious and who want to dive deeper into these type of strategies and are willing to put action behind their research, which is obviously great in my opinion.
Nick Baltus:Now I am interested in if you have other things you want to talk about from your recent travels, I know there were a few other points, or you want to jump into the next bigger topic we wanted to talk about.
Nils Castro Larsen:Look, I think segue to the next topic.
Nils Castro Larsen:Maybe it's this a very basic empirical finding that goes alongside what you said.
Nils Castro Larsen: emembered it because you said: Nils Castro Larsen: st caladayas of s and p since: Nils Castro Larsen:Can you guess?
Nils Castro Larsen:I'm not putting on the spot, but I'm pretty sure you're going to find them.
Nick Baltus: No, I mean, I would say: Nils Castro Larsen:Two.com, correct.
Nick Baltus:It was two.
Nick Baltus:Okay.
Nils Castro Larsen:Yeah.
Nick Baltus:So we ended zero, eight, and then 20.
Nick Baltus:Yeah.
Nick Baltus: And then: Nils Castro Larsen:Correct.
Nils Castro Larsen:So.com, gFC, and the inflation crisis.
Nils Castro Larsen:Yeah.
Nils Castro Larsen:What have been the best two duration years?
Nick Baltus:Duration years, what do you mean?
Nils Castro Larsen:As in fixed income.
Nils Castro Larsen:Buying bonds are.
Nick Baltus:Buying bonds would have been the best two?
Nick Baltus:Oh, I can't remember.
Nick Baltus:But it wasn't.
Nick Baltus:2022 was not one of them, so.
Nils Castro Larsen:Exactly.
Nils Castro Larsen:Right.
Nils Castro Larsen:So.com and GFC, best years for bonds.
Nick Baltus:Okay.
Nick Baltus:Right.
Nils Castro Larsen:2022, the worst year for bonds.
Nils Castro Larsen:What are the three best years for CTA's?
Nick Baltus:Ah.
Nick Baltus: would have been one of them,: Nick Baltus: I would have thought in: Nils Castro Larsen:Exactly.
Nils Castro Larsen: ending on variation, actually: Nils Castro Larsen:So you're absolutely right.
Nils Castro Larsen:It's like those three plus one.
Nils Castro Larsen:So the point I think we're going to get to, which is more about equity bonds and so on and so forth, at least to me, it's an interesting path towards equities.
Nils Castro Larsen:Do the job, fixed income has done the job.
Nils Castro Larsen: d, with all those dynamics in: Nils Castro Larsen:I think.
Nils Castro Larsen:I think it's.
Nils Castro Larsen:I think that's now the time to move in that direction.
Nick Baltus:Now.
Nick Baltus:Mann wrote a paper.
Nick Baltus:Edward Hoyle at Mann wrote a paper.
Nick Baltus:I thought it was a, I mean, it was a very good reminder, actually, for me, when I read the headline.
Nick Baltus:The headline is, although the name of the paper is risky business, why the smart money forecast risk, not returns.
Nick Baltus:And it goes very nicely with what I certainly often have said to people I talk to, probably on the podcast as well, and that is CTA's.
Nick Baltus:Much to people's surprise.
Nick Baltus:We are first and foremost risk managers, and we have no idea what returns we're going to get from the markets, but we have some idea of what risks we take, and this is exactly what they're getting at.
Nick Baltus:Do you want to dive into this a little bit?
Nils Castro Larsen:So I guess the gist of this work relates to whether we can forecast returns, whether we can forecast risk, and what does that mean?
Nils Castro Larsen:And I'm talking about the short term, and what does that mean for us?
Nils Castro Larsen:Allocation, as in combinations of equity and bonds and even maybe like commodities down the line.
Nils Castro Larsen:So they start by effectively looking into realization of returns and volatilities for the stock market, for the last hundred years.
Nils Castro Larsen:And by no surprise, they do find that there are those times whereby risk is elevated, as in volatility, but then subsequent to volatility spikes, volatility remains high, whereas there is no association between today's realization of volatility and tomorrow's returns.
Nils Castro Larsen:This seems to go against academic principles that basically suggest if you experience risky moments, you should anticipate positive returns going forward.
Nils Castro Larsen:It's not necessarily against it.
Nils Castro Larsen:I think what is missing here is the context of the horizon.
Nils Castro Larsen:I think they just put it nicely here.
Nils Castro Larsen:They say, look, yes, when risk is elevated and I'm in a down market scenario, it is more likely than nothing that in the next, I don't know, a year or two or five, my equity return would be positive, above and beyond cash to, if you like, to satisfy the premise for expected returns rising in a down market, but that doesn't happen next month.
Nils Castro Larsen:So today's risk has no forecasting ability for tomorrow's return, but it's actually a good predictor of tomorrow's volume.
Nils Castro Larsen:So tomorrow, today's risk is related to tomorrow's risk, but today's risk is unrelated tomorrow's return.
Nils Castro Larsen:And taking that as a given, then they end up saying, look, if you have like a 60 40 portfolio, well, maybe you should think more about how risk is distributed, because in a 60 40 portfolio, it ends up being 90% equity risk and 10% bond risk.
Nils Castro Larsen:And in down markets, not only is that becoming more risky because volatility is rising, you're not even compensated for it.
Nils Castro Larsen:So the portfolio, as a mix of equities and bonds a, becomes more risky, whether it's the volatility that is going up or the two can actually start correlating or breaking their correlation.
Nils Castro Larsen: I think: Nils Castro Larsen:And the point they bring forward, which I think has been well discussed in the industry for years, is that, first of all, you need to account for risk, and that is like volume.
Nils Castro Larsen:So at the minimum scale, your exposure as a function of realized volatility, because you don't have a good predictor of returns.
Nils Castro Larsen:I mean, you said it yourself, when we do trend following, in a way, that's what we do, we scale down when the market is falling.
Nils Castro Larsen:And if you take it to the other level, you end up shorting the market.
Nils Castro Larsen:But even by just reducing the exposure in a volume spike, you somehow implicitly play a trend.
Nick Baltus:Yeah, this is, of course, one of the big debates we've had over the many years on the podcast.
Nick Baltus:Because obviously with technology as it was back in the seventies and the eighties, that's not how trend followers started out.
Nick Baltus:They had the static position size and some still do.
Nick Baltus:Of course, what is somewhat interesting actually on that point is that I think it's fair to say that probably most of the bigger managers today, they would certainly embrace dynamic position sizing, I think.
Nick Baltus:I feel certain when I say that.
Nick Baltus:But I also know, of course, of people who don't do it.
Nick Baltus:And it's not that I could say specifically that their returns are vastly different.
Nick Baltus:I don't know about the sharp.
Nick Baltus:Maybe that it will show up in the sharp a bit, but it is sometimes difficult to tell the difference once you zoom out a little bit between the two.
Nick Baltus:Now, on a month by month basis, okay, maybe you could detect who's doing what, but long term, and maybe that goes to the robustness of the underlying strategy itself and the signal generation itself.
Nick Baltus:In the long run, maybe the difference is not vast.
Nick Baltus:And sometimes, and this opens up so many doors, maybe I should start many directions now.
Nils Castro Larsen:No, go on, go on, go on.
Nils Castro Larsen:I'll tell you my view.
Nick Baltus:No, but it's a little bit the same idea, this argument about should you trade 500 markets or 50 markets?
Nick Baltus:I mean, it'll be different from time to time.
Nick Baltus:Will one be vastly better than the other?
Nick Baltus:Overtime, I don't know.
Nick Baltus:I'm on the sideline on that.
Nick Baltus:I don't think it will be.
Nick Baltus:And I certainly don't buy into the point that the trading 500 markets is better than 50 markets.
Nick Baltus:But now I've opened two contentious topics in one sentence, so I need to really be careful now.
Nils Castro Larsen:No, look, I'll say the following.
Nils Castro Larsen:If volatility clusters, which they show that it does, and we have so much evidence that today's volatility is a good for tomorrow volatility.
Nils Castro Larsen:And there is no association between volatility and expected returns in the short term.
Nils Castro Larsen:Or, and we have experienced for some of the markets this negative association between volatility spikes and subsequent returns, in contrast to what financial economics would suggest, then you're better off scaling the exposure as a function of all because you scale down prior to negative realizations and you scale up prior to positive realizations.
Nils Castro Larsen:The reason why I feel over the longer term you can get to similar profiles or performance statistics with more static versus dynamic positioning to your point, is because volatility, beyond the fact that it's clustering, it's also mean revering.
Nils Castro Larsen:So over the longer term you have some exposure that you go in and out, in and out, in and out on a dynamic basis, but over the longer term tends to average out to some sort of long term volume.
Nils Castro Larsen:However, and I think that's the most important point, that as far as I'm concerned, is not the long term performance but the local one, specifically around the turning points, specifically around the times that it matters the most.
Nils Castro Larsen:Like actually you reminded me, now I'm going off tangent for a second.
Nils Castro Larsen:Seven, eight years back, we wrote a nice paper with a good friend and this was about predicting equity market returns.
Nils Castro Larsen:And there's this vast literature that says, oh, you can use, I don't know, dividend price or annex price or GDP growth.
Nils Castro Larsen:There's a variety of predictors for equity returns.
Nils Castro Larsen:And there were some models in the literature that was suggesting that hey, you need to constrain your model, because if you constrain your model to only predict positive numbers, otherwise you should scrap your prediction.
Nils Castro Larsen:If it's negative, then you outperform in the longer term.
Nils Castro Larsen:And our point was the following.
Nils Castro Larsen:Equity returns over the longer term are positive by design, purely because they constitute compensation for you taking on growth risk.
Nils Castro Larsen:Now if you constrain a model, however good or bad, that is to only keep the positive returns over the longer term, you would favor better because they happen to be more positive than not.
Nils Castro Larsen:Like, no, it's almost as if I'm telling you to predict the coin tones, a coin toss, and you tell me look, it's 50 50, but if it's like 70 30, the probabilities by design, if I constrain my model to only give me positive numbers, I'll be close to the 70 rather than the 30.
Nils Castro Larsen:So it might look that those models look better over the longer term.
Nils Castro Larsen:But my point is, what is the case in a down market scenario that you think you have a positive expected return, you're piling on equities and then you're getting hit by your prediction.
Nils Castro Larsen:Are you actually remaining solvent?
Nils Castro Larsen:So that was the point we were making, that maybe over the longer term, assessing prediction models and suggesting that a particular model is better than another might have statistically better performance because it captures the 70% of the times that this was positive but not the 30 that it was negative, but at the time it was negative.
Nils Castro Larsen:Leaving that through and managing money on behalf of that model, you might not even live up to the longer term to suggest that your model was a good one.
Nils Castro Larsen:And I think that's what happens here as well.
Nils Castro Larsen:And there are those choices that matter in the micro scale, possibly not in the macro scale, but it's the micro scale that our money ultimately is managed.
Nils Castro Larsen:And that's, I think, why it's very important.
Nils Castro Larsen:Anyway, I can digress all the way.
Nick Baltus:No, that's fine.
Nick Baltus:Now, we talked about volatility and forecasting that and using this in your models.
Nick Baltus:I think they also bring up correlation forecasting as well.
Nick Baltus:What are your thoughts on that?
Nils Castro Larsen:Actually, when we build.
Nils Castro Larsen:There's a nuance here.
Nils Castro Larsen:When we built a portfolio of two markets, correlation doesn't really matter.
Nils Castro Larsen:It only matters for leverage.
Nils Castro Larsen:If I have $100, whether I do 60 40 or inverse volume one, inverse volume the other, and I sum them up and I divide by the sum, so I still have $100, then correlation doesn't really matter if they become more or less correlated.
Nils Castro Larsen:It would simply be that I would need to.
Nils Castro Larsen:I mean, it would have no impact whatsoever on the relative holdings between the two.
Nils Castro Larsen:They will just come from the inverse volume dynamic.
Nils Castro Larsen:In a risk parity world, correlation only matters for the top level leverage if we have a volume target.
Nils Castro Larsen:But if we have a volume target, we don't have $100.
Nils Castro Larsen:We need to level up or level down.
Nils Castro Larsen: bonds suffer like they did in: Nils Castro Larsen:And you overshoot, I guess, the volume you thought you had.
Nils Castro Larsen:So the point they're making is that simply by scaling your exposures as a function of volume, it's also important to take into account correlations for better distribution of risk.
Nils Castro Larsen:In a way, I'm a proponent of this approach, as long as correlation is not too noisy and ends up creating more costs than not.
Nils Castro Larsen:But the point of the paper is to start from a 60 40 equity allocation.
Nils Castro Larsen:A 60 40 portfolio, in notional terms, would have much more, is coming from equities, would have a realized volatility that is very time varying.
Nils Castro Larsen:And this is precisely the consequence of individual volts as well as correlation.
Nils Castro Larsen:Then they say, how about you have a volume target, which in itself allows you to scale the exposures inversely to volume, but also have a top level leverage adjustment to hit that volume.
Nils Castro Larsen:So that reduces your volume.
Nils Castro Larsen:The portfolio is better behaved and more balanced.
Nils Castro Larsen:And then they say, how about you also become active or more frequent in assessing those volatility ratios?
Nils Castro Larsen:Because that eventually performs even better precisely because it's now active.
Nils Castro Larsen:And taking into account the contemporaneous dynamics around volume.
Nils Castro Larsen:So these are the three kind of transitions that go through nominal allocation, long term risk allocations, they call it static and then active risk allocation as a function of the realizations of volts and correlations.
Nils Castro Larsen:That's basically the whole story.
Nils Castro Larsen:It's not too different to building risk parity portfolios in a way, the way at least I read the papers, it's about risk parity portfolios and being risk prudent, which is something you and I, I think I agree very much.
Nick Baltus:So that's kind of a nice segue, because there's a third paper, or maybe it's the second paper, I can't remember what paper we're on now by longtail alpha, that talks about risk parity and trend following together.
Nick Baltus:So maybe you can talk a little bit about their findings.
Nils Castro Larsen:Yes.
Nils Castro Larsen:So I guess the starting point is on this one is the end point of the previous one that says, okay, suppose that I have a risk priority portfolio between equities and bonds.
Nils Castro Larsen:Okay, fine.
Nils Castro Larsen:So better risk balance between the two if I account for leverage, as in correlation between the two.
Nils Castro Larsen:I also have a volt target that is kind of well behaved through time, but I still hold two long exposures into asset classes, that there are times that both of them fail, specifically when the equity one correlation goes positive.
Nils Castro Larsen:So beyond the fact that the volatility can overshoot, if that correlation spikes to positive beyond my projections, I'm also exposed to the fact that both of them can sell off.
Nils Castro Larsen:So by design, if I hold a and b and a goes down and b goes down at whatever volume or correlation, I'm just going to lose money.
Nils Castro Larsen:So the point is, what can we do in that portfolio?
Nils Castro Larsen:And it's no surprise that the historical negative correlation between equities and bonds allow those portfolios, whether it's 64 or expired, to perform very well.
Nils Castro Larsen: But then the: Nils Castro Larsen:And they go into this journey of adding trend following, like a basic trend following example.
Nils Castro Larsen:You can even think about the, you know, the stocks and trend index they use, I believe another index, I can go into the details.
Nils Castro Larsen:There's a Credit Suisse index that we're using anyway, it doesn't really matter.
Nils Castro Larsen:It's a trend following strategy that you can add on top of equities and bonds, and lo and behold, it kind of works, it is helping.
Nils Castro Larsen:And then they go one step further that say, okay, how about we replace bonds with trend following?
Nils Castro Larsen:And that, to me, brings me back to maybe a couple of years that we're discussing about bond replacement with trend following as opposed to portfolio completion with trend following.
Nils Castro Larsen:What they find no surprises is that adding trend following over the longer term in the place of bonds leads to a relatively worse portfolio, or maybe, let's say similar portfolio to having stocks and bonds.
Nils Castro Larsen:But we know the story, right?
Nils Castro Larsen: Historically, over the last: Nils Castro Larsen:If, for example, there was like a short term underperformance in fixed income, you wouldn't be paid for it because the reality is just a long bonds exposure was good enough.
Nils Castro Larsen: course, the story changed in: Nils Castro Larsen:Positively carrying assets as in bonds.
Nils Castro Larsen:So then they introduce that flavor and say, maybe we should do a trend follower that doesn't go short assets with positive carry and doesn't go long, assets with negative carry.
Nils Castro Larsen:Did I say that correctly?
Nils Castro Larsen:Let me just rephrase.
Nils Castro Larsen:Do not go long appreciating markets that have negative carry.
Nils Castro Larsen:Do not go short depreciating markets that have positive carry that comes from bonds, right?
Nils Castro Larsen:No, do not short bonds if you're experiencing an upward term structure because you have to pay the carry and therefore do not trust your, I guess, your trend.
Nils Castro Larsen:And of course, what that brings no surprise is that in that they call it carry optimized trend program, you are not shorting fixed income historically as much as you would with an unconstrained trend.
Nils Castro Larsen: f the negative carry prior to: Nils Castro Larsen:So that's the enhancement above and beyond just adding or substituting bonds alongside stocks still in the risk parity context, right?
Nils Castro Larsen:I mean, concluding they end up also adding commodities into the mix.
Nils Castro Larsen:So if you add commodities alongside stocks and bonds, historically, yes, you have some diversification benefits, but sharpe ratio drops.
Nils Castro Larsen:This is no surprise because maybe for a decade or two the negative roll yield in those commodities would come at a cost.
Nils Castro Larsen:But incorporating the curry flavor in the trend following camp allows you also to avoid those commodity positions.
Nils Castro Larsen:So putting everything together, they finish off by saying, if I build disparity portfolios between stocks and bonds, whether I have commodities there or not, and they do bring some benefit and some value, having a carry optimized, trend following strategy is adding much more than just, than just beat asset classes.
Nils Castro Larsen: , was at the time that we had: Nils Castro Larsen:And I was making the point that maybe one of the more successful inflation hedges is to go short bonds, you go short equities and you go long commodities, and you find yourself paying the equity risk premium, you find yourself paying the term premium, and you find yourself being exposed to the negative royal yield and trend following at the minimum can allow you to be a bit more dynamic around those.
Nils Castro Larsen:Around those dynamics.
Nils Castro Larsen:And it's no surprise that in this paper they say, hey, I have stocks and bonds, maybe commodities at the time, that I have stagflation and so on and so forth.
Nils Castro Larsen:I'm benefiting from that.
Nils Castro Larsen:That's the whole story, right?
Nils Castro Larsen:I mean, nice paper, easy to go through.
Nils Castro Larsen:Is it something groundbreaking?
Nils Castro Larsen:I think we know the stuff, right?
Nick Baltus:No, no, exactly.
Nick Baltus:And again, I very quickly glanced through the paper this morning, and I agree.
Nils Castro Larsen:With the carry screen, by the way.
Nils Castro Larsen:In a way, yeah.
Nick Baltus:Well, yes and no.
Nils Castro Larsen:There's a purity part.
Nils Castro Larsen:There's a purity part.
Nick Baltus:Well, this is the thing, right?
Nick Baltus:This is the thing.
Nick Baltus:Now we have, the mic is yours.
Nick Baltus:Now, we talked about it a little bit earlier today that, sure, you can go back and I don't even remember how long they went.
Nils Castro Larsen:I'll tell you, 98.
Nils Castro Larsen:98, let's call it like 25 years.
Nick Baltus:I mean, of course, 98 is kind of exactly when this carry regime started, right?
Nick Baltus:Clearly you could have found a benefit of excluding or finding ways to limit the short positions or short exposure to fixed income.
Nick Baltus:But here's my point.
Nick Baltus:It's just that this is exactly what I mentioned earlier on, trying to be too clever and adding stuff to a trend following model to avoid some of these periods that you don't like.
Nick Baltus:I just think it's a dangerous game because we don't know what the future holds.
Nick Baltus:And clearly the first 20 years of this century is probably going to be very different when we look back in 20 years.
Nick Baltus: re doing this podcast in year: Nick Baltus:But boy, in the next 20 years, you wouldn't want to do that because look at where rates are at 25%, whatever.
Nick Baltus:So all I'm just saying is I like the purity of trend following, not being too clever, not trying to forecast, not trying to overfit.
Nick Baltus:And yes, you pay a price for it, but it makes it more robust in an uncertain, unknowable future in my view, humble view.
Nils Castro Larsen:I remember the days maybe ten years ago, a bit more.
Nils Castro Larsen: irst few years post GFC, post: Nils Castro Larsen:There were a number of doubts as to whether trend follow would work if rates go up right.
Nils Castro Larsen:I'm sure you remember those days.
Nick Baltus: w because he wrote a paper in: Nick Baltus:We brought him back a couple of years ago.
Nick Baltus:Alan and I, we talked about this particular paper because I remember it caused a lot of challenges for us in the longer term camp because people believe that narrative.
Nick Baltus:And what Roy said on the podcast, it's somewhere in the episode he said, well, he didn't expect the yields could invert.
Nick Baltus:The funny part, I do remember that we don't know what the future holds.
Nick Baltus:And in this case, shorting Bonds was one of the most profitable trades for a long time after having been long, bonds being one of the most profitable trades, you know, maybe as long as.
Nils Castro Larsen:You and I, we just discussed it, right?
Nils Castro Larsen:Taking those shorts back in time, you know, was not, was not compensated for.
Nick Baltus:Anyways, let's bring it all home.
Nick Baltus:We've still got another ten minutes or so.
Nick Baltus:Let's bring it home with a paper that is very familiar to yourself because you're one of the co authors of it.
Nils Castro Larsen: lot of industry maturity post: Nils Castro Larsen:And obviously the question then becomes, how much should I allocate to it?
Nils Castro Larsen:The sizing question, once somebody starts looking into it, becomes, I guess, of existential nature because it's very hard to come up with a number.
Nils Castro Larsen: ve years ago, it was November: Nils Castro Larsen:And that's precisely how much should somebody allocate to trend following?
Nils Castro Larsen:And interestingly, there was another paper from one of the large cdas that came out a couple of months ago on the same topic.
Nils Castro Larsen:And even the approach that they take is very similar to what we had five years ago in that conventional ways of determining sizing do not work.
Nils Castro Larsen:So let me go into the specifics.
Nils Castro Larsen:Being agnostic about what is your asset allocation and what is the alternative you want to add to it.
Nils Castro Larsen:I guess the modern portfolio theory would suggest that you put those two numbers.
Nils Castro Larsen:In an optimizer, you have some expected returns for asset A, expected returns for asset B, some volatility, some correlations.
Nils Castro Larsen:You build some efficient frontier, and then you have like, no, a portfolio that is maximizing the sharp ratio.
Nils Castro Larsen:That's the tangent portfolio, for example.
Nils Castro Larsen:Now if we take any SAA, like no equities bonds, call it 60 40, call it risk parity, we've discussed it at length in this past hour.
Nils Castro Larsen:Just have your SAA and then you put next to it.
Nick Baltus:And for people who don't know what.
Nils Castro Larsen:SAA means, strategic allocation.
Nils Castro Larsen:Yeah, so strategic as allocation or policy portfolios for the asset owner community is a guideline as to how their core allocations should play out.
Nils Castro Larsen:And then typically, depending on the organization, you have an overlay, you might have any liquids bucket.
Nils Castro Larsen:There's obviously the, and that I guess is the alternative complex that goes alongside the strategic as allocation.
Nils Castro Larsen:Of course there are tactical components.
Nils Castro Larsen:That's the TAA that we typically talk about, or I DAA, like dynamic as allocation.
Nils Castro Larsen:In case you need more acronyms, I can continue.
Nils Castro Larsen:But anyway, long story short, if I have an astral location, which is a blend between fixed income, between equity with some regional tilts depending on the mandate, what more can I get from a trend follower?
Nils Castro Larsen:Assuming that we know that we can get this convexity, this protection in extreme downturns and so on and so forth, how much do you allocate?
Nils Castro Larsen:That's the question.
Nils Castro Larsen:So what is the expected return of trend following to put into a mean variance optimizer?
Nils Castro Larsen:Bluntly, if you ask me, I'm going to tell you zero, because I have no clue and it shouldn't work in the first place.
Nils Castro Larsen:I think Andrew made a very nice point recently.
Nils Castro Larsen:Said people that don't feel comfortable about trend following is because it goes against their premises and their fundamental understanding of the market, that past returns should not predict future return.
Nils Castro Larsen:But the fact that it does cannot be ignored.
Nils Castro Larsen:Let's say we use historical Sharpe ratio of trend following doesn't really matter, just pick a number.
Nils Castro Larsen:That number historically as a sharp ratio is more likely than, not even higher than an equity bond portfolio.
Nils Castro Larsen:Let's call it equity bonds is like no, 0.6.
Nils Castro Larsen:We can say, okay, a CTA or a trend follower could be like 0.70.80.
Nils Castro Larsen:.9 the numbers don't really matter.
Nils Castro Larsen:What matters at the end is that any invariance analysis would tell you to do 70% trend following, 30% the remaining of your portfolio.
Nils Castro Larsen:So we're overlaying an alternative allocation with the strategic allocation it doesn't really make any sense.
Nils Castro Larsen:So conventional ways do not work.
Nils Castro Larsen:Then you can say, you know what, scrap the expected returns and simply focus on a minimum volatility portfolio.
Nils Castro Larsen:How can I minimize my volatility?
Nils Castro Larsen:Well, I can solve for this combination that the downside risk, for example, is minimized by the addition of x units of trend following.
Nils Castro Larsen:And I'm talking about on a funded basis, we can solve it for unfinished allegations.
Nils Castro Larsen:It does really change the result, even that.
Nils Castro Larsen:And I can quote some of our analysis gives you a 52%.
Nils Castro Larsen: And I'm using here data from: Nils Castro Larsen:As we said, you know, this was work that we did five years ago.
Nils Castro Larsen:So that now basically says you do 50% trend following, another 50% equities and bonds, it's too, too high, right?
Nils Castro Larsen:It's too high as a number to be consumed by an institution.
Nils Castro Larsen:Right?
Nils Castro Larsen:So then what we suggested back then is that there are two driving forces here, and these are the ones that should be balanced in determining that size.
Nils Castro Larsen:And that's where this basically paper goes.
Nils Castro Larsen:Basically says if you're holding a policy portfolio, a mix of equities and bonds, this is your benchmark.
Nils Castro Larsen:And benchmark has a very important psychological impact in how investors operate.
Nils Castro Larsen:And I mean, not just investors, all of us have a benchmark to beat in our personal lives, in our professional lives.
Nils Castro Larsen:If you beat the benchmark, you're better.
Nils Castro Larsen:If you, if you miss the benchmark, you're actually underperforming.
Nils Castro Larsen:So anything you do away from it is an active risk decision that unless it's properly rewarded for it, you'd rather not have it in the first place.
Nils Castro Larsen:But any active decision consciously comes with risk.
Nils Castro Larsen:That's the typical active risk that we talk about in single stocks, for instance.
Nils Castro Larsen:Right?
Nils Castro Larsen:So how big should that size be of allocating some dollars into another alternative?
Nils Castro Larsen:That's the question, right, that we have in here.
Nils Castro Larsen:So the point that we're making here goes as follows.
Nils Castro Larsen:There is no way you can maximize your returns.
Nils Castro Larsen:There is no way you can minimize your downside risk, because both approaches would give you unrealistic numbers.
Nils Castro Larsen:What you really have to assess is a scenario analysis and value add of various increments of trend following allocation, be it 2%, 5%, 10%, 15%, but then calculate a tracking error, quote, unquote, as to how much you now deviate from your benchmark, because that's now your risk.
Nils Castro Larsen:The more you deviate from it, the better your tail characteristic would look.
Nils Castro Larsen:The better your sharp ratio would look, the better your downside performance will be.
Nils Castro Larsen:The more likely it is that you're going to maintain.
Nils Castro Larsen:You remain solvent in a way, in a down market, but that comes with a business or a career risk.
Nils Castro Larsen:So where this kind of story concludes is that it's a balance between those two.
Nils Castro Larsen:What are those characteristics you're after in terms of longevity of an investment?
Nils Castro Larsen:And I think the industry paper talks about a one year horizon versus a ten year horizon changes dramatically your perception about CTA's.
Nils Castro Larsen:Maybe in a year, the value add is not as great as it is in a ten year.
Nils Castro Larsen:So the horizon is very important.
Nils Castro Larsen:The downside, the risk mitigation is very important.
Nils Castro Larsen:Maybe the long term sharpe ratio is the consequence of those two.
Nils Castro Larsen:But any decision becomes an active decision.
Nils Castro Larsen:Where do you draw the line?
Nils Castro Larsen:It's very different to me and you.
Nils Castro Larsen:That's the typical risk aversion in a different way, I guess, in a different concept.
Nils Castro Larsen:Right.
Nils Castro Larsen:And I'm not saying that you're not allocating into a trend follower is a risky decision.
Nils Castro Larsen:All I'm saying is that it has to be seen as a strategic decision.
Nils Castro Larsen:But sizing, it should not be too small because the impact would be tiny.
Nils Castro Larsen:But the more it becomes, the more conscious an institution should become about a tracking error to what ultimately everyone is assessed against.
Nils Castro Larsen:And I think it's very hard to go against what we are assessed by maybe, and I think we've discussed it here a couple of times, maybe the strategic ass allocation should change and contain maybe five or 10% or 20% of trend following.
Nils Castro Larsen:And that now becomes a different story, because if that is the benchmark, then we have more room to play with it.
Nils Castro Larsen:And I think this is where the industry is at the moment.
Nils Castro Larsen:Whether a 60 40 or a risk party combination of asset classes is the right benchmark, and the policy portfolio to be held or managed futures becomes part of that ecosystem and is accounted for as a core component in SAAE, as in strategic, as the location for the lack of a better acronym.
Nils Castro Larsen:So that's the whole story about sizing.
Nils Castro Larsen:I think it's a very, very, very important topic for us owners.
Nick Baltus:I think it's crucial because it is what's going to move the needle at some point if we do see a change in the way these quote unquote, benchmarks are constructed?
Nick Baltus:Maybe my final question, because you wrote this paper five years ago, as you said, maybe it's too early, but do you see any signs that the strategic asset allocation, quote unquote, the benchmark is slightly changing to maybe allow for a higher allocation, to things like trend following.
Nils Castro Larsen:So you mean introducing trend following in the strategic allegation or allowing for bigger sizes?
Nick Baltus:Or maybe in a sense saying, well, maybe the 60 40 isn't the best today.
Nick Baltus:Maybe it was for 20 years, right?
Nick Baltus:But maybe today, four years after interest rates found a low in a new environment, in a de globalizing world, whatever the arguments may be, in an inflationary environment we haven't seen for a while, maybe 60 40 as the starting point is really not where we should be having this conversation from.
Nick Baltus:I mean that because that is, as you say, that will allow more room for, quote unquote, the positive tracking error.
Nick Baltus:Hopefully that things like trend following could introduce.
Nils Castro Larsen:I would answer by saying that I don't see the reverse.
Nils Castro Larsen:Like I do not see, I do not see any specific, I guess, gravitational power holding now asset owners into the 60 40 premise.
Nils Castro Larsen:There are challenges that are coming to the surface month after month, year after year.
Nils Castro Larsen:These are not the same conversations I was having five years ago.
Nils Castro Larsen:The fact that this report became again relevant for a good amount of our clients is precisely the consequence of those questions now being asked much more than in the past.
Nick Baltus:I completely agree.
Nick Baltus:I see the same.
Nils Castro Larsen:And that's why I said, look a, we need to rank it again and discuss it and be having one of the large CTA's producing pretty much the same report in some variation of the analysis two months ago.
Nils Castro Larsen:I think it's testament that it is a topic that is heavily discussed.
Nils Castro Larsen:It's not that, hey, let's talk about that because I think it's interesting.
Nils Castro Larsen:I think it is a topic that most of my current discussions are going about.
Nick Baltus:If I can throw in a little bit of a topic that we can think about, maybe for next time we talk, even though it's probably not something we have much knowledge about, but I feel this conversation is changing simply from the fact that bonds had a big sell off.
Nick Baltus:People realized that there is risk in owning bonds.
Nick Baltus:They had maybe not seen that for 20 years or so, but that's purely performance driven.
Nick Baltus:When I read some of the news, the reports about the debt levels we are running, continuing to run, and the accumulated debt that we have out there from government side, I mean, that in itself should also, in my opinion, be part of the conversation as to why maybe 40% in bonds is way too risky today compared to what it was 20 years ago.
Nick Baltus:But that's not where our focus is today, because so far no government, big government, has defaulted on their debt.
Nick Baltus:But when you read some of the I was reading, not that I spent much time on Sopstack, but I did see whatever was on the free level from Richard Werner in terms of the debt levels in the US that he posted this week, and it's absolutely terrifying when you read those numbers.
Nick Baltus:Anyways, it's a discussion.
Nick Baltus:It's a big discussion for another day, but it should be part of why the 60 40 is maybe not the right measure to start with.
Nils Castro Larsen:No, I agree with you.
Nils Castro Larsen:Look, 60 40 was a carry trade and a yield reduction in a turning point.
Nils Castro Larsen:Now which of those components can still be there?
Nils Castro Larsen:I think that's a big question, right?
Nils Castro Larsen:And I couldn't agree more with you.
Nick Baltus:Well, let's end on a point of agreement.
Nick Baltus:That's always a good place to end.
Nick Baltus:Nick, this was tremendous, as always, so useful, so insightful.
Nick Baltus:And I'm sure everyone listening today will have picked up a lot of new and important stuff from you.
Nick Baltus:And I hope for people who listen in that you're going to show some appreciation to the work Nick has put into this by going to your favorite podcast platform, leave a rating and review.
Nick Baltus:Tell Nick how great he is.
Nick Baltus:That's always a good way to bring him back.
Nick Baltus:In a few weeks.
Nick Baltus:Another great person will join me next week.
Nick Baltus:That's going to be rich.
Nick Baltus:So if you have questions for him, probably more hardcore trend following questions I could imagine do send them to me.
Nick Baltus:Infobtradersonplugged.com is where they should go and I will bring them up from Nick and me.
Nick Baltus:Thanks ever so much for listening.
Nick Baltus:We look forward to being back with you next week and until that time, take care of yourself and take care of each other.
Niels Kostrup Larsen:Thanks for listening to the Systematic Investor podcast series.
Niels Kostrup Larsen:If you enjoy this series, go on over to iTunes and leave an honest rating and review.
Niels Kostrup Larsen:And be sure to listen to all the other episodes from top traders unplugged.
Niels Kostrup Larsen:If you have questions about systematic investing, send us an email with the word question in the subject line to infooptradersunplugged.com comma and we'll try to get it on the show.
Niels Kostrup Larsen: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.
Niels Kostrup Larsen: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.
Niels Kostrup Larsen:Thanks for spending some of your valuable time with us and we'll see you on the next episode of the Systematic Investor.
