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- [00:01]
A
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. No shortcuts. Just real conversations to help you think better and invest with confidence.
- [00:36]
B
Welcome or welcome back to this week's edition of the Systematic Investor series with Alan Dunn and I, Nils Kastrelason, 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.
- [00:56]
C
It seems summer has arrived for sure. Yeah, we're, 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, some records this week, 29 degrees or something like that. So yeah, a little bit cooler today. So I'm, I'm hopefully I'll be okay for, for the next hour at least.
- [01:21]
B
Exactly. No, 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 so. And one of them in particular I would say is, is quite fascinating and we're going to get into all of that. But, but before we do, I am very curious to hear what has hit your radar in the last few weeks. Anything exciting?
- [01:56]
C
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's 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 is written it but he worked 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 his Investment Outlooks and the Last Dance was a famous one. He had there a few years ago, but I was reading it for probably about 10, 15 years, but didn't really know that much about him and his background and how he managed his portfolio. 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. 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 there were also early pioneers of quant investing. So that was news to me. I didn't realize he's a quant bas or he spent a lot of his time doing quant and also that they used momentum and trend type strategies as well and quite good advocates for them in that they saw 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 were to build an early kind of quant equity model based on a couple of fundamental factors for a client. A client was the IMF and didn't do very well. And then it kind of 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 from 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, 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, it didn't work for six years or something and then they had to park it. So 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. So it just shows you how timeless these experiences are of running quant and systematic strategies. He's talking about these experiences from the 1980s, 1990s, and we still encounter them.
- [05:22]
B
Yeah, no, I mean, that's actually very interesting indeed. And it sounds like Alan, you should reach out and get him on your, on your series for sure. But, but joking aside, and I certainly remember a little bit in the same vein that during that kind of quote, unquote, 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're 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, 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 a 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. So 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 will 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 that 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.
- [09:19]
C
I guess what you see, I guess the CME is trying to compete in, in the new environment. You know, I guess you could say, you know, it's not all bad. I mean obviously we've had micro contracts being available on different markets, certainly S and 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 if you're a, you know, even if you're kind of a semi pro and you 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 know, you had the oil etf, can't remember exactly what it was called but you know, and that ran into challenges obviously when oil went to negative.
- [10:02]
B
Is that the one that went negative?
- [10:04]
C
Yes, you know, so I mean, and equally you can trade on spread betting obviously here, you know, on. 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.
- [10:23]
B
Yeah, yeah, no, no, I'm not surprised that they do it. It's just sometimes. But 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, we are about a week into the third quarter, but I thought it 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. So definitely been some, some changes in some of the directions in especially in energies, but, 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, but some of the other 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?
- [12:18]
C
I mean, looking at the year to date, it's definitely been a good year so far. I mean, you know, solid kind of, you know, returns. Obviously if we were to go back to the middle of May, it looked even better. We, you know, we've kind of heard a little bit of a drawdown since then. You know, I was, you know, 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 was there less than a couple of percent and my sense was across more 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, change in tone there was one thing, but equally metals, aluminium, copper and then also markets like soybean oil, which were kind of also related to that. And then it's 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, you know, looking at the returns year to date,
- [13:59]
B
you know what, why I was reminded of a little bit when I just look at the price action to some degree of the markets, right. So we had this massive surge in energy markets a few months ago and also in other commodities. Obviously, precious metals had been doing pretty well coming into this year and so on and so forth. And you did see a number of experts coming out on Bloomberg, cnbc, whatever the channels are called, saying that this looks like the beginning of another commodity super cycle, as you would expect. Now, if you think back, that's exactly what happened in 2022 after the Ukrainian war started, right? 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. Right. And I'm kind of thinking the last month or so, you kind of seen more or less the same picture in the commodity space. Now, interestingly enough, later today, I am recording with one of our favorite commodity experts, Adam Rosenzweig, and that's going to come out in only a few days, so on Wednesday. But we know historically, because we can see the data, that actually 2022 turned out to be a really great year for CTAs. I'm not predicting. I'm not making a prediction here, but it is interesting, some of the similarities, at least in terms of the narrative, the price action and so on and so forth. Is that. Is there something you've noticed or is that just.
- [15:37]
C
Yeah, I think a couple of things. I mean, I think when the conflict kicked off in the Middle east and, you know, in. In March, you know, 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 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 hard. Clearly wasn't the case. So it's like, well, what happened? And I mean, obviously after the fact, we got explanations around, you know, Chinese oil demand declined because they were able to tap into their own reserves and, you know, some of the oil flows were able to be rerouted via pipelines, et cetera. 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 if it's, you know, if the disruption persisted, that there's still a problem. But it did make, you know, it did make me think, you know, 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, you know, 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. You know, 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 fundamental, 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.
- [18:10]
B
Yeah, no, no, I completely agree. And that's the beauty of what we do, Alan, is we don't actually have to predict what, 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, beta 50 down about 23 basis points in July, still up 7 and a half for the year. Soctin 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 a quarter percent or so this year. And then the S and 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 Coco that keeps sort of surging now suddenly after it was in a, 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 your, your, the story that you were meant to talk about under your radar had been been we've moved that to the macro view. So I'm, I'm excited to hear what's, what's hiding in the macro view.
- [20:10]
C
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, 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 we've had, you know, 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 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 Alan Greenspan passed away there recently and Warsh does seem to be a fan of Greenspan. And obviously Greenspan was famous, 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 or 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, because 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? And actually it was Bernanke back in the 2000s who was a big proponent of more transparent communications and more and I guess forward guidance. And he had two speeches back in 2004 which kind of laid out the reasons for this. And I suppose a lot of it was a product of the time. 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's warships justified. That a different era now justifies a. You know, 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 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 Timiraeus at the Wall Street Journal of 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 fact. Because if you think about it, if the Fed starts a tightening cycle and then they put it into SEP, but 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 more. If information is digested more incrementally, you might see a bigger term premia on bond markets as well. Well, because of this, because of the uncertainty and while there are good aspects to it, it does also create maybe a bit more, 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 are used to from Jay 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 war 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 inflation risks are coming down and the big dilemma that he's facing. And this was the article that was on my Radar. It was in the Wall Street Journal recently about how the AI trade is fueling inflation across so many different products from iPhones to Nintendo consoles, but basically pushing up the price of memory and chips and pushing up obviously the price of electricity, et cetera. And this is the big dilemma that Warsh faces now in that, you know, and it goes back to the, the Greenspan dilemma of the 1990s. When you get a productivity shot, there's a supply element and a demand element. We're experiencing the demand element now. So the demand is pushing up prices. The supply side is the productivity gain that is expected to come down the line. And this is what, what Warsh is talking about. And he's saying, you know, 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 bit, 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.
- [28:24]
B
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.
- [28:43]
C
Yes.
- [28:44]
B
And speaking on the whole inflation point, I mean, not a very nice person. 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. Thanks for that. And I agree with, I mean, I think for me, maybe the most, the more interesting part about the changes, maybe not so much this thing about the narrative side, whether they give long press conferences, 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 more. 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, when you can't get that or it's completely restructured and, and it's calculated in a very different way. That's going to be interesting as well. What is also going to be interesting? 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, it's 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 paper. So 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 the tone for what they're actually about.
- [30:36]
C
Yes. 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 you know, I suppose re emphasizes many of these themes that the last 25 years were effectively an anomal in terms of kind of abundant energy and the peace dividend from globalization, et cetera. 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, surging demand for gold from central banks and I suppose commodities as much more strategic assets. And 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 an 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, et cetera, that could be disruptive and be negative for traditional assets. Because 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. But 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. 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 trend can. So 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 balance from. From a risk perspective. So I think the two papers are good in terms of summarizing those points. You know, probably things that we have spoken about before, but. But re. I may be restating those points with a different lens.
- [34:46]
B
Yeah. So when I think about, I mean, obviously these are, as you say, these are not necessarily new things that, 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 the 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 the 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 that investors and larger Investors will will be 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, to, you know, 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, so maybe we, we just need to get used to talking about 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 to maybe the 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, Sultan Eisler, Adam Ray and Jean Philippe Bouchot. Well known to many people, Chairman of cfm, previous guest on the the, on the podcast and highly respected of course. Now what I like about this paper and, and I, 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 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 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 try to explain what it is we've been observing why that could be the case. So if I can teed up like that to you Alan, and maybe you can, you can tell us much more about this, this wonderful paper.
- [38:35]
C
Yeah, no, it's definitely really interesting paper and as you say, it's you know, getting to a heart to the heart of something we've been looking at and debating in markets for a while. Not just you know, you had the kind of the more sluggish performance of trend generally for a period and then also you know, the challenges for fast trend as well and you know, we've talked about some of the explanations and some of the potential explanations. And I guess, you know, what's interesting in this paper is they also look at some of those ideas as well and are dismissive of them as well. You know, the classic, and maybe we
- [39:15]
B
should talk about those.
- [39:16]
C
I mean the classic ones are, you know, assets. We remember, we used to hear the industry has gone, got too big. So that was the source of the degradation in returns. But actually that's not consistent with the evidence in terms of AUM kind of 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 what does that mean? You've got different markets of different tick sizes and then you gotta think about the tick size relative to the volatility of the overall market. So for example, the tick size in currencies has got very small of late. The euro is say 1-13-001-13001. So the size or the value of a tick is small and even people probably traded even less than that. Whereas in the bonds it's much bigger, at 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, less liquidity. The liquidity is there, but it's not necessarily apparent that 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 at 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 up bank of America or whoever it was and give me a price in dollar yen in 50. But let's say if you wanted in a yard of dollars or $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 500 million in one, in one go. So 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, put in place a momentum effect. And this is the thesis of this paper, that that momentum effect that comes from the actual trading is a key part of, 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 trend following. They also touch about how behavioral factors like the speed of adjustment for different participants in the market, an 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 you could get 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 they're saying, well, something changed around 2010 where you had a lot more high frequency traders and the banks basically took a step back from warehousing risks like that, so you wouldn't be able to get a big trade on like that. 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 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, particularly equities and currencies. They also analyze the order books in different markets and another feature that they do see is that there used to be a lot more liquidity available for trend followers. So if you were looking to buy, there was plenty of liquidity there. That's less the case now and that's since 2010. Why is that? Is the liquidity providers are shying away from offering that liquidity. And they've also found another interesting feature of this research is they found that countertrend 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 Crabill 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 market markets seem to be much more mean reverting at short term time 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
- [46:39]
B
in front of you, but I'm looking at Figure 10 at the moment.
- [46:45]
C
Yeah, well actually I was going to talk about. Let me pull a figure 10 because, 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 download it. But actually what struck me is that it very much didn't work for a decade. You can see that it stopped working basically between 2010 and 2020, but since 2020 its performance has kind of improved again notwithstanding a little bit. So is it the case of a structural change or is it the case of we had a decade where it didn't work. So that's something that they don't address. And then the other thing that I think is interesting, if you look at the large tick markets, which is the chart on the right hand side, fast trend has actually been better over the full period since 1995, which is really surprising. And slow trend was quite challenged again kind of between 2008. It has picked up more recently. So again that's not addressed in the paper either. 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 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. I mean some people will argue, okay yes, the returns in fast trend following have deteriorated it, but there is still a value for it in terms of convexity and skew. There have been papers from man around this. So 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 this 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. It's kind of, you know, I think people will debate that but I think it's definitely intuitively makes sense to me. What do you think?
- [49:44]
B
So if someone came to me and said listen, we have found out exactly why short term trend follow or short term trend following hasn't worked for the last last 15 years. Plus I would not have thought about something as unsexy as texize. Let me just say that that is not what I would have expect. Could there be something about it? Well, I mean for managers it's fairly easy to test, right? We should go back and, and look at the. We can run short term time frames on our models. So that's the first thing we do. And I can say from what I see internally it done. Yeah, I mean shortterm time frames on a classical trend following model has not been profitable whatsoever for the past 15 years and actually ties in well with 2009 as the break point. So I would agree with that observation completely. Now I'm not going to argue against, you know, people like Jean Philippe Bouchot 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 two 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, 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 changed 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 pot shops because my impression is that they are much more short term. Maybe not necessarily only in their holding period, 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 happen to have lunch with a super interesting guy who are from that space this week, week and he was basically saying, I don't think I'm saying anything confidential when I say this. And he was basically saying, you know, if you're one of the parts and, and, and, 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, so I, I, I, I can't imagine that the rise of the AUM in these 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 convincing piece of evidence they put forward Forward. I just think there might be more to it. That would be my.
- [53:33]
C
Yeah, no, 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. It's, I mean it's, it's kind of equities and currencies are the two that have struggled. I mean it's not, it's not just they assign it specifically to the tick size, but in general that, that's what it shows. I mean the other thing we've had in equities has been, you know, zero dtes more volatility selling, you know what. So the market microstructure has changed in a few ways. You know, as you say, more POD shops shops but also new products and structured product volume selling, you know.
- [54:21]
B
Can I offer one more thing?
- [54:22]
C
Yeah.
- [54:22]
B
I mean if we think about it, let's just say that this is done using simulation. Right? 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 beginning, 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, 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.
- [55:38]
C
Yeah. No, just wanted a 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 large 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.
- [56:21]
B
So that speaks to the liquidity, right? That speaks to the liquidity.
- [56:25]
C
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, and the contract characteristics is what they're suggesting.
- [56:41]
B
Yeah, I mean without taking 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 two people, the loop it creates, right. The follow through, it recreates trades. Whether 10 people have to go out and get a market, I mean you would think that that pushes the price, right? Or whether it's two 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? It. But maybe I'm completely wrong here. So.
- [57:35]
C
Yeah, no, I mean that's why I think, you know, 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 cjs have actually disengaged from, from short term trading. Which is actually true. Which is true. Which is the anecdote. Most, most of you know, we, people are saying, you know, 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 signals have. Sorry.
- [58:19]
B
So what we could say maybe, maybe what we could say is that in the short term, in the short term timeframe frame, 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's basically just trying to, you know, make a bit of money on, on, on the spread or whatever they're doing. So, so maybe we, maybe that's part of the reason as well that in the last 20 years or so, the way the short term, specifically the short term timeframes are made up in terms of who's doing the trading has changed dramatically.
- [59:04]
C
I mean, they do allude to the fact that CTA behavior may be changing too. I mean, if you think about it, if CTAs are kind of all very focused on best execution, well, obviously everybody's focused on best execution. But if you're not trying to, if you're passively buying as opposed to crossing the spread, I mean that, you know, and they do touch on this as well, you're kind of going to miss the big kind of breakout moves because you're with your, your 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, that they allude to as well.
- [59:39]
B
And, and then finally, maybe before we, we wrap up, I would say the, the, 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, 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, from the, from the signal to the, to the exchange and they incorporate some kind of algo to do the actual execution. And these algos definitely behave differently than what a person, what an individual trader would do because they're not emotional, for example, and they have patience and, and so on and so forth. So I think that, 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, I'm not a quant, so easy for me to say. But really appreciate you digging into this and really, really appreciate, appreciate all the authors for putting this out there.
- [60:47]
C
Absolutely. No, it's definitely one of the more interesting additions to the whole debate around us.
- [60:54]
B
Yeah, yeah. Anything else you want to add before we wrap up, Alan?
- [61:01]
C
Not that I can think of now, no. Unless we want to get into the football or something.
- [61:09]
B
As long as Switzerland is part of the World Cup, I was definitely happy to get into football, but if they, 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 finding the podcast questions as usual for upcoming episodes. You can email them to Info top traders on pl.com 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.
- [62:11]
A
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