Inelastic Markets: Discussion of research claiming $1 of equity inflow can add ~$5 to market value, with skepticism about causality and concern this implies bubble-like conditions.
Managed Futures: Review of recent CTA index performance and the role of diversified, rules-based futures strategies in navigating shifting trends across asset classes.
Trend Following: Emphasis on how trend strategies benefit from market inelasticities and delayed supply responses, with characteristic payoff profile of steady bleed in quiet times and strong gains when many markets trend.
Inflation Protection: Analysis of Man Group’s findings that commodity and fixed income trend strategies historically perform best during rising inflation, while TIPS/REITs can lag when rates rise.
Commodities: Highlighted as a key vehicle in inflationary regimes due to inelastic demand and slow supply responses, creating longer, more persistent trends compared to financial assets.
Fixed Income: Bonds exhibit lower elasticity than equities with QE as a natural experiment, and a recent positive stock-bond correlation suggests valuation spillovers and potential policy risks.
Alternative Beta: QIS/alternative risk premia products are large and low-cost but face notable post-launch performance haircuts and execution/risk management differences versus hedge funds; useful as customizable building blocks.
Transcript
Imagine joining their experiences successes and not the most yet often. Welcome [music] to top traders unplugged the place where you can learn from the best hedge fund managers in the world. So you can [music] take your manager due diligence or investment career to the next level. Before we begin today's conversation, remember to keep two things in mind. All the discussion we will have [music] about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand [music] that there's a significant risk of financial loss with all investment strategies and you need to request [music] and understand the specific risks from the investment manager about their product before you make investment decisions. Here's your host, veteran [music] hedge fund manager Neil's Krup Larson. Welcome back to the latest edition of Top Traders Unplugged, where each week we take the pulse of the market from the perspective of a rules-based investor. It's Alan Dunn here sitting in for Neils again. Neils is away this week and I'm delighted to be joined by Yove. Yo, how you doing? >> Pleasure to be here. Doing fine in London. >> Good stuff. Um, great. Well, it's very very mild here in Dublin for for November. I presume it's the same over your side. >> Yeah, actually a very mild November. Um, no. Um, no snow, no cold. Uh, very good for cycling. >> Good for cycling. Good stuff. Well, we uh like to kick off with what's on your radar. Um, last time it was comedy. I I don't know if you'll give us an update on on on the comedy or tell us a few jokes, but but what's been on your radar? >> Oh, the comedy went quite well actually. Uh, I'm surprised you don't have a a bootleg copy. Um, but actually, I want to talk about something a lot more serious this time. Um what has been on my radar is what's um is mathematics in high schools and primary schools in the UK. um if you have a child who is halfdeent in mathematics um you start worrying about it and the reason why it came on the radar is because there's a new there's a new school uh 1729 open opening up in Milh Hill uh and that's like a private uh very expensive uh school which is specializing in mathematics and the nice thing about it is there are burseries but provided very kindly by uh XDX and Alex um for uh very you know for the good mathematicians with the aim of really providing um every every student a chance to really shine um and uh the application by the way is the deadline for application is the 9th of November so in 3 days time so hopefully uh if you hear it before before the deadline go and apply. uh but it started it started me thinking about um about like the two ends of how you can make mathematics accessible uh especially between key stage two and key stage three. that's between uh primary school to GCC's and um there's actually an excellent report uh when you look at it the by the Nottingham University about the pipeline of mathematics and they have a few really nice observation about the way that you know you start with 25,000 schools in in England and the UK and then how at each stage you know fewer and fewer people uh remain in what they call the excellence stream and they're making a few suggestions to how to increase that number. Um you know in increasing participations of of of ladies increasing participations of disadvantaged uh students from disadvantaged background. Um and then what was very interesting is that guess what the person who supported that Nottingham research with a great paper uh is none other than XTX. So actually you can see that um a lot of thought has gone into trying to um trying to improve the pipeline to get more mathematicians um through school and then into university. So and I think that's a very worthwhile a very worthwhile cause and Alex to be commended on that. >> Interesting. Yeah. Very good indeed. Um well um we normally uh like to start off um talking about performance and uh good to get it out of the way I think uh because we have a lot to get through in terms of meaty um articles and uh academic studies. We've got um three if we have time for all of them but I sense we might get uh embedded or beded down in one of them at least. Uh but in terms of where we are obviously early days in in the month of November um but um slightly negative performance on the managed feature side. Stock gen CTA down 40 basis points monthto date and year to date still down uh 1.9% uh this year and stockgen trend down 56 basis points on the month and down 1.44% so far um this year. Uh obviously we're very early in the month. We've had a little bit of a correction in some major trends obviously in equities uh gold as well as edged a little bit lower but from your perspective we've had a bit of a recovery in trend following in manage futures last few months and this month starting off a little bit negatively but any any thoughts on performance? >> Uh again I I kind of refuse to to to get drawn on that because uh I'm always a pessimist so I I I'll count my chickens at the end of the at the end of the year but uh certainly fixed income has been very difficult. Um we've seen up and down and uh and round we go and of course the UK has kept interest rates at 4% as well. Um so uh it's it's it's exciting time to be trading fixed income trend. >> Yeah very good. Well, um the first topic I wanted to get into is a an academic study, a research paper. Um it's called In Search of the Origins of Financial Fluctuations. Um the inelastic markets hypothesis um from a couple of academics. Um I mean I the the the uh I won't I won't steal the uh major takeaways but the the the takeaways here are quite dramatic and interesting in terms of the impact of uh um new buyers or new money coming into the equity market. So maybe I'll hand it over to you to give the the high level summary and and and maybe we can get into some of the implications of the research. Uh then >> yeah absolutely. So actually um Neils and Andrew Beer talked a little bit about it because there was a paper there was a article published in the Financial Times about about this very paper and the way the Jean JP Bushau um is talking about it and supporting that that paper. Um and the the idea behind it is about supply and demand and trying to understand how elastic or inelastic uh the the equity market in the US to money flowing into it, right? Um but we kind of need to step a little bit back and just a little bit understanding about what supply and demand is um and how to calibrate it and then we can think about this paper in terms of the outcome of that methodology. Um but the methodology but the outcome is completely astounding. So the the punchline is that whenever there's a $1 flowing into equity market that translates into a $5 increase in the overall valuation in the market. And the reason why this is kind of very surprising is because that makes that breaks the efficient market hypothesis in you know uh it just puts it straight into into the dust bin. Um and it's a it's a big thing. It's uh it it basically says that what we're doing at the moment, what we're seeing is is a bubble. Um and we're seeing flows basically driving the valuation and a 5x amplification whenever there's a new dollar flowing into the equities. So it's a very very surprising result and uh but you know maybe maybe it is correct. Okay. So um so that was the paper but before we before we we need to think about the methodology and we need to think also why this is important to trend following right or I mean I I kind of think about it and I'm trying to understand why this is important so what are supply and demand the idea is that you know if people want butter and people produce butter um there will be a point where they there is a demand curve so the more the higher the price the less people would want butter because they would want to eat something else uh And conversely, the higher the price, uh, the more supply there is, right? So, one curve, uh, the way that we look at the supply, it varies with price in one direction and in and it supply and the demand is varying in another direction with the price. So, the two curves will meet at a point and that will determine an equilibrium in the economy where we have both the price and the quantity of butter which is consumed are at an equilibrium. Okay. And then what is a trend? A trend is when when there is a shock to that system and suddenly people want more butter. They've watched bake off they really want to start um you know start cooking baking bread baking bread or baking uh more cakes. So there is a there is a demand shock or potentially there's a supply shock. You might have a situation where you know met cow disease and suddenly we have le less cows to produce butter. So when you have a supply shock or a demand shock the market needs to find a new equilibrium and the way that it does it it does it through the adjustment in price. So you know uh suddenly if there is less supply the prices will will rise until the market adjust demand adjusts to meet the supply. Um and the question of like how much the price needs to move uh is important for us as trend followers and it's called the elasticity of the market. So if a mark if a like in commodities for example demand is quite inelastic like the amount of electricity that we use is not really that very is not that dependent on like the price. So you we need a big change in price to get a small change in demand. Okay. So that gradient, how elastic, how responsive is the supply and demand to change in price is called the elasticity. And it really affects the the nature of trend, right? Because what you see is um is that the more the more inelastic the market, the more response we need to get in price to really drive to change the supply and demand. And the other aspect of supply and demand which is important to trend follower is the the time how long does it take for that new equilibrium to be reached. Because obviously if the market readjusted instantly then there wouldn't be a trend. It would be just like instantly from today to tomorrow there would be there would be like a new price and that was it and there's nothing more to do. But in a lot of the markets that we're looking at we have a a much more delayed response. like if you're if you are short of cows unfortunately you can't order them on Amazon and get new cows to produce new butter you actually have to grow them over a year right or you know then so it's it's much more difficult it's much more difficult so that's that's that's why it's important for us as trend followers um but the problem of course is that we it's very difficult for uh economists to really calibrate what is the elasticity of both supply and demand and the reason for that is because every time there is a shock uh you get a shock in both the both to the supply and to the demand and the two are mixed up. So you're trying to solve for two variables but you only have one observation and and that kind of make makes the whole process very difficult and you get a what's called a biased estimation of what's going on. So uh what is these two uh economists but actually I think mathematicians. So Zabia Gab and uh Ralph Hoyen from uh the US and from Harvard and from Chicago. They came up with a really really innovative idea which is something called uh the um instrumental variable an instrumental variable uh an improvement on an instrumental variable uh methodology. So let let me let me take a step back. What is an instrumental verbal to start with? That's that's in um that was actually discovered in the 1929 or thereabout. Um what it what it what it is is realizing that if we have real life third variable that is only correlated to one of those uh either to supply shocks or to demand shocks then it's you can use it as a sort of a ruler to calibrate uh to calibrate your estimation and actually get uh an unbiased estimation of what the elasticity is of the market. Uh so for example in the case of the cows if you have a mad cow disease it doesn't affect demand but it definitely affects supply right so events which are only affect one side of the equation can be used as a ruler to align uh to align one side of the innovation uh one side of the shocks and that allows us to to solve the problem. And what these two um economists came up with the idea of actually looking at the share of demand as a way for us to generate those variables. So what the in their model is a very nice idea is to say suppose we're using we're consuming oil. Okay. And there is a demand shock and it's but it's a generic demand shock and all you know all countries are equally affected by that. Okay. So the US and Europe and so forth are all affected. So when I look at the equilibrium the percentage of demand in each country will remain constant. The price will change the quality will change but the percentage that is being consumed by each country should remain constant. But what happens if we observe this like an orthogonal u a change in that that share of demand if suddenly the US starts consuming more and the and Europe starts consuming less that is definitely idiosyncratic shock it is not related to the general shock it's related to idiosyncratic shocks in the US or in Europe okay and that means that it's uncorrelated to the like the factor the factor shock in demand and and that means I can actually use it to calibrate um my supply and that's a really really impressive idea. Um and that was their first paper and on the back of that comes this paper where they look at the share the transfer of equity between different uh investors in the market. So they're saying if I'm trying to calibrate and see what happens if there's a dollar flowing into the US equity market obviously the price will change but how do I how do I estimate the gradient the way I do it is I look not just at the overall uh overall value I look at what how this changes between various institutions okay like uh you know pension funds uh mutual funds ETFs and so forth um so it's amazing idea really nicely done um and then you do the calculations s and whoa, you get to sort of $5 per $1 flowing in and that's a really great that's a really great deal. >> I know they touch on this point in the paper and it is something that you hear in the media as well. Um and there's two different views in it. uh people sometimes point to there's a lot of cash in money market funds and they'll say oh this is bullish for the market because if this money came into the market it'll push up the market and I guess if you're to believe this paper if if this money comes in it'll push it up by a magnitude of five um if if that's the case but at the same time people say no that's that that that that's in in incorrect because the market always clears so for every buyer there's a seller. So if there's money coming in there's money coming out. Now they addressed this in the paper but I didn't understand their argument. So could can you explain why that's not not the case? So, so they've given so um I think the the the point is that not all um assets are the same of the same elasticity, right? So, uh if one were to look at the fixed income market now the the which is actually the money money market funds we have actually natural experiments. So if I look at uh a very different market to the equity. So if I look at a period like GFC, if I look periods of quantitative easing or COVID, >> we have a natural experiment where um the Fed comes into the market and injects money straight away, right? So if I look at GFC, the the balance balance sheet grows from 10 trillion to about 11 trillion. Okay. Um so there's a 1 trillion flowing into the market. Now, did we see bond prices going up by 50%. Of course, we didn't see that, right? So, we didn't see like a drop of 5% in 10 year yields. Just didn't happen. Okay. Um so, uh the elasticity of the um the fixed income market is much much lower. The estimation is are somewhere between 0.25.5 maybe 75. So, a much much lower elasticity on the demand side. by the way on the supply side as well. So what like fixed income and equity markets are very very different right they've they've grown the the US treasury market has grown from 10 trillion you know GFC all the way to 25 trillion about now okay >> at the same time the equity market have grown to 50 trillion so you know about twice the size and the ratios remain roughly constant but you know if I look at the supply side where the price of bonds haven't moved at all right a bond is still worth a bond like about a $100 give or take. Okay. But the supply, thank you US Treasury for supplying us with tons tons and tons more of debt. Okay. So that's a very different dynamics to the equity market. In the equity market we see about I don't know 500 billion of issuance every year thereabouts. Actually a much much lower level of issuance um of new supply coming to the market because it's driven by real economy, right? there's just so many businesses that can come online in any given year. So it's a much more constraint from a supply perspective. And the way that the market has grown is actually in valuation, right? Which is what we've seen the S&P. So the idea behind so if you have a mismatch in the elasticity between these two markets, then you can actually take $1 out of the money market fund and push it into the equity. And what do you lo and behold, what are you going to get? you're going to get uh maybe a little bit of drop of price in the money market fund but like a huge in equities. >> Okay. So there is a mismatch in between. >> Yeah. But my point is there whoever bought the equity bought it off somebody and they've sold so they've realized a dollar so there's a dollar coming out of the market at the same time. >> Yes. No. Absolutely. Absolutely. So um but there is there is actually essentially a well the valuation will will go up. Um yeah I mean it's not there is any more value like there's not necessarily more value in the company right but it's just a question of the the the the way the price will clear the price will clear at at that point so >> um >> yeah know I mean the market always clears which is the point um I mean I always reconcile it in my own mind in from the perspective of the kind of the intensity of the buying and selling pressure that you know because it used to be the case when I started off in markets you're sitting on the desk >> in FX [clears throat] and you'd ask somebody why is the dollar going up and they more buyers and sellers. That was always the answer. >> But actually, it's not right because it's there's the same number of buyers and sellers. For every buyer, there is a seller, but it's the intensity of the buying and selling pressure. Yeah. >> So, they're the buyers are bidding up and the sellers are >> holding back their offers. >> Yeah. >> Um so, I mean, I just still I'm still not clear out what their um explanation for for on that point is. And no, I do I I I do hear what you're saying and they they make the point in the paper that equity markets are I suppose inelastic because there's not I mean as you say typically if the price goes up in in a lot of markets you get more supply and you do get that to an extent in equities I guess you get more equity issuance the cost of capital has come down >> but not a huge amount of that I suppose is the point is not it >> yes exactly so there is not actually a lot of supply coming into the market or not enough supply um coming into to meet it and by the way the supply is act you know so it it's almost independent of uh the price level of the equity market so that's actually quite interesting it is it is really driven by by real life constraint >> and and the other point about equities I mean there's this idea in economics of I think it's gif goods you know instead of uh demand going down when price goes up the the demand goes up when when price goes up >> I mean equities are like that I mean there's a wealth effect you know so psychology Gh people become more bullish when they see the price going up. So so so there but but that's already in the literature. We all really know that. So there's nothing kind of I suppose what was different about this paper was this number of for every dollar coming in. You know it's it's boosting the market valuation five times. So that yeah >> so so I I've got to tell you I actually don't believe that's the correct number. and and let me tell you what uh my crit I mean the main criticism really is about what drives what. Okay. So uh what we what we see is we see for every the the analysis the regression is contemporaneous uh effect right so we see one we see $1 flowing into the market and we see the valuation goes up by five uh by five uh dollars but it doesn't tell you what made you know what drove what okay and um in that respect here comes trend following um can trend following explain at least some of this right the idea is as you say if equity If equity prices goes up, people will start pushing more more money into equities, right? This is this is exactly what trend following is about. And if you look at the if you look at the hedge fund industry, uh and if you look at CTAs in general, uh you can do the maths, 300 billion under management in CTAs, that kind of translates into a quarterly a quarterly flows into equity if equity prices go up of about 0.2% 2% of the value of the overall market and that's not far from the 6% that they these guys are doing the analysis on. Okay. And another proportion of that can be coming from you know mutual funds becoming essentially more in internally more trend following right they will start allocating a little bit more to to equity if it's going up. I mean in these days nobody is like oh I'm going to stay out of the equity uh equity market right um so uh I think there are a lot of closet trend followers in the uh in the QIS market in the in the mutual funds in the ETFs um people will people like retail will put more money if the price of equity goes up they understand it and they would invest so it it may be the case that not all of the $5 are to do with with the actual sort the the market having to take that flow. It's actually the other way around. It's that as a result of the price going up, we see flows into the into the market. So that's um if I if you do that the math, I think the $5 is actually a little bit excessive. Um but you know, we are seeing we are seeing um a little bit of a bubble in the equity market. So maybe maybe um maybe right now there is actually this amplification effect. >> Yeah. Do they give I I only scan the paper. Did they talk about the time frame over which the the $1 translates into the $5 increase? Is it it's not instantaneous? Obviously, it's over a period of time, but >> it's it's over a quarter. So, >> over one quarter. >> Over one quarter. So, the the data that they use is uh uh uh flows of funds. They look at morning star data about uh mutual fund flows and they use the 13F um filings. So, it's actually very slowm moving data. >> Um So, so you know from our perspective when I look at quarterly quarterly changes in active funds both you know long short equity uh macro funds and CTAs there's a lot of there's a lot of flows that that actually are of similar size and they will happen as a result of price change during that quarter. So I think there is a little bit of work needs to be done on the on the on the on the uh paper but it's an amazing it's a it's it's really amazing methodology uh and and they've been very helpful because I've I've I've written to them and they've written back and uh they've been very helpful um in this discussion. So re really big thank you to them. >> Yeah I mean obviously if if it is the case I mean it would have policy implications. I mean they talked about how this you know their reference in the paper you know central banks buying um equity indices directly like in Hong Kong and we've had it in Japan by NGFS but equally that's the whole point of QE as well or at least it's one of the rationals for QE that you get this uh portfol port portfolio transmission effect from safe bonds into riskier bonds and then ultimately into risky assets like equity. So um >> yeah I mean if if if if it was if it was a given that this number is correct you would think it would >> it might caution central bankers a bit so much QE. >> Yeah. So absolutely. So from a well I think there's a moral hazard here galore. Uh but from a a practical implementation if you're only getting 25 cents of US bonds as a result of putting a dollar in uh you might be it might be more effective to put a dollar into the equity market. Um but uh you you know to me that that that smells of uh you know some you know a huge moral hazard and really uh I mean it's almost illegal in some in some in some countries right being able to run your own stock >> uh to uh to inflate it artificially. So um there are implications certainly u but of course there also moral implications of doing it. >> Yeah. So yeah, I mean you you talk about uh some of the kind of implications say for trend following and you know how different markets will have different elasticity of demand and supply and um so in this case we're talking about low low elasticity of supply in the sense that as the price goes up you don't get new supply coming in not not very quickly anyway. Um I mean we talked about bonds. I mean if if if the price of bonds go up and yields go down, we have seen more debt being issued. So there is a bit of elasticity of supply there. But um I mean so what I was going to get to is um should this impact on how trend followers think about trading different markets given the different characteristics? >> Oh absolutely. Um I think there a couple of things. So the first thing is that there's a if if the market is is more elastic it will have lower volatility and we see that again in bonds versus equity the bond volatility is lower than than equity volatility but I think from a trend following perspective you really need to understand the dynamics from the purpose of uh what is the delay for the market to find the new new equilibrium right and here you have a huge difference between financial assets and physical assets right so if we look if we look at the equity markets we can look at the impact act of uh how quickly does the market reach the new equilibrium and reverses actually we see the the rebalancing effect of that uh we can see that in the ETF market so if I look at shares outstanding in ETF market you see a very strong negative autocorrelation on the weekly scale so the idea is once you uh the money flows in and then there's some rebalancing and and that and a little bit flows back out and that negative correlation is a very fast process in the equity markets so equity markets maybe have a high uh maybe have a high multiplier and low elasticity but they are very quick to adjust. What we see in commodity markets is a complete opposite. Right? So we have a we have a demand which is very inelastic and we have uh supply which takes a long time to to provide. Right? If you need to dig more copper, if there is more demand for copper and you need to dig it, it takes time. Right? there is cost curves for the manufactur and there is also uh it's it's a dynamic which which plays itself out out over a year or even more than that and we see that the point where the price becomes negatively autocorrelated is like a year out because you know uh the decision to switch from uh planting wheat versus rice is a decision that will play itself essentially for next year. Um so the that delay between supply and demand basically means that price will have to do the work over an entire year and that means that you are looking at a a sort of a prolonged trend and that's how you should harvest it. If you're looking at equities you've got a lot of like intraday equity trend strategies, right? Because that process is is a much quicker the way the market finds its new equilibrium is a much quicker process. Now um I'm not going to tell you how to run your your your trend following um but um in some sense there is a frequency which is actually not a good frequency where you are sort of stuck in the mean reversion area of that of that process um and that that will vary depending on the nature the physical nature of the market um certainly in commodities it's really really really important um in equities I've got to tell you it's it's a it's a really complicated process And it also depends on what is the company and what the underlying stock is doing. So it's not a uh unfortunately for trend followers our life is not easy. Making money out of the market is never easy. >> Yeah. But generally there had been a sense that maybe you should have the same model in every market. And then obviously some some trend followers do deviate from that. Um but it can be a controversial decision. But I I think there was also a research paper from the two Maritzas a while back looking at the cocoa market or kind of inspired by the cocoa market >> and and a question you know on this topic like are some markets slower to adjust because it takes longer to plant in some markets? Obviously you get quick faster substitution say between soybeans and corn etc stuff like that but but you know presumably less in in other markets or um I mean so then would that suggest you trade all of the commodity markets at different speeds depending on their characteristics. So, so we already do. So, okay. So, the mathematics of the signal may be the right. So, suppose you're doing EWMA uh C crossover that that should be fine. Stick with what you know. Okay. Um but the the we already trade uh markets at different speeds because the cost, right? So, normally when we look at the market, we normally look at the the the cost of trading and if the market is expensive to trade, we will tend to trade it slower. Okay? So, so um the speed at which you trade is uh is already a function of um it's already a function of of something in the market like the and in some sense the liquidity is also reflecting uh some nature of the underlying physical market. Um but I think it is important to recognize that um the the the there may be a tilt in speed that you you when you observe it's not necessarily driven purely by oh it is completely accidental that uh the twoe trend has historically underperformed the two-month trend. Okay. Sometimes there is a genuine reason why the two-month trend actually is better suited >> to the underlying dynamics of the physical of the physical commodity that you're trading in. >> The other thing that comes to mind in in relation to this research paper and the uh kind of the five-fold change in value is I mean did they talk about has that number changed over time or is that has it been growing? No wonder um and also from the perspective of if and when things go in reverse and money starts to exit the market will we have a more amplified downturn I suppose is the question. Yeah. >> So so absolutely I mean the implication again from a policym perspective is that if if things go start going south we are heading for a bit of a roller coaster ride right there's no question about that. um the the data is quarterly so it's not it's not like you can do a a lot of uh variation. I think the they they start uh something in the early 2000s and they stop in uh I think 2021 if I remember correctly. Um so that's kind of where the data covers. Uh there's not a lot of data points, right? So um so I'm afraid we'll have to we'll have to take it as a single number. uh but uh I think one of the one of the key areas where to me is an indication of inflationary process at play is when I look at that that correlation between equities and bonds. Right? So we we talked about moving that money and the effect when you have u an inflationary process like 5x on equities is actually that you can actually even sell a little bit of equity and push it back into the into the bond market and actually push price the price of bond markets as well. So I think when there is such a uh an important asset class which is undergoing a an inflationary process I would have expected to see uh a positive bond equity correlation. Uh and of course we haven't seen it until the last two years but we are seeing it now. So to me that's also a little bit of a warning sign that under the under the hood there may be some uh some process where we have a spillover of valuation from the the bond from equity market to the bond market. >> Of course. Yeah. So I guess if the equity market goes up fivefold in value and you have all of you you have a rebalancing effect for everybody who's running on equity mandates. They have to sell some of that equity and and it rebalances the bonds isn't it? >> Yeah. Exactly. So that that's that's the that's exactly the process. So in in fact any like any rebalancing process uh spreads the the value from let's say from one stock if you're putting money into one stock into the other stocks which are maybe traded value stocks or maybe in the same industry. So that that process that RV process pushes money that rebalancing process pushes money to the the nearby stocks but it also pushes pushes it onto other asset classes. Um so that's that's uh it's kind of worrying at the moment we are seeing the positive uh correlation. >> So I know you you've written a a blog about this paper. I mean what was what was your takeaway or I mean in summary what the most relevant thing when obviously it's a it's a stark number if it's true it's it really frames uh things quite bluntly. >> So so my takeaway number is that um is I suspect the number is actually lower. It may be a little bit above one, but I suspect a lot of it is to do with um actually uh prices driving flow to my mind. So, I'm not 100% convinced that $5 is the right number. Uh but um but I think the the willingness to depart from the efficient market hypothesis and thinking exactly about the buying pressure and the selling pressure in the sort of in the market, right? the way that all the books clear and there is a buying pressure and that will translate into what we think about as permanent slippage but they think about in terms of uh long-term valuation changes. I think that is much closer to reality than the efficient market hypothesis. Um [music] and uh and that's that's definitely to be commended. [music] you brought uh a few different papers and the second one we wanted to get into was one [music] which we've probably touched on maybe gone back a few years but it's very interesting paper from the uh team at man about the best strategies for inflationary times any reason this is back on your agenda at the moment >> so [laughter] well I mean I wish I knew what's what's happening to inflation uh if the US if the US uh uh shutdown ends and we might actually get some numbers. Uh but I always like to look at things that actually work very nicely out of sambble. So a lot of our research and maybe if we get into the third paper we can talk a little bit about out of sambble. Um but uh I I looked at this um inflation paper um because um again interest rates we we seem to have gone through a cycle. We've we we are we have we've reached the peak. We're coming down. And to me the the question about where is inflation going and have we conquered inflation or if the Fed is very happy with inflation being like where it is right now. Um that is that is that is of importance to me. Um and um and this paper is by a chap who I really like. So uh personal is is is also a personal friend. I mean but that's because I was working with him in man. Uh so that's Otto um Otto Van Hammet. So um a great mathematician and a great economist um and just a very good allround um knowledge of the market and very sensible paper it is um and what is I I think is very interesting about this market is that this paper was was published in May 2021 before we saw inflation spiking to around 8% in the US um and it predicted exactly what it's like it couldn't have got it couldn't have got it more Right. Right. Even if he tried to, it's very rare that coins get it right, but but he he just managed to do it. So, um he was talking about what strategies and um are good during times of uh rising inflation and high level of inflation. So, uh we're not getting we're not at the moment inflation is not particularly high. It's of course higher than 2%. Um but it's the question is what's going to happen if inflation starts uh picking up again? Um and he's he's looking at you know which asset classes are going to do do well equities or bonds uh real assets gold uh real estate uh but also which type of strategies actually perform particularly well and again I think this is related to our discussion about equity and bond equity correlation. So uh you know one of the observation that he makes in the paper is how does in how does each of us ass each each asset class corresponds to a contemporaneous increase in inflation and you know in terms of bonds it's always bad right higher inflation generally means uh lower valuation of bonds uh because the the the yield has to rise. Uh in equities it's a much more nuanced view. So if inflation starts picking up from a low level that's actually quite good for equities. So uh you kind of want a little bit of a little bit of inflation in the in the in the system to basically ramp up demand and ramp up uh ramp up the valuation of your of your underlying asset. Uh conversely if you start from a very high level of inflation from above median level of inflation then a rise inflation is bad for equities. So that's actually from us it's from from our perspective is actually important in this point in time. So if we see the end of the uh if we see interest rates essentially staying where they are at the moment and we start seeing a pick up in inflation actually equities are not too bad which is which is quite good. Uh but from a trend perspective, one of the nicest things, one of the nicest observation that he makes is what trend strategies are likely to do well and um and is looking at commodity trend which is not surprising right inflation and commodities are very much linked together uh being sort of the physical asset um and to me what was quite surprising is fixed income. So uh and of course I'm trading a fixed income trend so I was like oh that is nice to see. Um so um it it's a really wonderful paper. They've done a very thorough job going back all the way to 1925 or thereabout uh looking both at inflation in the US also a small section about inflation in other countries. Uh but they've covered like I mean the the the the length it's kind of rare to see people going back to proper back test going back all the way to 1925. It just doesn't happen. Okay. Um and that was a very thorough job that that the people at man have done. Uh so Otto is to be commended on that. Um and um you know that there's a lot of and then of course in the [clears throat] fact that he got it completely right in 2022 uh was to me really exciting and there he's done it he's done a wonderful job and exactly what we he predicted in 2021 actually came to came to pass in in 2022 and the beginning of 2023. >> Yeah. As you say the um the the results were um uh in 2022 or 2021 and two were very much in line with with history. I mean it was I remember reading this paper at at the time in it came out in May 2021 and uh you know particularly with respect to trend following if you look at what they're talking about you know I think how they had performed uh historically just looking at it here like um trend following in periods of higher inflation 25% uh annualized returns etc which seemed like uh you know very fanciful returns you know after trend following had a kind of a 5year tough period but but actually obviously trend following did did even better than that in 2022 I mean for some managers 2021 was better for some 2022 is better but but actually it played out exactly as as expected >> exactly and and it was very surprising I mean a lot of people write down uh write off uh trend because um you go down the stairs um when trend goes wrong so to speak when is actually it's because not because there isn't any trend is because the percentage of trends in the market is slightly lower. So if I think about the heat ratio of how many markets are trending well well enough for us as a manager to make money. Uh what you find is that we just need about 40% heat ratio to sort of break even and start making money. And the last couple of years have been tough because we've had a heat ratio of 30% maybe. Right? So it's not that there aren't any trends. There are still trends in some markets, cocoa, coffee, gold uh and so forth. But it's just the percentage is slightly lower. Uh and that has been very tough. But the way that we die is we die by thousand cuts. We we essentially bleed money because it is like an option buying strategy. Um and it's just a a like a day by day by day by day we bleed a little bit of money and when it goes well, it goes spectacularly well. Right? So in what you see in 2021 2022 you saw the percentage of winners going to 60%. Right? And at that point you are printing money like there's no tomorrow. Okay. [clears throat] Uh so you go down the stairs then you go up the elevator and that's the nature of trend. Um and you know sometimes it's very difficult to tough out that period where where things going down but you have to sort of trust your alpha um trust your process and um maybe improve it a little bit um for when the good times come. It's interesting because I mean the um I guess for us in the managed futures industry the kind of inflation protecting aspects of managed futures and trend following are well you know well understood. We we know about papers like this but you know when I when I speak to investors working with different groups very often that doesn't feature so strongly that characteristic. I mean obviously people might allocate to trend following for diversification for for convexity um you know for for crisis uh alpha etc. Um but then they may have a a real asset book um with the where the kind of the the focus is on inflation protection. I mean what's your experience around that? Do you do you find investors using manage futures for that purpose? >> So it's actually quite rare. It's exactly I think your point is exactly correct and it's actually very surprising because quite a lot of uh mandates are inflation plus 4%. Right? So if you speak to sovereign wealth funds or if you speak to pension funds a lot of the time part of their mandate is inflation is embedded right and what they fail to appreciate is that if we do see an inflation pick up it's it's actually not necessarily the tips that will give you the inflation protection and it's not necessarily real estate that will give you protection but it's actually the active strategies that can can move into that into that universe um and take advantage of like let's say a rising commodities. So uh a commodity a a CTA with a high commodity allocation will do extremely well in periods of sort of rising and and falling inflation right so it's inflation volatility uh which is important to us and that is related to essential general uncertainty in the market on where prices are going to settle >> yeah the other thing that I wanted to just touch on I mean obviously if you look at they have a table in there of all of different kind of assets and strategies and you have commodities general commodity commodity the energies trend all the trend etc. Now obviously the the one that historically has done best has been commodities energy absolutely >> and I think if you were to I mean from the research I've done myself it's you know commodities in general have done better than trend in in these periods >> but but then they will suffer more bigger losses in in the other periods. Exactly. Oh, so I mean trend following has that ability to do okay in the other periods and still provide the the protection in in in the inflationary periods. >> So so if you look at commodities as an asset class um it actually drift down right there is a cost for holding a commodity because you you've got to store it you've got to finance it. So generally uh like if you look at the like a total return of holding a commodity asset generally downward sloping okay because there is a built-in uh sort of storage yield and all of these all of these uh which kind of needs to be financed. So it's in the same by the way in terms of VIX right the VIX might be oscillating but actually holding the VIX you're actually losing a lot of FIA so holding just just being sort of long only a commodity may not be the solution for an inflation product right uh if if you're trying to and as you say you have a downside um and um I think people fail to appreciate how beautifully trend responds to to inflation and by the way inflation as a risk factor is a much more slowly changing risk factor versus equity. So in terms of protection, right, if you think about the equity protection that you get from a CTA, it's a little bit uncertain because a crisis in equity can manifest itself over two days. And if we have a trend following who is trading on a twomonth horizon, you're just not going to get that protection that protection like it's not the first response, it's the second response in the equity market. But when it comes to inflation, inflation is a much more slowly evolving process. And that really plays very well with the speed at which CTAs trend. So it's not just that we are exposed to the factor, it's also that this factor is actually evolving in a speed which is much more relevant to the speed that CTA's trend. So uh people kind of fail to appreciate that. >> Yeah, it's interesting. I mean they do talk a little bit about to to the point about um kind of real assets. I I think they have I mean they have real estate I see it in their residential not doing that well. I mean I guess that and we saw this in 2022 as well with things like REITs obviously if inflation is associated with um higher interest rates then uh long duration assets can can be hit. So even though those assets may preserve their value against inflation over long term in the midst of the inflationary uh episodes they may not be optimal. >> No absolutely and and that's actually the same with bonds with tips. So if you have a long-term if you have a if you have a longdated bonds the there is it's they've got two risk factors built in. You've got both the inflation exposure but also DV1 interest rate exposure. And the two factors are playing against each other because higher inflation corresponds to also higher yields which means like the DVO ones you will suffer. So and and uh inflation linked bonds have got a very like they are they are topheavy so to speak the most of the of the cash flows are at the back of the to towards the maturity of the bond. So so tips will suffer because of the interest rate exposure and and housing will suffer because higher mortgage rates basically really depress the market. So um so high inflation is not necessarily uh alleviated by uh real estate holding. >> Yeah. Yeah. Very good. Well definitely one of one of the better papers around. I think it it one of one or two awards as I recall. I can't remember which ones but it's definitely is a a very well regarded paper. So if anybody hasn't read it uh it's um it's from uh Otto and the team at ManHl the best strategies for inflationary time. So um there's one more paper we wanted to get into which is another very interesting one. It's called quantifying back test overfitting in alternative beta strategies. Um and again this one came out I think it was 2017 or so. So it's been around a while but fairly uh timeless quality to it. >> So I think one of the problems actually with the QIS um is that actually there's not a lot of beta out there. So so I'll tell you the story. I'll tell you where how I came to see this paper. >> So um so I like >> I I keep suddenly like in the last couple of months I see QIS hitting me in multiple um situations. So I had one one allocator uh came to me and says uh we are thinking about this particular QIS index. Would you mind having a look tell us how it relates to you? What do you think of that? It's a it's a trend following it's a liquid trend following uh product and you know we value your opinion. Um now we don't mind doing that because we are very much at the very illquid side of the sort of the assets that we trade. Uh we're not we defin you know our correlation to the liquid universe is around 25%. So we don't we really don't mind you know we're not really competing with the liquid um trend offering. Um so I said yeah of course I'll have I'll have my opinion you know it may be good it may be good complimentary to what we're what we're holding. So that was the that was my first uh QIS this like last two months. Uh another one was a consultant and he came to me and he said well you really need to articulate the added value. People are coming to me and saying what is the added value of CTAs over above there those QIS products. >> Yeah. Um, and that's a really great question. It's a really great question and I think people need to, by the way, the the third QIS incident of course is last week. So, um, if let me plug in last week's TTU where Moritz and uh, Nick Baltage from Goldman Sachs are talking about the QIS market as a whole and that's and that's a huge market, right? It's like somewhere between 300 billion and 600 billion depending of how you measure it. So like a really chunky a really chunky market and I think it is the it is it is our responsibility as hedge fund managers to really justify what we are doing what we're doing and what's the added value over these QIS products. Okay. >> Um and I was looking at um and and like on paper and I was trying to get some data on the QIS products and I think one of the my initial reaction is it it's actually very difficult like if I have uh the sock gen index there's actually you know the information is out there if you have a if you have traded funds if you have ETF um trend following you see that you see the performance you can you can make some judgment you can see what's going on with QIS products each bank will be slightly defensive about what they are running and they will be running a lot of a lot of indices. So it's very difficult for us to actually assess to make a like a a bird's eye assessment of that industry. It's very difficult for us. So um so the the only the only uh um the only paper that I was able to find is this one. And even this one I had to ask uh as a favor from somebody like it took me some time. Uh I I spoke to somebody from Barklay who helped me find this paper. Um, and I was actually a little bit surprised to be honest. And the reason I was surprised is actually panel B in exhibit three if you're reading this paper, which is really the the haircut. So, let me tell you the the paper. The paper is looking at 200 betaike products, right? Uh, >> so we're talking about carry and trend and >> carry and trend. >> I mean, they call it alternative beta, but we, you know, alternative risk premium would be >> absolutely >> more typical name. Yeah. >> More appropriate. So, so the but these are products which are offered by the QIS industry by the okay and they have they actually look historically at those um at those funds and they have um and they have the back test and they have the live performance. Okay. >> And they have it going back you know from 2000 going back uh to 2015 or thereabout. Um and and they they compare the sharp before launch and after launch. And what they look at is they look at the haircut. So if you advertise the sharp of one and the real life sharp was 1.5, then like obviously there's no haircut at all, you've actually outperformed. But if you have uh if your performance is only a sharp of.5, then you had a 50% haircut um on your pre-launch shop. And then they look at a collection of you know 200 funds uh QAS products classified by the type of strategy that it's running um and they looked at the haircut and the average haircut is around 60%. So um you you think your shop is one but actually the shop you're getting is point4. Now I' I've got to tell you in within a hedge fund like when I was at when I was at other shots and a new strategy came along internally when it comes to allocation we were equally suspicious of new strategies. So like the back test would have been one we would have applied a haircut of 50% before like be before we allocate to that strategy. Uh right. So so um suspicion is a good thing but it's it's kind of interesting to see that realized. The thing that surprised me is the haircut on strategies that I thought were kind of wellnown. So if you right so you know we're sitting in 2017 and you might think um hang on a second surely everybody knows you know everybody knows how to do trend following. And I think that really speaks to this the original question that was like where is the value of research? What is the added value of um hedge fund CTAs over those QIS products? >> Yeah. And I think once once I've sort of ruminated on it and I actually looked at the specific ind the specific index the QIS product that I was asked to look at um it sort of cames to me because what's happening with trend it's precisely because it is actually well understood that the value of the overall performance is comes from the envelope around how you put that model together. So we we all know that like the the trend following you know it's not really in the signal the signal is actually going to be fairly well known and actually it doesn't really matter which particular signal you're looking at. Um that is going to give you let's say sharper point two per market. So now the question comes about how do you put together a portfolio of those. So portfolio construction is important. How do you manage the risk of that portfolio to make sure that you do get the diversity that is very important? So for example in the QIS index that I looked at you know by very wellrespected name and actually not a bad product at all really good paper really good maths but if you look at the returns very spiky okay and that's to me is a sign that the risk management isn't necessarily like cutting edge it's it we may be okay right execution right this is really important especially in the in the those alternative markets so but can you add value through execution. And you know, you have to realize that the the incentive, for example, on execution is very different for a hedge fund than it is for the um the QIS product because the QIS product makes money out of flow, right? So, right, so >> they are able to net I mean there's a lot of good stuff that they do, but you know, the way they make the money is they net the flows internally between the various the all the multiple flows internally. Um but it's it's it's this this is important to them. Um so I think it's because the alpha is not necessarily in oh I've got a better signal than you you know I've got a machine learning trend following signal. It really is about how you put together a portfolio. This is actually what makes a fund a better a better product in trend following. And I think that is partly something to do with why even for strategies which I thought were very well understood like curry or trend following um you see this haircut in performance in the QAS products there's a place for and for everything and QA is a great industry there's a lot of things that they offer that we do not offer okay so anything from very quick customization um to technology uh to you know very it's come a long way um in terms of how well they are being put together >> but we should remember that the the the incentives of the researchers and the the experience of the researchers in putting together uh a fullyfledged sort of product which stands on its own is slightly different from the QIS product than to the hedge industry. Fair enough. I mean, obviously the attraction for many people is the cost. So, uh, fees are generally lower. Um, >> absolutely. I think that if you're trying to put together an exposure to a risk factor and you you don't really have and and by the way, it's not necessarily uh static allocators, but like hedge funds, right? >> Well, they said a lot of the platforms are using these now. >> No, AB. Absolutely. if um if you if you if you think you can manage it actively and uh you want exposure and it's very difficult like you know for volatility it's very difficult to um you know you have to put in the work to to actually make it happen so um so I completely understand um the attraction and from a capital efficiency you get a very capital efficient solution because of course JP like you know JP Morgan or Morgan Stanley or any of those any of these product um right they they they they able to net all those QIS products that they're offering and the margin they can offer very effective margining. So, it's a really it's it there's there's a lot of good quality uh and good reasons why you might want a generic um you might consider it as a good like stocking filler. We're talk you're coming up to Christmas like no. >> Yeah. Yes. >> No. Absolutely. Right. And it's a good and it's a good thing, right? Um but you should realize that the the first of all the incentives on execution are different. Uh the alignment of the fund manager with you are different. Um and you know for better or for worse and and you know um but you know if you want a very low value a lowc cost solution um that that will be you know that that may be the way for you and it's very quick and it's customizable. You can say I don't want ads I don't want this. They they will do it for you straight away. It's really really good. >> Yeah, >> very good. Well, um it's an interesting one and uh definitely worth checking out as well. It's um a paper that that uh has been around a while if you can get your hands quantify and back test overfitting in alternative uh beta strategies. So, we're we're for going uh just a bit over the hour, but um you know, great to have you on again. Pleasure. >> Yeah, always always interesting to to see what research you're you're you're you're reading and and working on. >> It's it's really appreciated. Really real pleasure. And um yeah, and speak to you soon. >> Yeah. So, well, Neils will be back next week. So, if you have questions for Neil's uh please send them in. But from all of us here at Top Traders Unplugged, thanks and we'll be [music] back again soon. >> Thanks for listening to Top Traders Unplugged. If you [music] feel you learned something of value from today's episode, the best way to stay updated is to go on over to iTunes and subscribe [music] to the show so that you'll be sure to get all the new episodes as they're released. 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Why Trend Thrives When Inflation Returns | Systematic Investor | Ep.373
Summary
Transcript
Imagine joining their experiences successes and not the most yet often. Welcome [music] to top traders unplugged the place where you can learn from the best hedge fund managers in the world. So you can [music] take your manager due diligence or investment career to the next level. Before we begin today's conversation, remember to keep two things in mind. All the discussion we will have [music] about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand [music] that there's a significant risk of financial loss with all investment strategies and you need to request [music] and understand the specific risks from the investment manager about their product before you make investment decisions. Here's your host, veteran [music] hedge fund manager Neil's Krup Larson. Welcome back to the latest edition of Top Traders Unplugged, where each week we take the pulse of the market from the perspective of a rules-based investor. It's Alan Dunn here sitting in for Neils again. Neils is away this week and I'm delighted to be joined by Yove. Yo, how you doing? >> Pleasure to be here. Doing fine in London. >> Good stuff. Um, great. Well, it's very very mild here in Dublin for for November. I presume it's the same over your side. >> Yeah, actually a very mild November. Um, no. Um, no snow, no cold. Uh, very good for cycling. >> Good for cycling. Good stuff. Well, we uh like to kick off with what's on your radar. Um, last time it was comedy. I I don't know if you'll give us an update on on on the comedy or tell us a few jokes, but but what's been on your radar? >> Oh, the comedy went quite well actually. Uh, I'm surprised you don't have a a bootleg copy. Um, but actually, I want to talk about something a lot more serious this time. Um what has been on my radar is what's um is mathematics in high schools and primary schools in the UK. um if you have a child who is halfdeent in mathematics um you start worrying about it and the reason why it came on the radar is because there's a new there's a new school uh 1729 open opening up in Milh Hill uh and that's like a private uh very expensive uh school which is specializing in mathematics and the nice thing about it is there are burseries but provided very kindly by uh XDX and Alex um for uh very you know for the good mathematicians with the aim of really providing um every every student a chance to really shine um and uh the application by the way is the deadline for application is the 9th of November so in 3 days time so hopefully uh if you hear it before before the deadline go and apply. uh but it started it started me thinking about um about like the two ends of how you can make mathematics accessible uh especially between key stage two and key stage three. that's between uh primary school to GCC's and um there's actually an excellent report uh when you look at it the by the Nottingham University about the pipeline of mathematics and they have a few really nice observation about the way that you know you start with 25,000 schools in in England and the UK and then how at each stage you know fewer and fewer people uh remain in what they call the excellence stream and they're making a few suggestions to how to increase that number. Um you know in increasing participations of of of ladies increasing participations of disadvantaged uh students from disadvantaged background. Um and then what was very interesting is that guess what the person who supported that Nottingham research with a great paper uh is none other than XTX. So actually you can see that um a lot of thought has gone into trying to um trying to improve the pipeline to get more mathematicians um through school and then into university. So and I think that's a very worthwhile a very worthwhile cause and Alex to be commended on that. >> Interesting. Yeah. Very good indeed. Um well um we normally uh like to start off um talking about performance and uh good to get it out of the way I think uh because we have a lot to get through in terms of meaty um articles and uh academic studies. We've got um three if we have time for all of them but I sense we might get uh embedded or beded down in one of them at least. Uh but in terms of where we are obviously early days in in the month of November um but um slightly negative performance on the managed feature side. Stock gen CTA down 40 basis points monthto date and year to date still down uh 1.9% uh this year and stockgen trend down 56 basis points on the month and down 1.44% so far um this year. Uh obviously we're very early in the month. We've had a little bit of a correction in some major trends obviously in equities uh gold as well as edged a little bit lower but from your perspective we've had a bit of a recovery in trend following in manage futures last few months and this month starting off a little bit negatively but any any thoughts on performance? >> Uh again I I kind of refuse to to to get drawn on that because uh I'm always a pessimist so I I I'll count my chickens at the end of the at the end of the year but uh certainly fixed income has been very difficult. Um we've seen up and down and uh and round we go and of course the UK has kept interest rates at 4% as well. Um so uh it's it's it's exciting time to be trading fixed income trend. >> Yeah very good. Well, um the first topic I wanted to get into is a an academic study, a research paper. Um it's called In Search of the Origins of Financial Fluctuations. Um the inelastic markets hypothesis um from a couple of academics. Um I mean I the the the uh I won't I won't steal the uh major takeaways but the the the takeaways here are quite dramatic and interesting in terms of the impact of uh um new buyers or new money coming into the equity market. So maybe I'll hand it over to you to give the the high level summary and and and maybe we can get into some of the implications of the research. Uh then >> yeah absolutely. So actually um Neils and Andrew Beer talked a little bit about it because there was a paper there was a article published in the Financial Times about about this very paper and the way the Jean JP Bushau um is talking about it and supporting that that paper. Um and the the idea behind it is about supply and demand and trying to understand how elastic or inelastic uh the the equity market in the US to money flowing into it, right? Um but we kind of need to step a little bit back and just a little bit understanding about what supply and demand is um and how to calibrate it and then we can think about this paper in terms of the outcome of that methodology. Um but the methodology but the outcome is completely astounding. So the the punchline is that whenever there's a $1 flowing into equity market that translates into a $5 increase in the overall valuation in the market. And the reason why this is kind of very surprising is because that makes that breaks the efficient market hypothesis in you know uh it just puts it straight into into the dust bin. Um and it's a it's a big thing. It's uh it it basically says that what we're doing at the moment, what we're seeing is is a bubble. Um and we're seeing flows basically driving the valuation and a 5x amplification whenever there's a new dollar flowing into the equities. So it's a very very surprising result and uh but you know maybe maybe it is correct. Okay. So um so that was the paper but before we before we we need to think about the methodology and we need to think also why this is important to trend following right or I mean I I kind of think about it and I'm trying to understand why this is important so what are supply and demand the idea is that you know if people want butter and people produce butter um there will be a point where they there is a demand curve so the more the higher the price the less people would want butter because they would want to eat something else uh And conversely, the higher the price, uh, the more supply there is, right? So, one curve, uh, the way that we look at the supply, it varies with price in one direction and in and it supply and the demand is varying in another direction with the price. So, the two curves will meet at a point and that will determine an equilibrium in the economy where we have both the price and the quantity of butter which is consumed are at an equilibrium. Okay. And then what is a trend? A trend is when when there is a shock to that system and suddenly people want more butter. They've watched bake off they really want to start um you know start cooking baking bread baking bread or baking uh more cakes. So there is a there is a demand shock or potentially there's a supply shock. You might have a situation where you know met cow disease and suddenly we have le less cows to produce butter. So when you have a supply shock or a demand shock the market needs to find a new equilibrium and the way that it does it it does it through the adjustment in price. So you know uh suddenly if there is less supply the prices will will rise until the market adjust demand adjusts to meet the supply. Um and the question of like how much the price needs to move uh is important for us as trend followers and it's called the elasticity of the market. So if a mark if a like in commodities for example demand is quite inelastic like the amount of electricity that we use is not really that very is not that dependent on like the price. So you we need a big change in price to get a small change in demand. Okay. So that gradient, how elastic, how responsive is the supply and demand to change in price is called the elasticity. And it really affects the the nature of trend, right? Because what you see is um is that the more the more inelastic the market, the more response we need to get in price to really drive to change the supply and demand. And the other aspect of supply and demand which is important to trend follower is the the time how long does it take for that new equilibrium to be reached. Because obviously if the market readjusted instantly then there wouldn't be a trend. It would be just like instantly from today to tomorrow there would be there would be like a new price and that was it and there's nothing more to do. But in a lot of the markets that we're looking at we have a a much more delayed response. like if you're if you are short of cows unfortunately you can't order them on Amazon and get new cows to produce new butter you actually have to grow them over a year right or you know then so it's it's much more difficult it's much more difficult so that's that's that's why it's important for us as trend followers um but the problem of course is that we it's very difficult for uh economists to really calibrate what is the elasticity of both supply and demand and the reason for that is because every time there is a shock uh you get a shock in both the both to the supply and to the demand and the two are mixed up. So you're trying to solve for two variables but you only have one observation and and that kind of make makes the whole process very difficult and you get a what's called a biased estimation of what's going on. So uh what is these two uh economists but actually I think mathematicians. So Zabia Gab and uh Ralph Hoyen from uh the US and from Harvard and from Chicago. They came up with a really really innovative idea which is something called uh the um instrumental variable an instrumental variable uh an improvement on an instrumental variable uh methodology. So let let me let me take a step back. What is an instrumental verbal to start with? That's that's in um that was actually discovered in the 1929 or thereabout. Um what it what it what it is is realizing that if we have real life third variable that is only correlated to one of those uh either to supply shocks or to demand shocks then it's you can use it as a sort of a ruler to calibrate uh to calibrate your estimation and actually get uh an unbiased estimation of what the elasticity is of the market. Uh so for example in the case of the cows if you have a mad cow disease it doesn't affect demand but it definitely affects supply right so events which are only affect one side of the equation can be used as a ruler to align uh to align one side of the innovation uh one side of the shocks and that allows us to to solve the problem. And what these two um economists came up with the idea of actually looking at the share of demand as a way for us to generate those variables. So what the in their model is a very nice idea is to say suppose we're using we're consuming oil. Okay. And there is a demand shock and it's but it's a generic demand shock and all you know all countries are equally affected by that. Okay. So the US and Europe and so forth are all affected. So when I look at the equilibrium the percentage of demand in each country will remain constant. The price will change the quality will change but the percentage that is being consumed by each country should remain constant. But what happens if we observe this like an orthogonal u a change in that that share of demand if suddenly the US starts consuming more and the and Europe starts consuming less that is definitely idiosyncratic shock it is not related to the general shock it's related to idiosyncratic shocks in the US or in Europe okay and that means that it's uncorrelated to the like the factor the factor shock in demand and and that means I can actually use it to calibrate um my supply and that's a really really impressive idea. Um and that was their first paper and on the back of that comes this paper where they look at the share the transfer of equity between different uh investors in the market. So they're saying if I'm trying to calibrate and see what happens if there's a dollar flowing into the US equity market obviously the price will change but how do I how do I estimate the gradient the way I do it is I look not just at the overall uh overall value I look at what how this changes between various institutions okay like uh you know pension funds uh mutual funds ETFs and so forth um so it's amazing idea really nicely done um and then you do the calculations s and whoa, you get to sort of $5 per $1 flowing in and that's a really great that's a really great deal. >> I know they touch on this point in the paper and it is something that you hear in the media as well. Um and there's two different views in it. uh people sometimes point to there's a lot of cash in money market funds and they'll say oh this is bullish for the market because if this money came into the market it'll push up the market and I guess if you're to believe this paper if if this money comes in it'll push it up by a magnitude of five um if if that's the case but at the same time people say no that's that that that that's in in incorrect because the market always clears so for every buyer there's a seller. So if there's money coming in there's money coming out. Now they addressed this in the paper but I didn't understand their argument. So could can you explain why that's not not the case? So, so they've given so um I think the the the point is that not all um assets are the same of the same elasticity, right? So, uh if one were to look at the fixed income market now the the which is actually the money money market funds we have actually natural experiments. So if I look at uh a very different market to the equity. So if I look at a period like GFC, if I look periods of quantitative easing or COVID, >> we have a natural experiment where um the Fed comes into the market and injects money straight away, right? So if I look at GFC, the the balance balance sheet grows from 10 trillion to about 11 trillion. Okay. Um so there's a 1 trillion flowing into the market. Now, did we see bond prices going up by 50%. Of course, we didn't see that, right? So, we didn't see like a drop of 5% in 10 year yields. Just didn't happen. Okay. Um so, uh the elasticity of the um the fixed income market is much much lower. The estimation is are somewhere between 0.25.5 maybe 75. So, a much much lower elasticity on the demand side. by the way on the supply side as well. So what like fixed income and equity markets are very very different right they've they've grown the the US treasury market has grown from 10 trillion you know GFC all the way to 25 trillion about now okay >> at the same time the equity market have grown to 50 trillion so you know about twice the size and the ratios remain roughly constant but you know if I look at the supply side where the price of bonds haven't moved at all right a bond is still worth a bond like about a $100 give or take. Okay. But the supply, thank you US Treasury for supplying us with tons tons and tons more of debt. Okay. So that's a very different dynamics to the equity market. In the equity market we see about I don't know 500 billion of issuance every year thereabouts. Actually a much much lower level of issuance um of new supply coming to the market because it's driven by real economy, right? there's just so many businesses that can come online in any given year. So it's a much more constraint from a supply perspective. And the way that the market has grown is actually in valuation, right? Which is what we've seen the S&P. So the idea behind so if you have a mismatch in the elasticity between these two markets, then you can actually take $1 out of the money market fund and push it into the equity. And what do you lo and behold, what are you going to get? you're going to get uh maybe a little bit of drop of price in the money market fund but like a huge in equities. >> Okay. So there is a mismatch in between. >> Yeah. But my point is there whoever bought the equity bought it off somebody and they've sold so they've realized a dollar so there's a dollar coming out of the market at the same time. >> Yes. No. Absolutely. Absolutely. So um but there is there is actually essentially a well the valuation will will go up. Um yeah I mean it's not there is any more value like there's not necessarily more value in the company right but it's just a question of the the the the way the price will clear the price will clear at at that point so >> um >> yeah know I mean the market always clears which is the point um I mean I always reconcile it in my own mind in from the perspective of the kind of the intensity of the buying and selling pressure that you know because it used to be the case when I started off in markets you're sitting on the desk >> in FX [clears throat] and you'd ask somebody why is the dollar going up and they more buyers and sellers. That was always the answer. >> But actually, it's not right because it's there's the same number of buyers and sellers. For every buyer, there is a seller, but it's the intensity of the buying and selling pressure. Yeah. >> So, they're the buyers are bidding up and the sellers are >> holding back their offers. >> Yeah. >> Um so, I mean, I just still I'm still not clear out what their um explanation for for on that point is. And no, I do I I I do hear what you're saying and they they make the point in the paper that equity markets are I suppose inelastic because there's not I mean as you say typically if the price goes up in in a lot of markets you get more supply and you do get that to an extent in equities I guess you get more equity issuance the cost of capital has come down >> but not a huge amount of that I suppose is the point is not it >> yes exactly so there is not actually a lot of supply coming into the market or not enough supply um coming into to meet it and by the way the supply is act you know so it it's almost independent of uh the price level of the equity market so that's actually quite interesting it is it is really driven by by real life constraint >> and and the other point about equities I mean there's this idea in economics of I think it's gif goods you know instead of uh demand going down when price goes up the the demand goes up when when price goes up >> I mean equities are like that I mean there's a wealth effect you know so psychology Gh people become more bullish when they see the price going up. So so so there but but that's already in the literature. We all really know that. So there's nothing kind of I suppose what was different about this paper was this number of for every dollar coming in. You know it's it's boosting the market valuation five times. So that yeah >> so so I I've got to tell you I actually don't believe that's the correct number. and and let me tell you what uh my crit I mean the main criticism really is about what drives what. Okay. So uh what we what we see is we see for every the the analysis the regression is contemporaneous uh effect right so we see one we see $1 flowing into the market and we see the valuation goes up by five uh by five uh dollars but it doesn't tell you what made you know what drove what okay and um in that respect here comes trend following um can trend following explain at least some of this right the idea is as you say if equity If equity prices goes up, people will start pushing more more money into equities, right? This is this is exactly what trend following is about. And if you look at the if you look at the hedge fund industry, uh and if you look at CTAs in general, uh you can do the maths, 300 billion under management in CTAs, that kind of translates into a quarterly a quarterly flows into equity if equity prices go up of about 0.2% 2% of the value of the overall market and that's not far from the 6% that they these guys are doing the analysis on. Okay. And another proportion of that can be coming from you know mutual funds becoming essentially more in internally more trend following right they will start allocating a little bit more to to equity if it's going up. I mean in these days nobody is like oh I'm going to stay out of the equity uh equity market right um so uh I think there are a lot of closet trend followers in the uh in the QIS market in the in the mutual funds in the ETFs um people will people like retail will put more money if the price of equity goes up they understand it and they would invest so it it may be the case that not all of the $5 are to do with with the actual sort the the market having to take that flow. It's actually the other way around. It's that as a result of the price going up, we see flows into the into the market. So that's um if I if you do that the math, I think the $5 is actually a little bit excessive. Um but you know, we are seeing we are seeing um a little bit of a bubble in the equity market. So maybe maybe um maybe right now there is actually this amplification effect. >> Yeah. Do they give I I only scan the paper. Did they talk about the time frame over which the the $1 translates into the $5 increase? Is it it's not instantaneous? Obviously, it's over a period of time, but >> it's it's over a quarter. So, >> over one quarter. >> Over one quarter. So, the the data that they use is uh uh uh flows of funds. They look at morning star data about uh mutual fund flows and they use the 13F um filings. So, it's actually very slowm moving data. >> Um So, so you know from our perspective when I look at quarterly quarterly changes in active funds both you know long short equity uh macro funds and CTAs there's a lot of there's a lot of flows that that actually are of similar size and they will happen as a result of price change during that quarter. So I think there is a little bit of work needs to be done on the on the on the on the uh paper but it's an amazing it's a it's it's really amazing methodology uh and and they've been very helpful because I've I've I've written to them and they've written back and uh they've been very helpful um in this discussion. So re really big thank you to them. >> Yeah I mean obviously if if it is the case I mean it would have policy implications. I mean they talked about how this you know their reference in the paper you know central banks buying um equity indices directly like in Hong Kong and we've had it in Japan by NGFS but equally that's the whole point of QE as well or at least it's one of the rationals for QE that you get this uh portfol port portfolio transmission effect from safe bonds into riskier bonds and then ultimately into risky assets like equity. So um >> yeah I mean if if if if it was if it was a given that this number is correct you would think it would >> it might caution central bankers a bit so much QE. >> Yeah. So absolutely. So from a well I think there's a moral hazard here galore. Uh but from a a practical implementation if you're only getting 25 cents of US bonds as a result of putting a dollar in uh you might be it might be more effective to put a dollar into the equity market. Um but uh you you know to me that that that smells of uh you know some you know a huge moral hazard and really uh I mean it's almost illegal in some in some in some countries right being able to run your own stock >> uh to uh to inflate it artificially. So um there are implications certainly u but of course there also moral implications of doing it. >> Yeah. So yeah, I mean you you talk about uh some of the kind of implications say for trend following and you know how different markets will have different elasticity of demand and supply and um so in this case we're talking about low low elasticity of supply in the sense that as the price goes up you don't get new supply coming in not not very quickly anyway. Um I mean we talked about bonds. I mean if if if the price of bonds go up and yields go down, we have seen more debt being issued. So there is a bit of elasticity of supply there. But um I mean so what I was going to get to is um should this impact on how trend followers think about trading different markets given the different characteristics? >> Oh absolutely. Um I think there a couple of things. So the first thing is that there's a if if the market is is more elastic it will have lower volatility and we see that again in bonds versus equity the bond volatility is lower than than equity volatility but I think from a trend following perspective you really need to understand the dynamics from the purpose of uh what is the delay for the market to find the new new equilibrium right and here you have a huge difference between financial assets and physical assets right so if we look if we look at the equity markets we can look at the impact act of uh how quickly does the market reach the new equilibrium and reverses actually we see the the rebalancing effect of that uh we can see that in the ETF market so if I look at shares outstanding in ETF market you see a very strong negative autocorrelation on the weekly scale so the idea is once you uh the money flows in and then there's some rebalancing and and that and a little bit flows back out and that negative correlation is a very fast process in the equity markets so equity markets maybe have a high uh maybe have a high multiplier and low elasticity but they are very quick to adjust. What we see in commodity markets is a complete opposite. Right? So we have a we have a demand which is very inelastic and we have uh supply which takes a long time to to provide. Right? If you need to dig more copper, if there is more demand for copper and you need to dig it, it takes time. Right? there is cost curves for the manufactur and there is also uh it's it's a dynamic which which plays itself out out over a year or even more than that and we see that the point where the price becomes negatively autocorrelated is like a year out because you know uh the decision to switch from uh planting wheat versus rice is a decision that will play itself essentially for next year. Um so the that delay between supply and demand basically means that price will have to do the work over an entire year and that means that you are looking at a a sort of a prolonged trend and that's how you should harvest it. If you're looking at equities you've got a lot of like intraday equity trend strategies, right? Because that process is is a much quicker the way the market finds its new equilibrium is a much quicker process. Now um I'm not going to tell you how to run your your your trend following um but um in some sense there is a frequency which is actually not a good frequency where you are sort of stuck in the mean reversion area of that of that process um and that that will vary depending on the nature the physical nature of the market um certainly in commodities it's really really really important um in equities I've got to tell you it's it's a it's a really complicated process And it also depends on what is the company and what the underlying stock is doing. So it's not a uh unfortunately for trend followers our life is not easy. Making money out of the market is never easy. >> Yeah. But generally there had been a sense that maybe you should have the same model in every market. And then obviously some some trend followers do deviate from that. Um but it can be a controversial decision. But I I think there was also a research paper from the two Maritzas a while back looking at the cocoa market or kind of inspired by the cocoa market >> and and a question you know on this topic like are some markets slower to adjust because it takes longer to plant in some markets? Obviously you get quick faster substitution say between soybeans and corn etc stuff like that but but you know presumably less in in other markets or um I mean so then would that suggest you trade all of the commodity markets at different speeds depending on their characteristics. So, so we already do. So, okay. So, the mathematics of the signal may be the right. So, suppose you're doing EWMA uh C crossover that that should be fine. Stick with what you know. Okay. Um but the the we already trade uh markets at different speeds because the cost, right? So, normally when we look at the market, we normally look at the the the cost of trading and if the market is expensive to trade, we will tend to trade it slower. Okay? So, so um the speed at which you trade is uh is already a function of um it's already a function of of something in the market like the and in some sense the liquidity is also reflecting uh some nature of the underlying physical market. Um but I think it is important to recognize that um the the the there may be a tilt in speed that you you when you observe it's not necessarily driven purely by oh it is completely accidental that uh the twoe trend has historically underperformed the two-month trend. Okay. Sometimes there is a genuine reason why the two-month trend actually is better suited >> to the underlying dynamics of the physical of the physical commodity that you're trading in. >> The other thing that comes to mind in in relation to this research paper and the uh kind of the five-fold change in value is I mean did they talk about has that number changed over time or is that has it been growing? No wonder um and also from the perspective of if and when things go in reverse and money starts to exit the market will we have a more amplified downturn I suppose is the question. Yeah. >> So so absolutely I mean the implication again from a policym perspective is that if if things go start going south we are heading for a bit of a roller coaster ride right there's no question about that. um the the data is quarterly so it's not it's not like you can do a a lot of uh variation. I think the they they start uh something in the early 2000s and they stop in uh I think 2021 if I remember correctly. Um so that's kind of where the data covers. Uh there's not a lot of data points, right? So um so I'm afraid we'll have to we'll have to take it as a single number. uh but uh I think one of the one of the key areas where to me is an indication of inflationary process at play is when I look at that that correlation between equities and bonds. Right? So we we talked about moving that money and the effect when you have u an inflationary process like 5x on equities is actually that you can actually even sell a little bit of equity and push it back into the into the bond market and actually push price the price of bond markets as well. So I think when there is such a uh an important asset class which is undergoing a an inflationary process I would have expected to see uh a positive bond equity correlation. Uh and of course we haven't seen it until the last two years but we are seeing it now. So to me that's also a little bit of a warning sign that under the under the hood there may be some uh some process where we have a spillover of valuation from the the bond from equity market to the bond market. >> Of course. Yeah. So I guess if the equity market goes up fivefold in value and you have all of you you have a rebalancing effect for everybody who's running on equity mandates. They have to sell some of that equity and and it rebalances the bonds isn't it? >> Yeah. Exactly. So that that's that's the that's exactly the process. So in in fact any like any rebalancing process uh spreads the the value from let's say from one stock if you're putting money into one stock into the other stocks which are maybe traded value stocks or maybe in the same industry. So that that process that RV process pushes money that rebalancing process pushes money to the the nearby stocks but it also pushes pushes it onto other asset classes. Um so that's that's uh it's kind of worrying at the moment we are seeing the positive uh correlation. >> So I know you you've written a a blog about this paper. I mean what was what was your takeaway or I mean in summary what the most relevant thing when obviously it's a it's a stark number if it's true it's it really frames uh things quite bluntly. >> So so my takeaway number is that um is I suspect the number is actually lower. It may be a little bit above one, but I suspect a lot of it is to do with um actually uh prices driving flow to my mind. So, I'm not 100% convinced that $5 is the right number. Uh but um but I think the the willingness to depart from the efficient market hypothesis and thinking exactly about the buying pressure and the selling pressure in the sort of in the market, right? the way that all the books clear and there is a buying pressure and that will translate into what we think about as permanent slippage but they think about in terms of uh long-term valuation changes. I think that is much closer to reality than the efficient market hypothesis. Um [music] and uh and that's that's definitely to be commended. [music] you brought uh a few different papers and the second one we wanted to get into was one [music] which we've probably touched on maybe gone back a few years but it's very interesting paper from the uh team at man about the best strategies for inflationary times any reason this is back on your agenda at the moment >> so [laughter] well I mean I wish I knew what's what's happening to inflation uh if the US if the US uh uh shutdown ends and we might actually get some numbers. Uh but I always like to look at things that actually work very nicely out of sambble. So a lot of our research and maybe if we get into the third paper we can talk a little bit about out of sambble. Um but uh I I looked at this um inflation paper um because um again interest rates we we seem to have gone through a cycle. We've we we are we have we've reached the peak. We're coming down. And to me the the question about where is inflation going and have we conquered inflation or if the Fed is very happy with inflation being like where it is right now. Um that is that is that is of importance to me. Um and um and this paper is by a chap who I really like. So uh personal is is is also a personal friend. I mean but that's because I was working with him in man. Uh so that's Otto um Otto Van Hammet. So um a great mathematician and a great economist um and just a very good allround um knowledge of the market and very sensible paper it is um and what is I I think is very interesting about this market is that this paper was was published in May 2021 before we saw inflation spiking to around 8% in the US um and it predicted exactly what it's like it couldn't have got it couldn't have got it more Right. Right. Even if he tried to, it's very rare that coins get it right, but but he he just managed to do it. So, um he was talking about what strategies and um are good during times of uh rising inflation and high level of inflation. So, uh we're not getting we're not at the moment inflation is not particularly high. It's of course higher than 2%. Um but it's the question is what's going to happen if inflation starts uh picking up again? Um and he's he's looking at you know which asset classes are going to do do well equities or bonds uh real assets gold uh real estate uh but also which type of strategies actually perform particularly well and again I think this is related to our discussion about equity and bond equity correlation. So uh you know one of the observation that he makes in the paper is how does in how does each of us ass each each asset class corresponds to a contemporaneous increase in inflation and you know in terms of bonds it's always bad right higher inflation generally means uh lower valuation of bonds uh because the the the yield has to rise. Uh in equities it's a much more nuanced view. So if inflation starts picking up from a low level that's actually quite good for equities. So uh you kind of want a little bit of a little bit of inflation in the in the in the system to basically ramp up demand and ramp up uh ramp up the valuation of your of your underlying asset. Uh conversely if you start from a very high level of inflation from above median level of inflation then a rise inflation is bad for equities. So that's actually from us it's from from our perspective is actually important in this point in time. So if we see the end of the uh if we see interest rates essentially staying where they are at the moment and we start seeing a pick up in inflation actually equities are not too bad which is which is quite good. Uh but from a trend perspective, one of the nicest things, one of the nicest observation that he makes is what trend strategies are likely to do well and um and is looking at commodity trend which is not surprising right inflation and commodities are very much linked together uh being sort of the physical asset um and to me what was quite surprising is fixed income. So uh and of course I'm trading a fixed income trend so I was like oh that is nice to see. Um so um it it's a really wonderful paper. They've done a very thorough job going back all the way to 1925 or thereabout uh looking both at inflation in the US also a small section about inflation in other countries. Uh but they've covered like I mean the the the the length it's kind of rare to see people going back to proper back test going back all the way to 1925. It just doesn't happen. Okay. Um and that was a very thorough job that that the people at man have done. Uh so Otto is to be commended on that. Um and um you know that there's a lot of and then of course in the [clears throat] fact that he got it completely right in 2022 uh was to me really exciting and there he's done it he's done a wonderful job and exactly what we he predicted in 2021 actually came to came to pass in in 2022 and the beginning of 2023. >> Yeah. As you say the um the the results were um uh in 2022 or 2021 and two were very much in line with with history. I mean it was I remember reading this paper at at the time in it came out in May 2021 and uh you know particularly with respect to trend following if you look at what they're talking about you know I think how they had performed uh historically just looking at it here like um trend following in periods of higher inflation 25% uh annualized returns etc which seemed like uh you know very fanciful returns you know after trend following had a kind of a 5year tough period but but actually obviously trend following did did even better than that in 2022 I mean for some managers 2021 was better for some 2022 is better but but actually it played out exactly as as expected >> exactly and and it was very surprising I mean a lot of people write down uh write off uh trend because um you go down the stairs um when trend goes wrong so to speak when is actually it's because not because there isn't any trend is because the percentage of trends in the market is slightly lower. So if I think about the heat ratio of how many markets are trending well well enough for us as a manager to make money. Uh what you find is that we just need about 40% heat ratio to sort of break even and start making money. And the last couple of years have been tough because we've had a heat ratio of 30% maybe. Right? So it's not that there aren't any trends. There are still trends in some markets, cocoa, coffee, gold uh and so forth. But it's just the percentage is slightly lower. Uh and that has been very tough. But the way that we die is we die by thousand cuts. We we essentially bleed money because it is like an option buying strategy. Um and it's just a a like a day by day by day by day we bleed a little bit of money and when it goes well, it goes spectacularly well. Right? So in what you see in 2021 2022 you saw the percentage of winners going to 60%. Right? And at that point you are printing money like there's no tomorrow. Okay. [clears throat] Uh so you go down the stairs then you go up the elevator and that's the nature of trend. Um and you know sometimes it's very difficult to tough out that period where where things going down but you have to sort of trust your alpha um trust your process and um maybe improve it a little bit um for when the good times come. It's interesting because I mean the um I guess for us in the managed futures industry the kind of inflation protecting aspects of managed futures and trend following are well you know well understood. We we know about papers like this but you know when I when I speak to investors working with different groups very often that doesn't feature so strongly that characteristic. I mean obviously people might allocate to trend following for diversification for for convexity um you know for for crisis uh alpha etc. Um but then they may have a a real asset book um with the where the kind of the the focus is on inflation protection. I mean what's your experience around that? Do you do you find investors using manage futures for that purpose? >> So it's actually quite rare. It's exactly I think your point is exactly correct and it's actually very surprising because quite a lot of uh mandates are inflation plus 4%. Right? So if you speak to sovereign wealth funds or if you speak to pension funds a lot of the time part of their mandate is inflation is embedded right and what they fail to appreciate is that if we do see an inflation pick up it's it's actually not necessarily the tips that will give you the inflation protection and it's not necessarily real estate that will give you protection but it's actually the active strategies that can can move into that into that universe um and take advantage of like let's say a rising commodities. So uh a commodity a a CTA with a high commodity allocation will do extremely well in periods of sort of rising and and falling inflation right so it's inflation volatility uh which is important to us and that is related to essential general uncertainty in the market on where prices are going to settle >> yeah the other thing that I wanted to just touch on I mean obviously if you look at they have a table in there of all of different kind of assets and strategies and you have commodities general commodity commodity the energies trend all the trend etc. Now obviously the the one that historically has done best has been commodities energy absolutely >> and I think if you were to I mean from the research I've done myself it's you know commodities in general have done better than trend in in these periods >> but but then they will suffer more bigger losses in in the other periods. Exactly. Oh, so I mean trend following has that ability to do okay in the other periods and still provide the the protection in in in the inflationary periods. >> So so if you look at commodities as an asset class um it actually drift down right there is a cost for holding a commodity because you you've got to store it you've got to finance it. So generally uh like if you look at the like a total return of holding a commodity asset generally downward sloping okay because there is a built-in uh sort of storage yield and all of these all of these uh which kind of needs to be financed. So it's in the same by the way in terms of VIX right the VIX might be oscillating but actually holding the VIX you're actually losing a lot of FIA so holding just just being sort of long only a commodity may not be the solution for an inflation product right uh if if you're trying to and as you say you have a downside um and um I think people fail to appreciate how beautifully trend responds to to inflation and by the way inflation as a risk factor is a much more slowly changing risk factor versus equity. So in terms of protection, right, if you think about the equity protection that you get from a CTA, it's a little bit uncertain because a crisis in equity can manifest itself over two days. And if we have a trend following who is trading on a twomonth horizon, you're just not going to get that protection that protection like it's not the first response, it's the second response in the equity market. But when it comes to inflation, inflation is a much more slowly evolving process. And that really plays very well with the speed at which CTAs trend. So it's not just that we are exposed to the factor, it's also that this factor is actually evolving in a speed which is much more relevant to the speed that CTA's trend. So uh people kind of fail to appreciate that. >> Yeah, it's interesting. I mean they do talk a little bit about to to the point about um kind of real assets. I I think they have I mean they have real estate I see it in their residential not doing that well. I mean I guess that and we saw this in 2022 as well with things like REITs obviously if inflation is associated with um higher interest rates then uh long duration assets can can be hit. So even though those assets may preserve their value against inflation over long term in the midst of the inflationary uh episodes they may not be optimal. >> No absolutely and and that's actually the same with bonds with tips. So if you have a long-term if you have a if you have a longdated bonds the there is it's they've got two risk factors built in. You've got both the inflation exposure but also DV1 interest rate exposure. And the two factors are playing against each other because higher inflation corresponds to also higher yields which means like the DVO ones you will suffer. So and and uh inflation linked bonds have got a very like they are they are topheavy so to speak the most of the of the cash flows are at the back of the to towards the maturity of the bond. So so tips will suffer because of the interest rate exposure and and housing will suffer because higher mortgage rates basically really depress the market. So um so high inflation is not necessarily uh alleviated by uh real estate holding. >> Yeah. Yeah. Very good. Well definitely one of one of the better papers around. I think it it one of one or two awards as I recall. I can't remember which ones but it's definitely is a a very well regarded paper. So if anybody hasn't read it uh it's um it's from uh Otto and the team at ManHl the best strategies for inflationary time. So um there's one more paper we wanted to get into which is another very interesting one. It's called quantifying back test overfitting in alternative beta strategies. Um and again this one came out I think it was 2017 or so. So it's been around a while but fairly uh timeless quality to it. >> So I think one of the problems actually with the QIS um is that actually there's not a lot of beta out there. So so I'll tell you the story. I'll tell you where how I came to see this paper. >> So um so I like >> I I keep suddenly like in the last couple of months I see QIS hitting me in multiple um situations. So I had one one allocator uh came to me and says uh we are thinking about this particular QIS index. Would you mind having a look tell us how it relates to you? What do you think of that? It's a it's a trend following it's a liquid trend following uh product and you know we value your opinion. Um now we don't mind doing that because we are very much at the very illquid side of the sort of the assets that we trade. Uh we're not we defin you know our correlation to the liquid universe is around 25%. So we don't we really don't mind you know we're not really competing with the liquid um trend offering. Um so I said yeah of course I'll have I'll have my opinion you know it may be good it may be good complimentary to what we're what we're holding. So that was the that was my first uh QIS this like last two months. Uh another one was a consultant and he came to me and he said well you really need to articulate the added value. People are coming to me and saying what is the added value of CTAs over above there those QIS products. >> Yeah. Um, and that's a really great question. It's a really great question and I think people need to, by the way, the the third QIS incident of course is last week. So, um, if let me plug in last week's TTU where Moritz and uh, Nick Baltage from Goldman Sachs are talking about the QIS market as a whole and that's and that's a huge market, right? It's like somewhere between 300 billion and 600 billion depending of how you measure it. So like a really chunky a really chunky market and I think it is the it is it is our responsibility as hedge fund managers to really justify what we are doing what we're doing and what's the added value over these QIS products. Okay. >> Um and I was looking at um and and like on paper and I was trying to get some data on the QIS products and I think one of the my initial reaction is it it's actually very difficult like if I have uh the sock gen index there's actually you know the information is out there if you have a if you have traded funds if you have ETF um trend following you see that you see the performance you can you can make some judgment you can see what's going on with QIS products each bank will be slightly defensive about what they are running and they will be running a lot of a lot of indices. So it's very difficult for us to actually assess to make a like a a bird's eye assessment of that industry. It's very difficult for us. So um so the the only the only uh um the only paper that I was able to find is this one. And even this one I had to ask uh as a favor from somebody like it took me some time. Uh I I spoke to somebody from Barklay who helped me find this paper. Um, and I was actually a little bit surprised to be honest. And the reason I was surprised is actually panel B in exhibit three if you're reading this paper, which is really the the haircut. So, let me tell you the the paper. The paper is looking at 200 betaike products, right? Uh, >> so we're talking about carry and trend and >> carry and trend. >> I mean, they call it alternative beta, but we, you know, alternative risk premium would be >> absolutely >> more typical name. Yeah. >> More appropriate. So, so the but these are products which are offered by the QIS industry by the okay and they have they actually look historically at those um at those funds and they have um and they have the back test and they have the live performance. Okay. >> And they have it going back you know from 2000 going back uh to 2015 or thereabout. Um and and they they compare the sharp before launch and after launch. And what they look at is they look at the haircut. So if you advertise the sharp of one and the real life sharp was 1.5, then like obviously there's no haircut at all, you've actually outperformed. But if you have uh if your performance is only a sharp of.5, then you had a 50% haircut um on your pre-launch shop. And then they look at a collection of you know 200 funds uh QAS products classified by the type of strategy that it's running um and they looked at the haircut and the average haircut is around 60%. So um you you think your shop is one but actually the shop you're getting is point4. Now I' I've got to tell you in within a hedge fund like when I was at when I was at other shots and a new strategy came along internally when it comes to allocation we were equally suspicious of new strategies. So like the back test would have been one we would have applied a haircut of 50% before like be before we allocate to that strategy. Uh right. So so um suspicion is a good thing but it's it's kind of interesting to see that realized. The thing that surprised me is the haircut on strategies that I thought were kind of wellnown. So if you right so you know we're sitting in 2017 and you might think um hang on a second surely everybody knows you know everybody knows how to do trend following. And I think that really speaks to this the original question that was like where is the value of research? What is the added value of um hedge fund CTAs over those QIS products? >> Yeah. And I think once once I've sort of ruminated on it and I actually looked at the specific ind the specific index the QIS product that I was asked to look at um it sort of cames to me because what's happening with trend it's precisely because it is actually well understood that the value of the overall performance is comes from the envelope around how you put that model together. So we we all know that like the the trend following you know it's not really in the signal the signal is actually going to be fairly well known and actually it doesn't really matter which particular signal you're looking at. Um that is going to give you let's say sharper point two per market. So now the question comes about how do you put together a portfolio of those. So portfolio construction is important. How do you manage the risk of that portfolio to make sure that you do get the diversity that is very important? So for example in the QIS index that I looked at you know by very wellrespected name and actually not a bad product at all really good paper really good maths but if you look at the returns very spiky okay and that's to me is a sign that the risk management isn't necessarily like cutting edge it's it we may be okay right execution right this is really important especially in the in the those alternative markets so but can you add value through execution. And you know, you have to realize that the the incentive, for example, on execution is very different for a hedge fund than it is for the um the QIS product because the QIS product makes money out of flow, right? So, right, so >> they are able to net I mean there's a lot of good stuff that they do, but you know, the way they make the money is they net the flows internally between the various the all the multiple flows internally. Um but it's it's it's this this is important to them. Um so I think it's because the alpha is not necessarily in oh I've got a better signal than you you know I've got a machine learning trend following signal. It really is about how you put together a portfolio. This is actually what makes a fund a better a better product in trend following. And I think that is partly something to do with why even for strategies which I thought were very well understood like curry or trend following um you see this haircut in performance in the QAS products there's a place for and for everything and QA is a great industry there's a lot of things that they offer that we do not offer okay so anything from very quick customization um to technology uh to you know very it's come a long way um in terms of how well they are being put together >> but we should remember that the the the incentives of the researchers and the the experience of the researchers in putting together uh a fullyfledged sort of product which stands on its own is slightly different from the QIS product than to the hedge industry. Fair enough. I mean, obviously the attraction for many people is the cost. So, uh, fees are generally lower. Um, >> absolutely. I think that if you're trying to put together an exposure to a risk factor and you you don't really have and and by the way, it's not necessarily uh static allocators, but like hedge funds, right? >> Well, they said a lot of the platforms are using these now. >> No, AB. Absolutely. if um if you if you if you think you can manage it actively and uh you want exposure and it's very difficult like you know for volatility it's very difficult to um you know you have to put in the work to to actually make it happen so um so I completely understand um the attraction and from a capital efficiency you get a very capital efficient solution because of course JP like you know JP Morgan or Morgan Stanley or any of those any of these product um right they they they they able to net all those QIS products that they're offering and the margin they can offer very effective margining. So, it's a really it's it there's there's a lot of good quality uh and good reasons why you might want a generic um you might consider it as a good like stocking filler. We're talk you're coming up to Christmas like no. >> Yeah. Yes. >> No. Absolutely. Right. And it's a good and it's a good thing, right? Um but you should realize that the the first of all the incentives on execution are different. Uh the alignment of the fund manager with you are different. Um and you know for better or for worse and and you know um but you know if you want a very low value a lowc cost solution um that that will be you know that that may be the way for you and it's very quick and it's customizable. You can say I don't want ads I don't want this. They they will do it for you straight away. It's really really good. >> Yeah, >> very good. Well, um it's an interesting one and uh definitely worth checking out as well. It's um a paper that that uh has been around a while if you can get your hands quantify and back test overfitting in alternative uh beta strategies. So, we're we're for going uh just a bit over the hour, but um you know, great to have you on again. Pleasure. >> Yeah, always always interesting to to see what research you're you're you're you're reading and and working on. >> It's it's really appreciated. Really real pleasure. And um yeah, and speak to you soon. >> Yeah. So, well, Neils will be back next week. So, if you have questions for Neil's uh please send them in. But from all of us here at Top Traders Unplugged, thanks and we'll be [music] back again soon. >> Thanks for listening to Top Traders Unplugged. If you [music] feel you learned something of value from today's episode, the best way to stay updated is to go on over to iTunes and subscribe [music] to the show so that you'll be sure to get all the new episodes as they're released. 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