How Alpha Hides in Plain Sight | Systematic Investor | Ep.362
Summary
Market Outlook: The podcast discusses the impact of macroeconomic events like Jackson Hole and interest rate movements, highlighting the challenges in trend-following strategies, particularly in fixed income markets.
Investment Strategies: A significant focus is on the concept of curve trading in commodities, where dislocations between different contract months can present unique trading opportunities, diverging from traditional trend-following approaches.
Market Dynamics: The discussion includes insights into the concentration of market makers and dealers in the FX derivatives market, emphasizing the dominance of a few key players and the potential implications for market liquidity.
Hedge Fund Allocations: BlackRock's recommendation to increase hedge fund allocations by 5% is noted, reflecting a growing interest in hedge funds despite recent underperformance in the CTA sector.
Performance Analysis: The podcast reviews recent performance metrics for trend indices, noting a challenging environment with mixed results across different asset classes and regions.
Asset Allocation: A blog discussion highlights the role of systematic strategies like CTAs in dynamically adjusting portfolio exposures, contrasting with traditional long-term asset allocation models.
Research Insights: The Bank of England's comprehensive study on FX derivatives provides unprecedented insights into market participant behaviors, offering valuable data for understanding market structure and dynamics.
Key Takeaways: The overall discussion underscores the importance of adaptive strategies and the potential benefits of incorporating systematic approaches to enhance portfolio resilience in volatile markets.
Transcript
Imagine spending an hour with the world's greatest traders. Imagine learning from their experiences, their successes, and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world, so you can 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 about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there's a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their product before you make investment decisions. Here's your host, veteran hedge fund manager Neil's Castro Larson. [Music] Welcome back to the latest edition of Top Traders Unplugged, where each week we take the pulse of the markets from the perspective of a rulesbased investor. It's Alan Dunn here this week sitting in for Neils who's away uh and delighted to be joined by Yol Git. Yol, how are you today? >> Uh absolutely fine. Just enjoying the sunshine here in Cambridge and uh the break that I took over August. >> Good stuff. You had a you've had a good summer. You've been away a bit. >> Uh yeah. Yeah, I actually went a little bit north. Uh, I went to Budapest first, but then I went off to the Fringe uh with my family. Uh, it was a marathon of uh of uh shows and it was just absolutely the city was beautiful. >> Very nice. Nice. Nice to get away um for a bit and uh it's back to school now, I guess. Is it? >> Yeah, the the kids are back to university. Uh the youngest one is back to back to school soon. Uh so it's all back to business and and of course we're here for CTA. So that that's uh um we're back to business. >> Good stuff. Well, plenty going on in the markets and uh you know, we've a lot to talk about. You brought some some some great topics as we as we always say, but but certainly a lot to to to get into. Um as we always do, we we like to start off by saying uh and asking what's on on your radar. So, anything been standing out uh from your perspective over the last while? >> Yeah. Yeah, absolutely. Uh to be honest, um I've been dreading uh what's coming next. Um, I've been working on comedy. So, um, >> so of obviously enjoying the Fringe with plenty of very good comedians. Um, but I've got my own little set which is coming up on Sunday. So, first time ever that I'm doing uh I'm taking the plunge. >> Um, probably the last one I suspect. Um and uh really really interesting about the way the motivation I was talking to um to people about why you do this um about the way that you do things actually because they are uncomfortable. So sometimes you do things not because you kind of enjoy them but actually it's a challenge. It's something that you need to do um and this one has been on my radar. Um and if you want a joke then I'll probably can give you one probably. But >> and um so yeah I mean have you done one? Is this your absolute first time doing it in public or have you done it before? >> Uh well, we speak to clients and they think that that I'm quite funny. >> They think you're a joke, isn't it? >> No, but uh uh but but this is this is the first official time that I'm supposed to be funny. >> Uh so let's let's let's hope I'm funny for the right reasons. >> Okay. Will this be recorded or available anywhere for for our listeners to see? >> So I think the the people from work are are are going there and I think they're already pre-selling a bootleg copy of that. So, if if you want to see me humiliated in public, then uh I'm sure it's going to be available and it's going to go on the Quant uh network in in London. >> Great. Well, well, we look forward to hearing about this and maybe we'll catch a clip of it somewhere along the way, but uh fair play to you. That's a brave brave thing to do and uh um I'm sure it'll go very well. Um in more mundane matters, um I mean obviously there's been a lot going on in markets. We've got um Jackson Hole going on at the moment and uh bed chair Jerome Pal speaking today. So that's that's a big market focus. I guess as quant you don't tend to think too much about what Jerome Pal might say. Yo >> um well of course we think about what he's going to say. It's a question of what what we can do about what he says right so um I mean it it has been a very difficult uh period for trend in fixed income. So uh if you look at the US it's been oscillating you know I want to be long I want to be short. um 10 year yields have been moving around quite um you know indeterminantly but there have been there have been uh other markets where you see very significant drifts in in yield uh in Japan if you go if you go to 10-year yield um they've started a long climb back in 2022 from zero now sitting at an all-time high last night so um that's the that's definitely one place where there is an impact and you know in markets like Taibaf you see exactly the opposite where yields have been coming down quite significantly over the last year. So there the it's interesting that uh the US and the and the rest of the the world are doing their own thing. Um and it will be interesting but actually for the economy and for the equity market in the US it will be very interesting to see what uh what we get in Jackson Hall. >> Yeah absolutely. A couple of things on my radar that I saw this week that were interesting. One was NFTT story about fiscal dominance and this is something people have been talking about for a long time the idea that monetary policy will um kind of have to adapt to the fiscal stance you know when debt levels get so great. We're kind of approaching that level but not quite there yet. But interesting that how it is becoming such a topic in markets and as you say um Japanese yields touching alltime um or touching record highs I guess uh put alltime highs um reflecting that concern and and and the general drift higher in in yields. And then the second thing that I saw today was uh Black Rockck out with a report um uh recommending that investors increase their allocations to hedge funds by 5%. So, good news, I guess, for all in the hedge fun industry. Um, I haven't read the full story. I just saw the the FT talking about it. But, um, are you sensing that from investors you speak to as well, you know, more appetite for for hedge funds generally? >> Um, well, possibly hedge funds, but uh, CTAs, I think we have the the exact opposite, right? We've had six months of um, poor performance in the beginning of the year, and I think people were very, uh, comfortable with it. Uh but now you can see there was like a Wall Street Journal talking about trend. Um it's so actually in the city it doesn't matter how well or badly your um your own CTA is doing. I think there is a general malaise in the CTA industry. Investors are waiting to see what's happening. Um which is which is fair. Um and it's a bit difficult to uh come to investors when you're down. um uh but uh I think that's why we talk about it because um if you look at historical record and alltime performance of CTAs, the reasons why they should invest in CTAs is that actually hasn't gone away at all. >> Sure. >> So um so that's that's my experience. >> Yeah. Interesting. No, I mean certainly I think all the reasons that were highlighted for why investors might consider more allocations to hedge funds in terms of a more volatile macro environment and greater dislocations in in macro variables and market um volatility all apply for reasons why you might consider CTAs as well um obviously as part of the the the hedge fund allocation. So maybe um we'll touch on performance first uh and and before we get into the main topic. So just to update um as of um as of uh yesterday sock chain trend index up 1.67% on the month sock gen CTA index up uh up about a half percent and year to date the trend index down 8 and a half% and the sock CTA index down just under 7%. So as I said um you know Japanese yields trending higher. There have been a few uh trends continuing particularly in the fixed income side I would say over the month. Japan European yields US yields are a bit more choppy. Um outside of that it has to it hasn't been obviously been a been a positive period but looking across a lot of the markets they are still quite rangy. FX uh equities uh up and and then a little bit of a correction the last few days. You any perspective on uh performance this month or the the general environment we're seeing? Obviously, it's been a tough year, but we've had a, you know, July positive, August looking more positive. Now, are you starting to see more persistent trends emerging? >> I'm a pessimist by nature, so I I'll count my chickens at the end of the at the end of the year. I think um uh but I I think um it will be a mistake to look at at you know, one month performance, two months per even six month performance. Uh it's of course encouraging and I think what is interesting is clients are rooting. They really want they really want us to do well. Um and this is very this has been very encouraging. Um but I think the the if you if you're going into into trend you know it is it is painful right? It's going down the stairs and up the elevator. And as you say the dynamic nature of the the trading is what you're buying. you're buying that that uh beautiful zero correlation to the um to the rest of the rest of your portfolio while you have a dynamic adjustment to market conditions and and that that that hasn't gone away and that's a very fundamental reason to to investing in in trend. Well, let's get into the main topics. um you brought along a couple of interesting papers and uh I wanted to talk to you about a couple of your own blogs as well. So so plenty to delve into. Um so the first paper is one that you highlighted from Maritz at Takahi Capital. Do you want to give a quick intro to it and get into it then? >> Yeah, absolutely. I I I love their papers. I really I really do like it. I mean um it's a it's a paper called don't just trend it, curve it. Um and they're talking a little bit about um about curve uh curve trading. So of course if you're trading uh copper or if you're trading corn uh the natural thing is you say well there's just one object called corn. uh but really there isn't because um you can buy corn for delivery at different months and the different months may behave differently right specifically for example corn delivery at the moment it's using this year's crop but corn deliver in December will be already um next year's crop so there is a difference between them there's also a difference in terms of supply um because but also there is a difference in terms of demand and sometimes there's a difference to do with um financial condition and regulation changing And I think that that paper is taking is taking one example of that which is looking at the copper right because we know that we've seen uh a taxation on copper uh changing over um over the last period to do with Trump deciding to include it or exclude it from the tariffs and what they're doing is they're saying well actually if you look at if you look at the uh if you look at copper prices they have a certain behavior but if I look at the difference between two deliveries two contracts Suddenly sometimes you get a dislocation uh and they behave differently precisely because you know one contract is before tariff one contract is you know is after tariff. So um so the real there's a there's a there's a very transient risk factor which you can get take advantage of it. Okay. Uh, and I really like the paper and I think the there are a couple of really good p points they make about um about this and I think it's actually interesting what they do because it's actually quite different to what traditional European CTAs are doing. So um full kudos for them. So the first the first point that I really like about that that paper is the general observation that they make which is that the front of the curve is generally the one which is more volatile in the commodity business world and it is the one which is more affected by macronuse flow. Okay. And we see that we see that precisely like the long the long-term um price of copper is going to be affected by long-term supply and demand and it's going to um and it's going to be less affected by local news because you know the tariff coming on the tariff coming off is at the end of the day a very local a very sort of locally temporally it's a very local local news story. Okay. So that affects the front of the curve and um and therefore you therefore that's why you see this dislocation um and that's something that we see in not just in copper we see that across the across the across the the commodities in general. What we see is that when we have a um when other players come onto the markets they tend to congregate where the the liquidity is and the front of the curve is where the liquidity is. So everybody congregates in the same place where everybody else is trading which is good for them and that allows a lot of volume to be traded and we see that in terms of increase in volumes in the in the front contract. Okay. Um the second the second point that um they make in the paper which is that spreads exhibit strong breakouts and reversals and I like I like the what they say about breakouts because the um when spreads actually break do break out it's actually quite violent and I think um I think it's an observation that I would like to add it's about risk management and uh about allocation of risk right so normally in if you were to look at traditional CTAs then they allocate to each of the individual markets and that allocation is relatively static over time. So you will expect suppose if I were to allocate to outright copper trading I will allocate maybe 2% of my portfolio to that to that market and I will expect copper to provide me with 2% of volatility um day in day out. a little bit less when there's less trend, a little bit more when there is more trend. Um, but overall sort of a 2% sort of over over a long period of history. What we when we look at spreads, you can't do that. Okay? And for for a couple of reasons. The first one is that they do mention in the paper which is well that specific spread is going to disappear when the front contract actually expires and there is a delivery. this particular object which is the spread between you know the the August and September contract that that just doesn't exist anymore in the market. Uh but more importantly although it has existed maybe for the last few years the volatility is itself is actually very volatile. You will have a period where this spread is doing nothing. And if you try to make this spread provide you with that risk you will have to leverage your position to such an extent that when a dislocation does happen you will be out of business. Okay. you cannot allocate to um to the spread on an ongoing continuous basis um hoping you know hoping I'm going to make money because when there is a dislocation uh like the Trump trade this is going to be very violent for you it's very left skew so what you have to do is to understand that you have to wait until actually a dislocation happens you can't get into the trade first you have to wait until spread can actually provide you with the minimum level of liquidity a little of minimum level of risk because there's a certain volatility and then you can start trading it and it's sizing the position at that point is actually possible um and I'm a big fan of this approach I have to say um because um it's dynamic you don't know that this is going to happen you know and indeed if the Trump hasn't made a comment about about tariffs then maybe it wouldn't have happened okay but when it does happen being able to have the framework to allocate that risk factor um is really nice and a lot of a lot of CTAs, a lot of streamlined CTAs which don't trade spreads or just haven't attacked this problem properly. um and being able to allocate meaningful risk to risk factors that um rise and they are transient by nature is something which I think is quite important um and in terms of providing divers diversification because when it does happen it is actually trading something very concrete which is very uncorrelated to the rest of our portfolio. Um so that's one of the reasons why I really like this um one of the reasons I like these papers. anything you want to add on this one? >> Um, just to get I mean to set the stage. So, we're talking here about uh spread trading more from a a trend perspective, a breakout perspective. Isn't that correct? >> Yes, absolutely. So, >> yeah, I mean because obviously a lot of managers trade spreads more from I suppose for the spread to revert to more mean reversion I guess. Wouldn't that be fair to say? >> That is absolutely that's absolutely correct. So there's there's a relative value and and if you like to think the carry system >> is is very much the traditional long-term I think about um about the difference between two if I think about the difference between two spreads um it embeds a certain amount of sort of uh cost of carry yes >> okay uh some s some convenience yield and that thing over a long period of time they tend to merge right so um if you ask if you ask me What's the difference between uh 5year delivery and 5 year and two months delivery? Right? There isn't really a good reason for that. The only reason for that is essentially a cost of capital because there is going to be some interest rate differential. There's going to be some um some storage cost and so forth. Okay? So um so the the play for the convergence of these two things is is normally the carriage rate and it's a kind of a nice and slow process. But then what you have is you have these dislocations which are to do with the two contracts behaving differently because they become not exactly substitutable. Okay. So normally in if there if the two objects are funible then you will expect them to converge. But in a case where for example this year um there's a good supply of corn but there is a drought or there is a disease and suddenly we have a supply shock. That supply shock will hit you at sort of next year's crop. Okay. Okay. >> So then what you have is you have a real reason for that divergence between those spreads and that will create a a trend. It will be a short short uh time trend. It's not going to be a very fast moving thing. Um but it's going to be but that that's kind of what's going to drive that dynamics of that particular spread. Um in crack spread. So suppose you have a a spread between the oil uh sort of the the raw oil and you have the distillates the things that you get to distill and you like heating oil and uh jet fuel and all of these things and what you have sometimes you have say a breakdown in the sort of the um the processing of that of that oil. So if there is a Gulf of Mexico, most of the most of the work is done in stealing um oil is done in the Gulf of Mexico. Suppose there is a storm there or there is unscheduled stoppage in those refineries, right? So suddenly suddenly what you have is you have uh that spread will start trending. >> Okay. To to to match that and those risk factors are generally transient but they are very exciting, right? and they are diversifying because that's, you know, that refinery closing down in the Gulf of Mexico is nothing to do with maybe the overall long-term behavior of oil. So, so that's that's that's what they're doing. But yes, it's it's it's actually very tricky and it requires some care and it's interesting that they use breakout rather than using sort of a smooth trading because you actually are looking for a breakout as an indication of something something fundamental happening there. Yeah. >> Um yeah, I think you're correct. >> It is interesting that they are uncorrelated with the underlying. I mean because as you mentioned there the front of the curve is more volatile, more influenced by macro factors. So you would have thought that those macro factors are driving the the front month or the near month future wherever you got your main trend position. >> Yeah. So you would have thought they would be more correlated possibly if the if if that tends to be the driver. But but that doesn't I mean I think they show that or they mention that in in the paper. Isn't that right? So, so we have to be cognizant about what's going on. So, the the underlying two contracts will most of the volatility in the underlying two contracts will be very much correlated to general trends, macro trends or uh uh or trends in copper. Okay. But what they're looking for is like the residual volatility, the the difference in movement between the two. Okay. And that's important in terms of sizing. So normally there will be a 90 98% correlation say and there will be very little volatility in that spread. Okay, which means actually if you want to have meaningful allocation for it in your portfolio, you would have to take 50x position to get it to right. And that's and that's insane. It's it's a little bit like LTCM. LTCM was betting on the on the run and off the run yield curves. So these are two US yield curves, right? two different types of bonds to converge right normally they behave completely the same okay so the correlation is 98%. So they in order to get exposure to that difference, that tiny difference, that 2% of residual volatility, LTCM bumped up the risk profile by you know 50x 100x and then of course when those spreads we refuse to converge or refuse to do what you kind of expect mathematically to do then it becomes very expensive. What you need to do is you need to wait until there isn't a structural break news tariff refineries whatever okay at that point that spread becomes more volatile so instead of saying being 2% of the overall volatility becomes 10% of the volatility and now it's interesting it's a it's actually a valid risk factor that you can trade with not too much leverage okay and um and so that's the one thing which is good about it and the second thing which is good about it is that a lot of the time the reason why there is a breakout is because there is an underlying risk factor which is transient but it is happening right now. Okay. And therefore there is going to be a trend. Um we see that in in the FX market in currency basis. So a currency basis is the difference between uh funding funding in local currency versus the US. And sometimes there is there is just a transient pressure. Maybe maybe what we have is a company issues bonds in a in a in a in a US dollar and it wants to bring it into the local market and that brings a certain funding um uh a certain funding pressure and you see that basis trade moving and then you can you can trend that as well right but you have to be very careful because you have to appreciate that risk management is key here the ability to say I'm going to wait until there is a sufficient risk to start trading it um and then I'm going to get out of this when when there isn't enough volatility. >> A couple of thoughts I had. One is, you know, obviously we have the kind of uh justification or the rationale for why trend following works on on on markets in general, you know, in terms of behavioral biases, etc. H and then does that still apply to spreads? And then and then the second question is do you then get into the whole realm of of synthetic markets and you know trading all manner of different crosses to create these multiple spreads which obviously some CTAs do as well or where do you draw the line or what are your thoughts on all of that? >> So so that's that's that's very interesting. So generally uh trend is very prevalent in in all areas but I think you're right in terms of uh relative value trades are called relative value because uh it's value rather than trend. So making money out of spreads is more difficult. Um and I think that takes us to synthetic or just factor trending. Okay that that takes us into that into that universe. And um let's let's let's look it in the normal CTA universe and I if you break the the factors that you that you look at. So suppose I'm looking at uh all interest rate markets all all bond markets um and I and I do a PCA on it and I look at what what's what's the trend behavior um that you see and and what we see is as follows. um you see the the front the the main dominant um factor um is it trends generally very well okay because that's exactly what we we kind of want and in fact what we see is that maybe the first 25% of of PCA factors trend very well sort of then then we have like a 50% of the remaining uh PCA factors and they do trend okay so although they might look to you like a spread between you know Japanese and US rates they there there will be a trend behavior because there is an underlying macro behavior okay they are less uh they may be less dominant okay but they they they have a sort of a low level to trend but what is interesting about them is that the volatility available on them is it's a much smaller risk factor right so the first PCA covers about 70% of your money of like the first the top quartiles covers a lot of the risk so there's a lot of risk but it's very diversifying and it still trends quite nicely and then you get to the very very bottom of your PCA factors which are very pure RV trades and they tend to actually move in the opposite direction. So they will tend to be uh actually very strongly mean reverting. So um so there there are ways there are ways you can actually incorporate that into your um in your trading strategy in a way that um that sort of allows you to essentially get rid of those um of those small factors maybe. Okay. Or maybe you want to upweight the middle factors because although they are they are they they trend less but they are still uh they trend they still trend well and they still provide you with with some volatility. So um you just have to pick you we we're just trying to create a system which harvest alpha in in all sort of factors. Um but you have to be you just have to be aware about what's happening >> and presumably in terms of speed if these are transient risk factors as you say the the spread will diminish over time you have to trade them faster presumably than you would on a pure and following basis. >> So fast but not as fast as you think you you kind of uh you to be. So that's that's that's interesting and because otherwise uh cost so we have to think we have to think also about costs. So um when we look at the outright if I'm trading the outright there's going to be a certain cost in sharper basis stuff. So maybe three two or three basis points of sharp okay so 002 of sharp that I'm giving up in trading the underlying and as you say I can trade it slowly because slow trend is actually very dominant and that will be even less expensive if I'm trading spread and I have um I have couple of considerations. The first one is that I have to trade a lot of contracts in both directions, right? In order to be able to get the risk that I want. So like the notional amount that I trade is higher and therefore my trading cost will be higher. So like per turnover the spread will be more expensive than trading outright. Okay? And then of course you're saying well and only fast trend if only fast trend is making money at that point it's actually becoming economically unviable right now there are ways you can still incorporate it into your main system in a way that I think I suspect um the two more researchers are doing is even if you think it's not it's too expensive to trade um it can feed into the process of which contract you want to trade. Okay. So for example, if there is a spread which says okay right now the back of the curve looks cheap while the front of the curve looks dear. If you if momentum wants to buy something then maybe you should buy the back. You shouldn't buy the front. Okay. So although the the relative the the contribution is not going to be as great as like trading, you know, going full gang ho and trading the spread, it can still have uh incremental benefit to your overall trading by allowing you to sort of choose where which point on the curve. And I think that's very interesting because when you think about what's happening um that's related to the to the comment in terms of the the front of the curve is more shocky. it's more exposed to macro um sort of the macro trends which are actually more to do with what's happening with the S&P and the and the US Treasury whereas the back of the curve is more affected by supply and demand. So you you like so generally uh you would tend to um to move slightly further out of the curve. Um and I think one of the things that they failed to mention which I think is quite which I think it's not failed it's a very short piece so I'm not going to begrudge them that um but uh it's to do with who is actually trading. Okay. So um as we said when you know if you were to look 5 10 years ago there were very few shops even multi strategies that were looking at trading copper but these days everybody is trading copper and as a result the copper has become sort of more speculative in nature right if I look at who's trading the front curve in in copper it's it's a lot of CTAs a lot of multistrats a lot of speculators not necessarily the people who are actually hedging and producing and buying copper for production. And we see that in terms of the ratio between there are multiples way of seeing it. First one is to look at it in terms of the um the volume and the open interest, right? the open interest when the the open interest when the contract closes is the what remains like who is actually wanting to um to get exposure to the to the copper contract. Okay. So we can compare like the volume during the the trading versus what who actually wanted to take that position or we can look at the cot report the commitment of traders reports by the US and see which ones are the speculators which ones are the the uh the heders. um and you see the front of the curve becoming more dominant by the speculators. So that in that universe if you were to move you know a year out in copper I'm not sure you can actually move a year out it's quite a uh but I suppose we can move a couple of contracts out then the people who are doing that are the people who actually want to take um are actually more the the the hedges and producers and they tend to trade more slowly so there's less volume there is more open interest and that's the difference between taking between the stock between position and volume between stock and flow So the back of the curve has got so the the curves do have different dynamics. Um and when you're doing when you're doing trend following these different uh physical characteristic of the contract actually will feed in into your trading system >> and just to your point a bit like the front being more speculative activity I mean does that suggest you know that that it's more zero sum than trading in that sphere? Obviously, you know, if it's all specs, they're just profling from each other, which, you know, some winners, some losers. >> Well, the the the the efficient market hypothesis applies everywhere, right? But it's it's it's more about what is the fundamental reason for things trading. >> But if there's a lot of hedggers in a market, then there and they're risk averse, then in theory there's a >> there is a premium a risk. >> There's something to Yeah. for spec to to capitalize on. Yeah. >> Yeah. Absolutely. So, yes. So I I I I would say that that that is the issue. I think actually I'm going to say um something about the loading on trend at this point. Actually a lot of a lot of uh we're having a lot of discussion with clients and uh some an argument which comes up quite often is to say oh uh trend is at capacity. The reason why why the trend hasn't performed in the last year is because there's just too much money in trend. Um and what is interesting is okay the the I think the the most famous paper is there was a recent paper by man um which Russell um talks about oh uh the size of the AUM of the of the AUM of the industry is has been constant at 300 billion. Uh the industry has grown significantly which is true. Okay. So that means we are a small part of the market. Okay. Um the problem with this argument is that there is tons of trend being done at other places where you don't see it. Uh then in QIS you see there's tons of trend inside inside the multistrat if you were going into you know millennium QT any of the big any of the big shops there there will be pods inside that there will be trading trend I can I can guarantee you that is happening. Um so um so taking a global uh bird's eye view of what's happening is is not actually necessarily uh informative but what is what is informative is that we can actually look at um the speculators and the hedgers in the court record and we can fit the behavior to different trading strategies. So what we see we we you know I'm not doing it's not a prediction it's much more des a descriptive uh a descriptive view he says I'm looking at the behavior of the the speculators over the last couple of weeks does that load on trend like if we if we if the industry was overly trend reliant then what you would see is you would see a good correlation yeah a beta between the speculators positioning in the cult report to your signal And we can fit that. >> Um and what we find what we find is that we can actually detect a few things that are very interesting. So if you look historically um you can see that the industry the speculators have become very sensitive to volatility. So the loading on changes in volatility i.e. if volatility goes up the it goes the speculators uh proportion goes down. Um that has become that is now it's quite a dominant it's quite a dominant effect. So that's the first thing we see the reduction in loading on on fast trend. So if you go historically and you go back to sort of the early 2000s um you see that um fast trend was changes in fast trend explain changes in uh speculators uh positioning um that has gone down over the years and that actually reflects and it's quite nice it's quite reassuring that we see this because that actually reflects the reality that we know if I look at the sock gen uh CTA index if I look at the way that the CTAs have moved. They've migrated to trading slowly um and loading less on on on fast trend. What we don't see is we don't see like suddenly a huge rise or in fact any rise whatsoever in terms of the loading on on slow trend or mid-frequency trend in the data. So um basically the industry is is uh actually being very careful not to take too much risk in any particular contract and then that capacity argument just like the data just doesn't bear it right we just don't see this we just where we can see this data the that argument just is not there so I don't like people the clients are always asking me what is causing this issue why do we why did why didn't we see trend performing in the last that we can have a long discussion about that. But in terms of the loading on like are we are we just too big in the market. Um no we're not uh in in just from the that data just doesn't bury down. Well, that's maybe a good segue into the second topic um which is a paper which gives a lot of really interesting um granular data on different market participants and their exposures in the FX markets and that's a recent paper from the Bank of England um which is really monumental uh uh paper in terms of the the data they have put together. Do do you want to give some context and and an overview of this one? >> Yes, absolutely. So um so if you look at um FX FX data so first of all a little bit about the the FX market um by size in terms of volume of trading uh probably the biggest like easily dwarfing um easily dwarfing the the equity market say so if I look at um the BAS trianual survey from 2022 um the amount of daily trading in FX is something like 7.5 trillion okay that's just like insane Okay. So, it's a huge market and there are lots of there are lots of players in it. Of course, anything from the retail people buying uh wanting to buy uh uh some some dollars to go on holiday in the US uh to Tesco which is sort of the non-financial corporations that they uh they want to hedge. They have assets abroad. They have income from abroad. um Tesco less so but you know companies that export they might have they might have an overseas operation and they will hedge their position into into the local currency um and then all the way to our hedge funds and our sort of uh our investors so there will be asset managers who are in this market so you like everybody's playing the FX game okay and 7.5 trillion per day it's just an insanely big market >> and um there are few data sets for that in terms of understanding the positioning there's uh CLS is one of the biggest providers they do settlement FX settlements and they offer some data which is very anonymized but now we're going we've just hit the mother load so this this paper is just insanely amazing in terms of data so okay so this is called the paper is called topography of FX derivative market and it's a view from London and it's a it's a it's a collaboration of a few people from the bank of England a guy called Daniel Austri, a few people from uh a few people from the Fed, there's a guy called Cinnam with I can't say his surname, so you'll have to excuse with me. Uh and and it's a collaboration of of a few central banks and a few researchers. Um and they have data which is non anonymized. They have 100 million transactions, millions of transactions in the London FX markets from 2015 to 2020. And it's non anonymized. So it's the advantage of being the regulator. you can see everything absolutely at daily firm level uh positioning um and that that's that's and that's just amazing right and that allows you to do things that you wouldn't be able to do otherwise um and what I love about this paper first and foremost is that they don't try to predict cross-sectional FX returns they don't try to many a times you will see academic papers in you know in our finance industry and the researcher rushes into okay here's an effect here is some here's some data that I have let's see if I can use it to predict cross-sectional equity returns I mean it's just like hundreds and hundreds of papers thousands of papers which are trying to do that okay and what I love about this paper is that it in in some sense it says okay I'm not I'm just going to let the data speak for itself I'm just going to look at the data I'm going to do very little adjustment of few things that we actually have to adjust to to um sort of to correct the way the data is reported um or to understand what is happening. But I'm not going to try and make any prediction. I'm just going to describe the structure of the market. And I find it extremely informative. Um and I think um a lot of quans again rush into here's a trading strategy. Sit back just just look at the data. Let it tell you a story. And when the story is done, I mean you can you can probably guess you know there's a there's the there's a paper there's a famous paper just which went out in March the virtue of complexity uh which basically says you know I'm good to sh I'm going to make it over complicated. You can probably tell which in which camp I lie um I think before we start before we start uh doing anything with the data it behooves us as corns rather than just shoving it into a machine to really understand what's going on. and this paper really does it beautifully. >> So um there are few there are a few observations actually let's start with the with the appendix because that's the one that relates pretty much to our earlier discussion. So if you go back to if you go if you go to the appendix there is a um there's a beautiful description about where do each player which each type of player in the market which derivative contract they trade. So the the paper does is not looking at spot. It looking at at FX derivatives and FX derivatives can be anything from one day like tomorrow next or spot next. So it can be either one day all the way to maybe two three years. Okay. So we're moving from um FX forwards to FX swaps further out of the curve. And what you see is exactly the same phenomenon that we just described in terms of the um the habitat of different players habit like sitting in different parts of the curves. So um the market makers the ones that try to hold um they try to hold most of the risk in the very front. So if you look at the if you look at the the chart distribution of their positioning most of it is up to one one week uh expiry right and and that's the most liquid part. That's the part that's the part that they use to hedge their risk. And then you move to the hedge funds of the universe and the asset managers. And you move further out and you move to sort of the one to three month maturity. This is not a huge surprise. And this is how we would do that. And I think most most ces will be trading the next IMM expiry the the sort of the uh every three months sort of the March, June, September and December uh Wednesday the third Wednesday of the month expiry. Um and this is where the sort of the hedge funds congregate with their uh with their um liquidity. And then what's happening to the back of the curve? Who is holding the two or three uh uh FX swaps? These are real people. These are the non-financial corporations, the you know the the companies that have exposure. They have a genuine long-term USD cash flows and they need to bring those backs into the local currency. This is all taken from the London market. So this is all uh so the the local currency is is GBP or some or euro before the before the Brexit happened. And what we see is that they they inhabit that habitat. The two and three years out, these are by the the hedggers, the people who actually genuinely use it. And I think a lot of the risk is basically rolling that swap every, you know, that's what their activities. They just want to make sure that they hedge their cash flows. Um, and they don't have the risk. Um, yeah. So, it's it's very interesting. So, that's that's one amazing amazing part of this of this paper. Uh, but there are plenty of other stuff. >> Yeah. as you say, I mean the it is it must be the first of its kind in terms of this level of detail that we see. Um a few things that were were were interesting. Um as you say the kind of the time horizon that that that different segments hold their positions or primarily trade is interesting. And then they also do show the um the net exposure by the different segments over time. Um which is interesting as well which um obviously as you'd expect the the hedge funds uh specs their net exposures to the dollar euro and sterling fluctuate a lot. Um but one that was interesting was I think um that the the market makers or the dealers obviously like tended to hold the opposite risk to to to the hedgers. Did you notice that? >> So so that's a little bit um that's correct and a little bit misleading in a way. So what what you have um is one side of the picture. So what what you there are two types of people. There's the market makers and the dealers. You will see that the market makers have relatively little risk overall. And these are the ones who really trading like uh dural bunnies. They are they are buying and selling and they really adjusting the the their prices to ensure that they don't have net risk. But what you have is you also have dealers that will be taking the risk the dollar risk. So oh so there's a structural short dollar for UK corporates right because they have they hedge their dollars back to the UK. They are long GBP, short US dollar. And the dealers on on our data set will look like they will be the opposite. They will be long US dollar and short GBP. But what we don't see is we don't see the positioning in the other side of the uh of the Atlantic which is what the position of the dealers against US corporates. So the US corporates will have the exactly the opposite position um which is you know they will be all short all other currencies uh GBP amongst them and they will be long USD and the dealers will be providing that. So the dealers are sort of a more a slower netting. They will provide a slower netting of this of this universe. And I think what you get overall is that the um and and the reason why I'm saying they are able they they will hold less risk is because they can't hold a lot of risk. Right. So these days >> but I thought this was the net their net exposure. >> I may be incorrect but I I'll need to check. But I >> we'll have to check. Yeah. >> No, no, no. But but the the the the problem that we dealer banks in the US is that you can't actually you can't hold on your book too much risk these days. Right? So the one of the outcomes of of uh the great the GFC and the great financial crisis is that the amount of risk which is available on the market that you are you are able to hold is actually not not not that great. And we see that in bonds, we see that in in credits, we see that we see that everywhere. So um uh I suspect a lot of that risk is actually transferred through to through US corporates. >> The others are as you would kind of expect really I mean obviously you know um non-financial corpse obviously holding the kind of exposures that you would expect uh from a hedging perspective. So you know um short effectively short dollars I guess selling their dollars generally from their positions overseas outside of the positioning and anything else stand out that >> yeah so >> that that might have an obvious takeaway for you >> so so um there is one which is ve very much related to trend and and carry but but be before we get to that I actually um um there's a little bit about the the market structure and that's that's very that's very interesting. thing because uh and that was a huge surprise for me. Um so with a market that big and you um you kind of expect to see um a lot of players in in the center. So there there are a lot of disperate players. But what is interesting is how concentrated the it is like a star-shaped domain. There is the center which is the which is providing the liquidity. But what what is insane is that like the top five dealer and the top five market makers really dominate the everything. Okay. Uh and it wasn't used to be like that. I mean if um uh when I was uh 20 years ago and we were looking at the EBS EBS data which is the interbank um netting sort of FX FX trading FX trading application. um a lot of banks were involved in the game and yeah um and uh and I suspect there's still local currency and there is going to be a local effect so you know so there will be a a Swedish bank dealing with Swedish corona but by and large the these days there is the the real trading is basically channeled through very few counterparties um and that's an interesting and potentially a cause for concern the interesting thing is that this is actually very different to the to the structure in the FX spot market. So if you look at the so this is all the derivatives and if you look at the FX spot market the emergence of players like the the non-bank um market makers so like the XTX and the J Street of the of the universe. Um, so there's there's it's actually a very interesting it's a very interesting uh different difference between the the forward and the swaps and the spot market. Um, so but but structurally that's very interesting to me. Um, and I don't I'm not I'm not sure exactly what the implication is, but this was like really important. >> I think I mean I think there's a lot of uh data in this one. It's definitely worth having a look at. I mean I think uh I'm sure some more observations will come from from further review. But I wanted to move on to something conscious of time. You you've you published a blog recently which I wanted to touch on which is around you know asset allocation. So it's obviously Topco given what we talked about a little bit earlier with with Black Rockck suggesting increasing hedge fund allocations and elsewhere I saw Vanguard kind of going against the tide a little bit by suggesting they're suggesting 7030 is the optimal for the next decades. Let me tell you a little bit about my blog and a little bit about Vanguard and actually so I don't I don't know that much about um I didn't know much about and I still don't know much about the way that allocators are allocating. Okay. And we normally when we go to an allocator we say oh give us some money um you know we are trend following we are uncorrelated to everybody else. You just give us some money you put us aside and so forth. And um and I talked to um to uh an allocator and I asked him you know how do you take into account the fact that the positioning might change and suddenly all of your allocations are long equity and suddenly you have a lot of risk in equity and and again his his reply was well we actually do try to figure out the the beta let's say the equity beta on each of the uh data sets and we fit the the P&L of each of uh the people that we allocate to and that gives us an idea about what the positioning is like. Um, and this is kind of how we do uh it's quite messy, but this is how we do um which we try to find out the bit of of the equity that we have right now with this hedge fund positioning. Um, and we exclude you guys, we exclude CTAs because you guys change, you change your mind too too often and like we we can't really tell you, we can't tell uh retrofit what your what your positioning is, which I think actually shows you how uncorrelated we are to other asset classes because it's like you can't do the fit. We are zero correlation. It's very difficult to fit what our positioning is. And that started think me thinking about what the process of uh an allocator to allocate is. Um and I felt hang on a second right what they do is they go through a process the first things they do say they make a capital market assumption they make an assumption or in the Vanguard paper that you mentioned sort of VMA sort of time varying asset allocation model um what you do is you say what do I think long term in the next 10 years what's going to be happening to equities what do I think what is the annual growth I expect in bonds what's the income that I'm expecting from commodities is um there's some there's some correlation matrix assumptions and I'm going to make and based on that I'm expecting some long-term based on long-term growth I'm going to have um I'm going to the allocation I'm just going to create an allocation matrix and that's actually probably one of the most important decisions that you have to make about you know what's the proportion between equities and bonds and not surprisingly it's going to be related to how much long-term how much value you you expect to extract from equities and bonds in over a 10 year horizon and I thought to myself hang on a second within this process when you do this optimization and you do this correlation matrix and you do this optimization then there is a gradient right so the idea is if you think that equities are going to go a little bit further up then actually should allocate a little bit more so there's a delta to your assumption right so whatever allocation that you've decided on you kind of think um uh there is a delta to your your assumptions both in bonds and equities and so forth and and I thought the delta was positive right so you if you think you might want to say if you think that equities have gone up you might think that they will go up more so I wrote this piece and I wrote this piece about CPAs but actually I think it is more about the the role of systematic strategies so systematic strategies you know risk parity relative value, trend following. There will be funds that do that do that and you kind of know what they're going to do that it will be a mechanical adjustment of the data and I thought I wrote it about CTA because of course we trade CTAs. Um and of course the feedback I got was you got it completely wrong. What you got is you got it completely wrong. The in actual fact most most of these models are mean reverting by nature i.e. If equities go up, they will actually underweight equity. They will say long-term I will drop the my expectations about what's what's going to happen to equity and as a result they will I will deallocate from equity. Now interestingly enough that's actually coming back to the positioning. This is exactly those those long-term investors are the ones that take the opposite side. We talk about positioning. These are the ones who take the opposite side to trend in the market. Um and in fact the paper the Vanguard paper is exactly what that you sent me and I thought oh my god yes this is I'm going to have to own up to this one. Um what what they are what they're saying is in June equities went up tons. Okay so they went up 10 11%. So they so in July they came up with a paper and said oh actually now we are adjusting half of like if you think about that 10% equities have done their 10% rise. We thought they were going to go up four and a half% over 10 years. Now that 10% is gone, right? So I think we're left with three and a half percent. Actually, they only cut 50% of it. So we we they cut the expect long-term expectation to to equity by half a percent based on actually very short-term change in equities. Okay. Um and as a result of that they will you basically underallocate um you want to underallocate to equities and they came up with a very bold number to be honest. They they go for 30% um 30% in equities and 70% in bonds. Okay. Notice no hedge funds here. >> Yeah. I mean I think it's just between the two assets that that absolutely this model. Yeah. >> But I mean I guess the benchmark is probably 6040 equity. So it's it's I mean I think as you say it reflects more the equity valuation more than the view and landing else. I think that's just >> no absolutely and and it makes sense and and and I've had a chat with my my allocator >> uh and he said yeah yeah but wo on to those models right we kind of don't like them because they they have been negative equity for years. Okay. Yes. Right. Yeah. >> So, so uh it's like you know it's it's the naysayer that you know one day they will they will pay they will make money right long-term PE Sheila ratio all of these all of these uh all of these very long-term 10-year horizon things um uh all of these are uh maybe make sense if you're investing for 100 years um but like suppose you took the like after the equity uh rise you then decided to go and sell your equity um you wouldn't have done particularly well. I mean at the end of June I think the S&P was at 6 six 6.3K and now it's no it was 6.2 and now it's in 6.4. So equity has been has been uh has been rising quite happily regardless of what Vanguard is saying. Okay. And I think that is that comes into the role of trend not necessarily as a long-term but as a tactical as a long-term right but as a tactical way of you phasing in that long-term view right we talked about the way spreads which spreads I'm I favor right now as a way of phasing of of improving your trend we can think about the way trend improves the long-term allocation model right so we took we take from the perspective of the vanguards of the universe trend is one of those very funny very fastm moving object okay but we can we can use that signal if you're allocating to to CTAs to say oh okay right now I want to deallocate from from equities but you know trend is really strong right I don't really want to allocate right now I'm going to wait maybe by the end of the year trend will reverse now I've naturally deallocated from equity the way I kind of feel about it. So um so but so I think the the although the premise that I had in my mind that the the delta of uh long-term allocators is positive is completely false. Okay. Um nevertheless the I think the principle of what I'm suggesting is correct which is that the um systematic strategies or rule-based uh strategies you want them in your portfolio because they will if you include them inside your allocation process the optimization process that you're doing you will be able to create an optimal allocation over a much wider set of parameters. So you know in your mind what would be your allocation if your assumption is three and a half for equity in the long term or 4% in equity or three in equity. You should pick a collection of systematic rules of trading which is actually available in the market to allow you to essentially automatically autocorrect how depending on how your assumptions changes. >> So um so that that >> I mean is it's kind of like the role the allocation to CTA should be upgraded. Is that kind of what you're suggesting? I mean, I understand what your point is like. So, CTAs will modulate your overall equity exposure. So, if you have 50% equities and you have 20% CTA, you're going to pick up some more equity exposure in your CTA allocation and that exposure will fluctuate over time depending on the strength of the trend in the equity market. So in a strong bull market it'll go up and in a bare market it might go short and that has a a favorable portfolio impact. But as you say the way most people do asset allocation is they think about okay well here's I mean everybody produces capital market assumptions and then they feed that into some kind of optimizer or some kind of framework where they're thinking about what's the expected return from these asset classes and what's the >> yes >> volatilities and correlations. So, so that would determine some level of exposure for CTAs depending on how you know I mean you have to formulate a uh a return expectation. Um but are you suggesting that because of this additional role uh CTA should be higher because it does point to I mean this is something I've been thinking about you know this kind of framework was originally designed when you're combining different assets you know bonds equities property okay but now we got the we're adding strategies such as CTA which are trading some of the assets that you're diversifying so this is the point we're talking about here sometimes you're going to pick up more exposure sometimes But you I mean you're allocating to them for a risk factor. So how do you reconcile all of that? >> So so I think it is the the time horizon that we're talking about in this >> time. Absolutely. Absolutely. So so it it actually the entire right time horizon and habitat. Right. So if you think about the the those capital market assumptions these are about the 10ear horizon. >> Exactly. >> Right. and and in that horizon the natural fluctuation of equity. In fact, what you should do is you should like what we advise a lot of retail people and a lot of actually you know stick with those numbers have those allocations go and play golf right you know allocate for equity long-term don't be for for the long-term allocation which is what the CMA model is designed for which is looking at long-term growth right the the what's happening in the the the next three months is completely irrelevant from their perspective and you are just going to ride this out and you should go and play golf and just ignore Trump uh and you should ignore whatever COVID we should just go and and enjoy your positioning all the time and what what we are seeing as you say is that those active traders not just CTAs but multistrats and you know other macro hedge funds and so forth they are playing in a different time horizon than you they're playing at the three-month horizon that for you you know is almost invisible and it's very uncolored and that's the reason why over time they will be uncorrelated. So you you might be a situation that like right now you are long equity and the CTA is long equity or the hedge fund is you know this micro hedge fund is long equity but that risk is going to change so much and you know in a month's time they will be negative. So don't worry about it too much. you should the way you should think about you know in that that part of the the if you're thinking about in term of of alpha that alpha is almost distinct to what you are doing from an allocation perspective and that's why um it is a uncorrelated to what you're doing and b is very additive to your portfolio and I think that's kind of the way that a big allocator should think about that um and the actual positioning right now you would use it in terms of modulating things some small changes in your long-term allocation. So like the trading that you would do from your CMA, you kind of want to modulate it by by trend but and or systematic strategies but uh but in terms of alpha, you just think of it as almost an independent play. >> Yeah. Yeah. Well, it's true because that's effectively what the CTA allocation is doing for you. It is uh tactically adjusting your portfolio while as you say, you're you're gone playing golf. It's uh increasing your exposure to equities if they're trending higher and reducing it if it's trending lower. >> Yes, absolutely. Um so I mean to be honest it was an it was an an experimental thought process. I don't think anybody um I I don't expect the allocators or the consultants who are running those CMA I don't think Morgan Install or Vanguard will all sort of shift to my methodology. I'll be very surprised. Right. But but I think it's it's important to understand like the tools of the trade that you have at your disposable at disposal if you're an allocator. And you know we normally think of of trend as as like outside that that universe that you're living in. But you actually might want to consider in embedding it in in into your process. Not just actually not just CTAs but a lot of the systematic systemat and and you know we do embed some systematic process. So for example, you will manage your FX exposure, right? A lot of the if you are uh an Australian allocator and you you have uh structural um structural FX exposure in the USD then you would want to hedge a lot of that risk and you will manage it in a systematic fashion. Okay. So, so some systematic strategies like FX hedging are part of the way that you embed are embedded into your process. Okay. And uh there's a great paper by van Hemtt um about the best ways to hedge FX exposure. So there's a there's a really nice paper um I'll can send you later um about doing this as an allocator. How do you embed a systematic strategy? And you know, FX edging is like the simplest one, but already there is a lot of stuff that you can do with it. Um, and CTA is just another tool of a trade that you might want to think about embedding into your crowds. >> Yeah. Very good. And what's the name of your LinkedIn blog on that one? It's >> uh what's cooking this one? Yeah. >> Very good. Good. So far, we we've gone we've gone over a bit on time, but uh that's all good. Um, so Neils will be back next week. Um, I'm not sure who's with them, but send in your questions for for Neil's. Um, great to have Yo on this week. Thanks very much, Yo. Um, and for all of us here, from all of us here on Top Traders Unplugged. Thanks for tuning in, and we'll be back next week uh with more content. >> Thanks for listening to Top Traders Unplugged. If you 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 to the show so that you'll be sure to get all the new episodes as they're released. We have some amazing guests lined up for you. And to ensure our show continues to grow, please leave us an honest rating and review in iTunes. It only takes a minute and it's the best way to show us you love the podcast. We'll see you next time on Top Traders Unplugged. [Music]
How Alpha Hides in Plain Sight | Systematic Investor | Ep.362
Summary
Transcript
Imagine spending an hour with the world's greatest traders. Imagine learning from their experiences, their successes, and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world, so you can 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 about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there's a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their product before you make investment decisions. Here's your host, veteran hedge fund manager Neil's Castro Larson. [Music] Welcome back to the latest edition of Top Traders Unplugged, where each week we take the pulse of the markets from the perspective of a rulesbased investor. It's Alan Dunn here this week sitting in for Neils who's away uh and delighted to be joined by Yol Git. Yol, how are you today? >> Uh absolutely fine. Just enjoying the sunshine here in Cambridge and uh the break that I took over August. >> Good stuff. You had a you've had a good summer. You've been away a bit. >> Uh yeah. Yeah, I actually went a little bit north. Uh, I went to Budapest first, but then I went off to the Fringe uh with my family. Uh, it was a marathon of uh of uh shows and it was just absolutely the city was beautiful. >> Very nice. Nice. Nice to get away um for a bit and uh it's back to school now, I guess. Is it? >> Yeah, the the kids are back to university. Uh the youngest one is back to back to school soon. Uh so it's all back to business and and of course we're here for CTA. So that that's uh um we're back to business. >> Good stuff. Well, plenty going on in the markets and uh you know, we've a lot to talk about. You brought some some some great topics as we as we always say, but but certainly a lot to to to get into. Um as we always do, we we like to start off by saying uh and asking what's on on your radar. So, anything been standing out uh from your perspective over the last while? >> Yeah. Yeah, absolutely. Uh to be honest, um I've been dreading uh what's coming next. Um, I've been working on comedy. So, um, >> so of obviously enjoying the Fringe with plenty of very good comedians. Um, but I've got my own little set which is coming up on Sunday. So, first time ever that I'm doing uh I'm taking the plunge. >> Um, probably the last one I suspect. Um and uh really really interesting about the way the motivation I was talking to um to people about why you do this um about the way that you do things actually because they are uncomfortable. So sometimes you do things not because you kind of enjoy them but actually it's a challenge. It's something that you need to do um and this one has been on my radar. Um and if you want a joke then I'll probably can give you one probably. But >> and um so yeah I mean have you done one? Is this your absolute first time doing it in public or have you done it before? >> Uh well, we speak to clients and they think that that I'm quite funny. >> They think you're a joke, isn't it? >> No, but uh uh but but this is this is the first official time that I'm supposed to be funny. >> Uh so let's let's let's hope I'm funny for the right reasons. >> Okay. Will this be recorded or available anywhere for for our listeners to see? >> So I think the the people from work are are are going there and I think they're already pre-selling a bootleg copy of that. So, if if you want to see me humiliated in public, then uh I'm sure it's going to be available and it's going to go on the Quant uh network in in London. >> Great. Well, well, we look forward to hearing about this and maybe we'll catch a clip of it somewhere along the way, but uh fair play to you. That's a brave brave thing to do and uh um I'm sure it'll go very well. Um in more mundane matters, um I mean obviously there's been a lot going on in markets. We've got um Jackson Hole going on at the moment and uh bed chair Jerome Pal speaking today. So that's that's a big market focus. I guess as quant you don't tend to think too much about what Jerome Pal might say. Yo >> um well of course we think about what he's going to say. It's a question of what what we can do about what he says right so um I mean it it has been a very difficult uh period for trend in fixed income. So uh if you look at the US it's been oscillating you know I want to be long I want to be short. um 10 year yields have been moving around quite um you know indeterminantly but there have been there have been uh other markets where you see very significant drifts in in yield uh in Japan if you go if you go to 10-year yield um they've started a long climb back in 2022 from zero now sitting at an all-time high last night so um that's the that's definitely one place where there is an impact and you know in markets like Taibaf you see exactly the opposite where yields have been coming down quite significantly over the last year. So there the it's interesting that uh the US and the and the rest of the the world are doing their own thing. Um and it will be interesting but actually for the economy and for the equity market in the US it will be very interesting to see what uh what we get in Jackson Hall. >> Yeah absolutely. A couple of things on my radar that I saw this week that were interesting. One was NFTT story about fiscal dominance and this is something people have been talking about for a long time the idea that monetary policy will um kind of have to adapt to the fiscal stance you know when debt levels get so great. We're kind of approaching that level but not quite there yet. But interesting that how it is becoming such a topic in markets and as you say um Japanese yields touching alltime um or touching record highs I guess uh put alltime highs um reflecting that concern and and and the general drift higher in in yields. And then the second thing that I saw today was uh Black Rockck out with a report um uh recommending that investors increase their allocations to hedge funds by 5%. So, good news, I guess, for all in the hedge fun industry. Um, I haven't read the full story. I just saw the the FT talking about it. But, um, are you sensing that from investors you speak to as well, you know, more appetite for for hedge funds generally? >> Um, well, possibly hedge funds, but uh, CTAs, I think we have the the exact opposite, right? We've had six months of um, poor performance in the beginning of the year, and I think people were very, uh, comfortable with it. Uh but now you can see there was like a Wall Street Journal talking about trend. Um it's so actually in the city it doesn't matter how well or badly your um your own CTA is doing. I think there is a general malaise in the CTA industry. Investors are waiting to see what's happening. Um which is which is fair. Um and it's a bit difficult to uh come to investors when you're down. um uh but uh I think that's why we talk about it because um if you look at historical record and alltime performance of CTAs, the reasons why they should invest in CTAs is that actually hasn't gone away at all. >> Sure. >> So um so that's that's my experience. >> Yeah. Interesting. No, I mean certainly I think all the reasons that were highlighted for why investors might consider more allocations to hedge funds in terms of a more volatile macro environment and greater dislocations in in macro variables and market um volatility all apply for reasons why you might consider CTAs as well um obviously as part of the the the hedge fund allocation. So maybe um we'll touch on performance first uh and and before we get into the main topic. So just to update um as of um as of uh yesterday sock chain trend index up 1.67% on the month sock gen CTA index up uh up about a half percent and year to date the trend index down 8 and a half% and the sock CTA index down just under 7%. So as I said um you know Japanese yields trending higher. There have been a few uh trends continuing particularly in the fixed income side I would say over the month. Japan European yields US yields are a bit more choppy. Um outside of that it has to it hasn't been obviously been a been a positive period but looking across a lot of the markets they are still quite rangy. FX uh equities uh up and and then a little bit of a correction the last few days. You any perspective on uh performance this month or the the general environment we're seeing? Obviously, it's been a tough year, but we've had a, you know, July positive, August looking more positive. Now, are you starting to see more persistent trends emerging? >> I'm a pessimist by nature, so I I'll count my chickens at the end of the at the end of the year. I think um uh but I I think um it will be a mistake to look at at you know, one month performance, two months per even six month performance. Uh it's of course encouraging and I think what is interesting is clients are rooting. They really want they really want us to do well. Um and this is very this has been very encouraging. Um but I think the the if you if you're going into into trend you know it is it is painful right? It's going down the stairs and up the elevator. And as you say the dynamic nature of the the trading is what you're buying. you're buying that that uh beautiful zero correlation to the um to the rest of the rest of your portfolio while you have a dynamic adjustment to market conditions and and that that that hasn't gone away and that's a very fundamental reason to to investing in in trend. Well, let's get into the main topics. um you brought along a couple of interesting papers and uh I wanted to talk to you about a couple of your own blogs as well. So so plenty to delve into. Um so the first paper is one that you highlighted from Maritz at Takahi Capital. Do you want to give a quick intro to it and get into it then? >> Yeah, absolutely. I I I love their papers. I really I really do like it. I mean um it's a it's a paper called don't just trend it, curve it. Um and they're talking a little bit about um about curve uh curve trading. So of course if you're trading uh copper or if you're trading corn uh the natural thing is you say well there's just one object called corn. uh but really there isn't because um you can buy corn for delivery at different months and the different months may behave differently right specifically for example corn delivery at the moment it's using this year's crop but corn deliver in December will be already um next year's crop so there is a difference between them there's also a difference in terms of supply um because but also there is a difference in terms of demand and sometimes there's a difference to do with um financial condition and regulation changing And I think that that paper is taking is taking one example of that which is looking at the copper right because we know that we've seen uh a taxation on copper uh changing over um over the last period to do with Trump deciding to include it or exclude it from the tariffs and what they're doing is they're saying well actually if you look at if you look at the uh if you look at copper prices they have a certain behavior but if I look at the difference between two deliveries two contracts Suddenly sometimes you get a dislocation uh and they behave differently precisely because you know one contract is before tariff one contract is you know is after tariff. So um so the real there's a there's a there's a very transient risk factor which you can get take advantage of it. Okay. Uh, and I really like the paper and I think the there are a couple of really good p points they make about um about this and I think it's actually interesting what they do because it's actually quite different to what traditional European CTAs are doing. So um full kudos for them. So the first the first point that I really like about that that paper is the general observation that they make which is that the front of the curve is generally the one which is more volatile in the commodity business world and it is the one which is more affected by macronuse flow. Okay. And we see that we see that precisely like the long the long-term um price of copper is going to be affected by long-term supply and demand and it's going to um and it's going to be less affected by local news because you know the tariff coming on the tariff coming off is at the end of the day a very local a very sort of locally temporally it's a very local local news story. Okay. So that affects the front of the curve and um and therefore you therefore that's why you see this dislocation um and that's something that we see in not just in copper we see that across the across the across the the commodities in general. What we see is that when we have a um when other players come onto the markets they tend to congregate where the the liquidity is and the front of the curve is where the liquidity is. So everybody congregates in the same place where everybody else is trading which is good for them and that allows a lot of volume to be traded and we see that in terms of increase in volumes in the in the front contract. Okay. Um the second the second point that um they make in the paper which is that spreads exhibit strong breakouts and reversals and I like I like the what they say about breakouts because the um when spreads actually break do break out it's actually quite violent and I think um I think it's an observation that I would like to add it's about risk management and uh about allocation of risk right so normally in if you were to look at traditional CTAs then they allocate to each of the individual markets and that allocation is relatively static over time. So you will expect suppose if I were to allocate to outright copper trading I will allocate maybe 2% of my portfolio to that to that market and I will expect copper to provide me with 2% of volatility um day in day out. a little bit less when there's less trend, a little bit more when there is more trend. Um, but overall sort of a 2% sort of over over a long period of history. What we when we look at spreads, you can't do that. Okay? And for for a couple of reasons. The first one is that they do mention in the paper which is well that specific spread is going to disappear when the front contract actually expires and there is a delivery. this particular object which is the spread between you know the the August and September contract that that just doesn't exist anymore in the market. Uh but more importantly although it has existed maybe for the last few years the volatility is itself is actually very volatile. You will have a period where this spread is doing nothing. And if you try to make this spread provide you with that risk you will have to leverage your position to such an extent that when a dislocation does happen you will be out of business. Okay. you cannot allocate to um to the spread on an ongoing continuous basis um hoping you know hoping I'm going to make money because when there is a dislocation uh like the Trump trade this is going to be very violent for you it's very left skew so what you have to do is to understand that you have to wait until actually a dislocation happens you can't get into the trade first you have to wait until spread can actually provide you with the minimum level of liquidity a little of minimum level of risk because there's a certain volatility and then you can start trading it and it's sizing the position at that point is actually possible um and I'm a big fan of this approach I have to say um because um it's dynamic you don't know that this is going to happen you know and indeed if the Trump hasn't made a comment about about tariffs then maybe it wouldn't have happened okay but when it does happen being able to have the framework to allocate that risk factor um is really nice and a lot of a lot of CTAs, a lot of streamlined CTAs which don't trade spreads or just haven't attacked this problem properly. um and being able to allocate meaningful risk to risk factors that um rise and they are transient by nature is something which I think is quite important um and in terms of providing divers diversification because when it does happen it is actually trading something very concrete which is very uncorrelated to the rest of our portfolio. Um so that's one of the reasons why I really like this um one of the reasons I like these papers. anything you want to add on this one? >> Um, just to get I mean to set the stage. So, we're talking here about uh spread trading more from a a trend perspective, a breakout perspective. Isn't that correct? >> Yes, absolutely. So, >> yeah, I mean because obviously a lot of managers trade spreads more from I suppose for the spread to revert to more mean reversion I guess. Wouldn't that be fair to say? >> That is absolutely that's absolutely correct. So there's there's a relative value and and if you like to think the carry system >> is is very much the traditional long-term I think about um about the difference between two if I think about the difference between two spreads um it embeds a certain amount of sort of uh cost of carry yes >> okay uh some s some convenience yield and that thing over a long period of time they tend to merge right so um if you ask if you ask me What's the difference between uh 5year delivery and 5 year and two months delivery? Right? There isn't really a good reason for that. The only reason for that is essentially a cost of capital because there is going to be some interest rate differential. There's going to be some um some storage cost and so forth. Okay? So um so the the play for the convergence of these two things is is normally the carriage rate and it's a kind of a nice and slow process. But then what you have is you have these dislocations which are to do with the two contracts behaving differently because they become not exactly substitutable. Okay. So normally in if there if the two objects are funible then you will expect them to converge. But in a case where for example this year um there's a good supply of corn but there is a drought or there is a disease and suddenly we have a supply shock. That supply shock will hit you at sort of next year's crop. Okay. Okay. >> So then what you have is you have a real reason for that divergence between those spreads and that will create a a trend. It will be a short short uh time trend. It's not going to be a very fast moving thing. Um but it's going to be but that that's kind of what's going to drive that dynamics of that particular spread. Um in crack spread. So suppose you have a a spread between the oil uh sort of the the raw oil and you have the distillates the things that you get to distill and you like heating oil and uh jet fuel and all of these things and what you have sometimes you have say a breakdown in the sort of the um the processing of that of that oil. So if there is a Gulf of Mexico, most of the most of the work is done in stealing um oil is done in the Gulf of Mexico. Suppose there is a storm there or there is unscheduled stoppage in those refineries, right? So suddenly suddenly what you have is you have uh that spread will start trending. >> Okay. To to to match that and those risk factors are generally transient but they are very exciting, right? and they are diversifying because that's, you know, that refinery closing down in the Gulf of Mexico is nothing to do with maybe the overall long-term behavior of oil. So, so that's that's that's what they're doing. But yes, it's it's it's actually very tricky and it requires some care and it's interesting that they use breakout rather than using sort of a smooth trading because you actually are looking for a breakout as an indication of something something fundamental happening there. Yeah. >> Um yeah, I think you're correct. >> It is interesting that they are uncorrelated with the underlying. I mean because as you mentioned there the front of the curve is more volatile, more influenced by macro factors. So you would have thought that those macro factors are driving the the front month or the near month future wherever you got your main trend position. >> Yeah. So you would have thought they would be more correlated possibly if the if if that tends to be the driver. But but that doesn't I mean I think they show that or they mention that in in the paper. Isn't that right? So, so we have to be cognizant about what's going on. So, the the underlying two contracts will most of the volatility in the underlying two contracts will be very much correlated to general trends, macro trends or uh uh or trends in copper. Okay. But what they're looking for is like the residual volatility, the the difference in movement between the two. Okay. And that's important in terms of sizing. So normally there will be a 90 98% correlation say and there will be very little volatility in that spread. Okay, which means actually if you want to have meaningful allocation for it in your portfolio, you would have to take 50x position to get it to right. And that's and that's insane. It's it's a little bit like LTCM. LTCM was betting on the on the run and off the run yield curves. So these are two US yield curves, right? two different types of bonds to converge right normally they behave completely the same okay so the correlation is 98%. So they in order to get exposure to that difference, that tiny difference, that 2% of residual volatility, LTCM bumped up the risk profile by you know 50x 100x and then of course when those spreads we refuse to converge or refuse to do what you kind of expect mathematically to do then it becomes very expensive. What you need to do is you need to wait until there isn't a structural break news tariff refineries whatever okay at that point that spread becomes more volatile so instead of saying being 2% of the overall volatility becomes 10% of the volatility and now it's interesting it's a it's actually a valid risk factor that you can trade with not too much leverage okay and um and so that's the one thing which is good about it and the second thing which is good about it is that a lot of the time the reason why there is a breakout is because there is an underlying risk factor which is transient but it is happening right now. Okay. And therefore there is going to be a trend. Um we see that in in the FX market in currency basis. So a currency basis is the difference between uh funding funding in local currency versus the US. And sometimes there is there is just a transient pressure. Maybe maybe what we have is a company issues bonds in a in a in a in a US dollar and it wants to bring it into the local market and that brings a certain funding um uh a certain funding pressure and you see that basis trade moving and then you can you can trend that as well right but you have to be very careful because you have to appreciate that risk management is key here the ability to say I'm going to wait until there is a sufficient risk to start trading it um and then I'm going to get out of this when when there isn't enough volatility. >> A couple of thoughts I had. One is, you know, obviously we have the kind of uh justification or the rationale for why trend following works on on on markets in general, you know, in terms of behavioral biases, etc. H and then does that still apply to spreads? And then and then the second question is do you then get into the whole realm of of synthetic markets and you know trading all manner of different crosses to create these multiple spreads which obviously some CTAs do as well or where do you draw the line or what are your thoughts on all of that? >> So so that's that's that's very interesting. So generally uh trend is very prevalent in in all areas but I think you're right in terms of uh relative value trades are called relative value because uh it's value rather than trend. So making money out of spreads is more difficult. Um and I think that takes us to synthetic or just factor trending. Okay that that takes us into that into that universe. And um let's let's let's look it in the normal CTA universe and I if you break the the factors that you that you look at. So suppose I'm looking at uh all interest rate markets all all bond markets um and I and I do a PCA on it and I look at what what's what's the trend behavior um that you see and and what we see is as follows. um you see the the front the the main dominant um factor um is it trends generally very well okay because that's exactly what we we kind of want and in fact what we see is that maybe the first 25% of of PCA factors trend very well sort of then then we have like a 50% of the remaining uh PCA factors and they do trend okay so although they might look to you like a spread between you know Japanese and US rates they there there will be a trend behavior because there is an underlying macro behavior okay they are less uh they may be less dominant okay but they they they have a sort of a low level to trend but what is interesting about them is that the volatility available on them is it's a much smaller risk factor right so the first PCA covers about 70% of your money of like the first the top quartiles covers a lot of the risk so there's a lot of risk but it's very diversifying and it still trends quite nicely and then you get to the very very bottom of your PCA factors which are very pure RV trades and they tend to actually move in the opposite direction. So they will tend to be uh actually very strongly mean reverting. So um so there there are ways there are ways you can actually incorporate that into your um in your trading strategy in a way that um that sort of allows you to essentially get rid of those um of those small factors maybe. Okay. Or maybe you want to upweight the middle factors because although they are they are they they trend less but they are still uh they trend they still trend well and they still provide you with with some volatility. So um you just have to pick you we we're just trying to create a system which harvest alpha in in all sort of factors. Um but you have to be you just have to be aware about what's happening >> and presumably in terms of speed if these are transient risk factors as you say the the spread will diminish over time you have to trade them faster presumably than you would on a pure and following basis. >> So fast but not as fast as you think you you kind of uh you to be. So that's that's that's interesting and because otherwise uh cost so we have to think we have to think also about costs. So um when we look at the outright if I'm trading the outright there's going to be a certain cost in sharper basis stuff. So maybe three two or three basis points of sharp okay so 002 of sharp that I'm giving up in trading the underlying and as you say I can trade it slowly because slow trend is actually very dominant and that will be even less expensive if I'm trading spread and I have um I have couple of considerations. The first one is that I have to trade a lot of contracts in both directions, right? In order to be able to get the risk that I want. So like the notional amount that I trade is higher and therefore my trading cost will be higher. So like per turnover the spread will be more expensive than trading outright. Okay? And then of course you're saying well and only fast trend if only fast trend is making money at that point it's actually becoming economically unviable right now there are ways you can still incorporate it into your main system in a way that I think I suspect um the two more researchers are doing is even if you think it's not it's too expensive to trade um it can feed into the process of which contract you want to trade. Okay. So for example, if there is a spread which says okay right now the back of the curve looks cheap while the front of the curve looks dear. If you if momentum wants to buy something then maybe you should buy the back. You shouldn't buy the front. Okay. So although the the relative the the contribution is not going to be as great as like trading, you know, going full gang ho and trading the spread, it can still have uh incremental benefit to your overall trading by allowing you to sort of choose where which point on the curve. And I think that's very interesting because when you think about what's happening um that's related to the to the comment in terms of the the front of the curve is more shocky. it's more exposed to macro um sort of the macro trends which are actually more to do with what's happening with the S&P and the and the US Treasury whereas the back of the curve is more affected by supply and demand. So you you like so generally uh you would tend to um to move slightly further out of the curve. Um and I think one of the things that they failed to mention which I think is quite which I think it's not failed it's a very short piece so I'm not going to begrudge them that um but uh it's to do with who is actually trading. Okay. So um as we said when you know if you were to look 5 10 years ago there were very few shops even multi strategies that were looking at trading copper but these days everybody is trading copper and as a result the copper has become sort of more speculative in nature right if I look at who's trading the front curve in in copper it's it's a lot of CTAs a lot of multistrats a lot of speculators not necessarily the people who are actually hedging and producing and buying copper for production. And we see that in terms of the ratio between there are multiples way of seeing it. First one is to look at it in terms of the um the volume and the open interest, right? the open interest when the the open interest when the contract closes is the what remains like who is actually wanting to um to get exposure to the to the copper contract. Okay. So we can compare like the volume during the the trading versus what who actually wanted to take that position or we can look at the cot report the commitment of traders reports by the US and see which ones are the speculators which ones are the the uh the heders. um and you see the front of the curve becoming more dominant by the speculators. So that in that universe if you were to move you know a year out in copper I'm not sure you can actually move a year out it's quite a uh but I suppose we can move a couple of contracts out then the people who are doing that are the people who actually want to take um are actually more the the the hedges and producers and they tend to trade more slowly so there's less volume there is more open interest and that's the difference between taking between the stock between position and volume between stock and flow So the back of the curve has got so the the curves do have different dynamics. Um and when you're doing when you're doing trend following these different uh physical characteristic of the contract actually will feed in into your trading system >> and just to your point a bit like the front being more speculative activity I mean does that suggest you know that that it's more zero sum than trading in that sphere? Obviously, you know, if it's all specs, they're just profling from each other, which, you know, some winners, some losers. >> Well, the the the the efficient market hypothesis applies everywhere, right? But it's it's it's more about what is the fundamental reason for things trading. >> But if there's a lot of hedggers in a market, then there and they're risk averse, then in theory there's a >> there is a premium a risk. >> There's something to Yeah. for spec to to capitalize on. Yeah. >> Yeah. Absolutely. So, yes. So I I I I would say that that that is the issue. I think actually I'm going to say um something about the loading on trend at this point. Actually a lot of a lot of uh we're having a lot of discussion with clients and uh some an argument which comes up quite often is to say oh uh trend is at capacity. The reason why why the trend hasn't performed in the last year is because there's just too much money in trend. Um and what is interesting is okay the the I think the the most famous paper is there was a recent paper by man um which Russell um talks about oh uh the size of the AUM of the of the AUM of the industry is has been constant at 300 billion. Uh the industry has grown significantly which is true. Okay. So that means we are a small part of the market. Okay. Um the problem with this argument is that there is tons of trend being done at other places where you don't see it. Uh then in QIS you see there's tons of trend inside inside the multistrat if you were going into you know millennium QT any of the big any of the big shops there there will be pods inside that there will be trading trend I can I can guarantee you that is happening. Um so um so taking a global uh bird's eye view of what's happening is is not actually necessarily uh informative but what is what is informative is that we can actually look at um the speculators and the hedgers in the court record and we can fit the behavior to different trading strategies. So what we see we we you know I'm not doing it's not a prediction it's much more des a descriptive uh a descriptive view he says I'm looking at the behavior of the the speculators over the last couple of weeks does that load on trend like if we if we if the industry was overly trend reliant then what you would see is you would see a good correlation yeah a beta between the speculators positioning in the cult report to your signal And we can fit that. >> Um and what we find what we find is that we can actually detect a few things that are very interesting. So if you look historically um you can see that the industry the speculators have become very sensitive to volatility. So the loading on changes in volatility i.e. if volatility goes up the it goes the speculators uh proportion goes down. Um that has become that is now it's quite a dominant it's quite a dominant effect. So that's the first thing we see the reduction in loading on on fast trend. So if you go historically and you go back to sort of the early 2000s um you see that um fast trend was changes in fast trend explain changes in uh speculators uh positioning um that has gone down over the years and that actually reflects and it's quite nice it's quite reassuring that we see this because that actually reflects the reality that we know if I look at the sock gen uh CTA index if I look at the way that the CTAs have moved. They've migrated to trading slowly um and loading less on on on fast trend. What we don't see is we don't see like suddenly a huge rise or in fact any rise whatsoever in terms of the loading on on slow trend or mid-frequency trend in the data. So um basically the industry is is uh actually being very careful not to take too much risk in any particular contract and then that capacity argument just like the data just doesn't bear it right we just don't see this we just where we can see this data the that argument just is not there so I don't like people the clients are always asking me what is causing this issue why do we why did why didn't we see trend performing in the last that we can have a long discussion about that. But in terms of the loading on like are we are we just too big in the market. Um no we're not uh in in just from the that data just doesn't bury down. Well, that's maybe a good segue into the second topic um which is a paper which gives a lot of really interesting um granular data on different market participants and their exposures in the FX markets and that's a recent paper from the Bank of England um which is really monumental uh uh paper in terms of the the data they have put together. Do do you want to give some context and and an overview of this one? >> Yes, absolutely. So um so if you look at um FX FX data so first of all a little bit about the the FX market um by size in terms of volume of trading uh probably the biggest like easily dwarfing um easily dwarfing the the equity market say so if I look at um the BAS trianual survey from 2022 um the amount of daily trading in FX is something like 7.5 trillion okay that's just like insane Okay. So, it's a huge market and there are lots of there are lots of players in it. Of course, anything from the retail people buying uh wanting to buy uh uh some some dollars to go on holiday in the US uh to Tesco which is sort of the non-financial corporations that they uh they want to hedge. They have assets abroad. They have income from abroad. um Tesco less so but you know companies that export they might have they might have an overseas operation and they will hedge their position into into the local currency um and then all the way to our hedge funds and our sort of uh our investors so there will be asset managers who are in this market so you like everybody's playing the FX game okay and 7.5 trillion per day it's just an insanely big market >> and um there are few data sets for that in terms of understanding the positioning there's uh CLS is one of the biggest providers they do settlement FX settlements and they offer some data which is very anonymized but now we're going we've just hit the mother load so this this paper is just insanely amazing in terms of data so okay so this is called the paper is called topography of FX derivative market and it's a view from London and it's a it's a it's a collaboration of a few people from the bank of England a guy called Daniel Austri, a few people from uh a few people from the Fed, there's a guy called Cinnam with I can't say his surname, so you'll have to excuse with me. Uh and and it's a collaboration of of a few central banks and a few researchers. Um and they have data which is non anonymized. They have 100 million transactions, millions of transactions in the London FX markets from 2015 to 2020. And it's non anonymized. So it's the advantage of being the regulator. you can see everything absolutely at daily firm level uh positioning um and that that's that's and that's just amazing right and that allows you to do things that you wouldn't be able to do otherwise um and what I love about this paper first and foremost is that they don't try to predict cross-sectional FX returns they don't try to many a times you will see academic papers in you know in our finance industry and the researcher rushes into okay here's an effect here is some here's some data that I have let's see if I can use it to predict cross-sectional equity returns I mean it's just like hundreds and hundreds of papers thousands of papers which are trying to do that okay and what I love about this paper is that it in in some sense it says okay I'm not I'm just going to let the data speak for itself I'm just going to look at the data I'm going to do very little adjustment of few things that we actually have to adjust to to um sort of to correct the way the data is reported um or to understand what is happening. But I'm not going to try and make any prediction. I'm just going to describe the structure of the market. And I find it extremely informative. Um and I think um a lot of quans again rush into here's a trading strategy. Sit back just just look at the data. Let it tell you a story. And when the story is done, I mean you can you can probably guess you know there's a there's the there's a paper there's a famous paper just which went out in March the virtue of complexity uh which basically says you know I'm good to sh I'm going to make it over complicated. You can probably tell which in which camp I lie um I think before we start before we start uh doing anything with the data it behooves us as corns rather than just shoving it into a machine to really understand what's going on. and this paper really does it beautifully. >> So um there are few there are a few observations actually let's start with the with the appendix because that's the one that relates pretty much to our earlier discussion. So if you go back to if you go if you go to the appendix there is a um there's a beautiful description about where do each player which each type of player in the market which derivative contract they trade. So the the paper does is not looking at spot. It looking at at FX derivatives and FX derivatives can be anything from one day like tomorrow next or spot next. So it can be either one day all the way to maybe two three years. Okay. So we're moving from um FX forwards to FX swaps further out of the curve. And what you see is exactly the same phenomenon that we just described in terms of the um the habitat of different players habit like sitting in different parts of the curves. So um the market makers the ones that try to hold um they try to hold most of the risk in the very front. So if you look at the if you look at the the chart distribution of their positioning most of it is up to one one week uh expiry right and and that's the most liquid part. That's the part that's the part that they use to hedge their risk. And then you move to the hedge funds of the universe and the asset managers. And you move further out and you move to sort of the one to three month maturity. This is not a huge surprise. And this is how we would do that. And I think most most ces will be trading the next IMM expiry the the sort of the uh every three months sort of the March, June, September and December uh Wednesday the third Wednesday of the month expiry. Um and this is where the sort of the hedge funds congregate with their uh with their um liquidity. And then what's happening to the back of the curve? Who is holding the two or three uh uh FX swaps? These are real people. These are the non-financial corporations, the you know the the companies that have exposure. They have a genuine long-term USD cash flows and they need to bring those backs into the local currency. This is all taken from the London market. So this is all uh so the the local currency is is GBP or some or euro before the before the Brexit happened. And what we see is that they they inhabit that habitat. The two and three years out, these are by the the hedggers, the people who actually genuinely use it. And I think a lot of the risk is basically rolling that swap every, you know, that's what their activities. They just want to make sure that they hedge their cash flows. Um, and they don't have the risk. Um, yeah. So, it's it's very interesting. So, that's that's one amazing amazing part of this of this paper. Uh, but there are plenty of other stuff. >> Yeah. as you say, I mean the it is it must be the first of its kind in terms of this level of detail that we see. Um a few things that were were were interesting. Um as you say the kind of the time horizon that that that different segments hold their positions or primarily trade is interesting. And then they also do show the um the net exposure by the different segments over time. Um which is interesting as well which um obviously as you'd expect the the hedge funds uh specs their net exposures to the dollar euro and sterling fluctuate a lot. Um but one that was interesting was I think um that the the market makers or the dealers obviously like tended to hold the opposite risk to to to the hedgers. Did you notice that? >> So so that's a little bit um that's correct and a little bit misleading in a way. So what what you have um is one side of the picture. So what what you there are two types of people. There's the market makers and the dealers. You will see that the market makers have relatively little risk overall. And these are the ones who really trading like uh dural bunnies. They are they are buying and selling and they really adjusting the the their prices to ensure that they don't have net risk. But what you have is you also have dealers that will be taking the risk the dollar risk. So oh so there's a structural short dollar for UK corporates right because they have they hedge their dollars back to the UK. They are long GBP, short US dollar. And the dealers on on our data set will look like they will be the opposite. They will be long US dollar and short GBP. But what we don't see is we don't see the positioning in the other side of the uh of the Atlantic which is what the position of the dealers against US corporates. So the US corporates will have the exactly the opposite position um which is you know they will be all short all other currencies uh GBP amongst them and they will be long USD and the dealers will be providing that. So the dealers are sort of a more a slower netting. They will provide a slower netting of this of this universe. And I think what you get overall is that the um and and the reason why I'm saying they are able they they will hold less risk is because they can't hold a lot of risk. Right. So these days >> but I thought this was the net their net exposure. >> I may be incorrect but I I'll need to check. But I >> we'll have to check. Yeah. >> No, no, no. But but the the the the problem that we dealer banks in the US is that you can't actually you can't hold on your book too much risk these days. Right? So the one of the outcomes of of uh the great the GFC and the great financial crisis is that the amount of risk which is available on the market that you are you are able to hold is actually not not not that great. And we see that in bonds, we see that in in credits, we see that we see that everywhere. So um uh I suspect a lot of that risk is actually transferred through to through US corporates. >> The others are as you would kind of expect really I mean obviously you know um non-financial corpse obviously holding the kind of exposures that you would expect uh from a hedging perspective. So you know um short effectively short dollars I guess selling their dollars generally from their positions overseas outside of the positioning and anything else stand out that >> yeah so >> that that might have an obvious takeaway for you >> so so um there is one which is ve very much related to trend and and carry but but be before we get to that I actually um um there's a little bit about the the market structure and that's that's very that's very interesting. thing because uh and that was a huge surprise for me. Um so with a market that big and you um you kind of expect to see um a lot of players in in the center. So there there are a lot of disperate players. But what is interesting is how concentrated the it is like a star-shaped domain. There is the center which is the which is providing the liquidity. But what what is insane is that like the top five dealer and the top five market makers really dominate the everything. Okay. Uh and it wasn't used to be like that. I mean if um uh when I was uh 20 years ago and we were looking at the EBS EBS data which is the interbank um netting sort of FX FX trading FX trading application. um a lot of banks were involved in the game and yeah um and uh and I suspect there's still local currency and there is going to be a local effect so you know so there will be a a Swedish bank dealing with Swedish corona but by and large the these days there is the the real trading is basically channeled through very few counterparties um and that's an interesting and potentially a cause for concern the interesting thing is that this is actually very different to the to the structure in the FX spot market. So if you look at the so this is all the derivatives and if you look at the FX spot market the emergence of players like the the non-bank um market makers so like the XTX and the J Street of the of the universe. Um, so there's there's it's actually a very interesting it's a very interesting uh different difference between the the forward and the swaps and the spot market. Um, so but but structurally that's very interesting to me. Um, and I don't I'm not I'm not sure exactly what the implication is, but this was like really important. >> I think I mean I think there's a lot of uh data in this one. It's definitely worth having a look at. I mean I think uh I'm sure some more observations will come from from further review. But I wanted to move on to something conscious of time. You you've you published a blog recently which I wanted to touch on which is around you know asset allocation. So it's obviously Topco given what we talked about a little bit earlier with with Black Rockck suggesting increasing hedge fund allocations and elsewhere I saw Vanguard kind of going against the tide a little bit by suggesting they're suggesting 7030 is the optimal for the next decades. Let me tell you a little bit about my blog and a little bit about Vanguard and actually so I don't I don't know that much about um I didn't know much about and I still don't know much about the way that allocators are allocating. Okay. And we normally when we go to an allocator we say oh give us some money um you know we are trend following we are uncorrelated to everybody else. You just give us some money you put us aside and so forth. And um and I talked to um to uh an allocator and I asked him you know how do you take into account the fact that the positioning might change and suddenly all of your allocations are long equity and suddenly you have a lot of risk in equity and and again his his reply was well we actually do try to figure out the the beta let's say the equity beta on each of the uh data sets and we fit the the P&L of each of uh the people that we allocate to and that gives us an idea about what the positioning is like. Um, and this is kind of how we do uh it's quite messy, but this is how we do um which we try to find out the bit of of the equity that we have right now with this hedge fund positioning. Um, and we exclude you guys, we exclude CTAs because you guys change, you change your mind too too often and like we we can't really tell you, we can't tell uh retrofit what your what your positioning is, which I think actually shows you how uncorrelated we are to other asset classes because it's like you can't do the fit. We are zero correlation. It's very difficult to fit what our positioning is. And that started think me thinking about what the process of uh an allocator to allocate is. Um and I felt hang on a second right what they do is they go through a process the first things they do say they make a capital market assumption they make an assumption or in the Vanguard paper that you mentioned sort of VMA sort of time varying asset allocation model um what you do is you say what do I think long term in the next 10 years what's going to be happening to equities what do I think what is the annual growth I expect in bonds what's the income that I'm expecting from commodities is um there's some there's some correlation matrix assumptions and I'm going to make and based on that I'm expecting some long-term based on long-term growth I'm going to have um I'm going to the allocation I'm just going to create an allocation matrix and that's actually probably one of the most important decisions that you have to make about you know what's the proportion between equities and bonds and not surprisingly it's going to be related to how much long-term how much value you you expect to extract from equities and bonds in over a 10 year horizon and I thought to myself hang on a second within this process when you do this optimization and you do this correlation matrix and you do this optimization then there is a gradient right so the idea is if you think that equities are going to go a little bit further up then actually should allocate a little bit more so there's a delta to your assumption right so whatever allocation that you've decided on you kind of think um uh there is a delta to your your assumptions both in bonds and equities and so forth and and I thought the delta was positive right so you if you think you might want to say if you think that equities have gone up you might think that they will go up more so I wrote this piece and I wrote this piece about CPAs but actually I think it is more about the the role of systematic strategies so systematic strategies you know risk parity relative value, trend following. There will be funds that do that do that and you kind of know what they're going to do that it will be a mechanical adjustment of the data and I thought I wrote it about CTA because of course we trade CTAs. Um and of course the feedback I got was you got it completely wrong. What you got is you got it completely wrong. The in actual fact most most of these models are mean reverting by nature i.e. If equities go up, they will actually underweight equity. They will say long-term I will drop the my expectations about what's what's going to happen to equity and as a result they will I will deallocate from equity. Now interestingly enough that's actually coming back to the positioning. This is exactly those those long-term investors are the ones that take the opposite side. We talk about positioning. These are the ones who take the opposite side to trend in the market. Um and in fact the paper the Vanguard paper is exactly what that you sent me and I thought oh my god yes this is I'm going to have to own up to this one. Um what what they are what they're saying is in June equities went up tons. Okay so they went up 10 11%. So they so in July they came up with a paper and said oh actually now we are adjusting half of like if you think about that 10% equities have done their 10% rise. We thought they were going to go up four and a half% over 10 years. Now that 10% is gone, right? So I think we're left with three and a half percent. Actually, they only cut 50% of it. So we we they cut the expect long-term expectation to to equity by half a percent based on actually very short-term change in equities. Okay. Um and as a result of that they will you basically underallocate um you want to underallocate to equities and they came up with a very bold number to be honest. They they go for 30% um 30% in equities and 70% in bonds. Okay. Notice no hedge funds here. >> Yeah. I mean I think it's just between the two assets that that absolutely this model. Yeah. >> But I mean I guess the benchmark is probably 6040 equity. So it's it's I mean I think as you say it reflects more the equity valuation more than the view and landing else. I think that's just >> no absolutely and and it makes sense and and and I've had a chat with my my allocator >> uh and he said yeah yeah but wo on to those models right we kind of don't like them because they they have been negative equity for years. Okay. Yes. Right. Yeah. >> So, so uh it's like you know it's it's the naysayer that you know one day they will they will pay they will make money right long-term PE Sheila ratio all of these all of these uh all of these very long-term 10-year horizon things um uh all of these are uh maybe make sense if you're investing for 100 years um but like suppose you took the like after the equity uh rise you then decided to go and sell your equity um you wouldn't have done particularly well. I mean at the end of June I think the S&P was at 6 six 6.3K and now it's no it was 6.2 and now it's in 6.4. So equity has been has been uh has been rising quite happily regardless of what Vanguard is saying. Okay. And I think that is that comes into the role of trend not necessarily as a long-term but as a tactical as a long-term right but as a tactical way of you phasing in that long-term view right we talked about the way spreads which spreads I'm I favor right now as a way of phasing of of improving your trend we can think about the way trend improves the long-term allocation model right so we took we take from the perspective of the vanguards of the universe trend is one of those very funny very fastm moving object okay but we can we can use that signal if you're allocating to to CTAs to say oh okay right now I want to deallocate from from equities but you know trend is really strong right I don't really want to allocate right now I'm going to wait maybe by the end of the year trend will reverse now I've naturally deallocated from equity the way I kind of feel about it. So um so but so I think the the although the premise that I had in my mind that the the delta of uh long-term allocators is positive is completely false. Okay. Um nevertheless the I think the principle of what I'm suggesting is correct which is that the um systematic strategies or rule-based uh strategies you want them in your portfolio because they will if you include them inside your allocation process the optimization process that you're doing you will be able to create an optimal allocation over a much wider set of parameters. So you know in your mind what would be your allocation if your assumption is three and a half for equity in the long term or 4% in equity or three in equity. You should pick a collection of systematic rules of trading which is actually available in the market to allow you to essentially automatically autocorrect how depending on how your assumptions changes. >> So um so that that >> I mean is it's kind of like the role the allocation to CTA should be upgraded. Is that kind of what you're suggesting? I mean, I understand what your point is like. So, CTAs will modulate your overall equity exposure. So, if you have 50% equities and you have 20% CTA, you're going to pick up some more equity exposure in your CTA allocation and that exposure will fluctuate over time depending on the strength of the trend in the equity market. So in a strong bull market it'll go up and in a bare market it might go short and that has a a favorable portfolio impact. But as you say the way most people do asset allocation is they think about okay well here's I mean everybody produces capital market assumptions and then they feed that into some kind of optimizer or some kind of framework where they're thinking about what's the expected return from these asset classes and what's the >> yes >> volatilities and correlations. So, so that would determine some level of exposure for CTAs depending on how you know I mean you have to formulate a uh a return expectation. Um but are you suggesting that because of this additional role uh CTA should be higher because it does point to I mean this is something I've been thinking about you know this kind of framework was originally designed when you're combining different assets you know bonds equities property okay but now we got the we're adding strategies such as CTA which are trading some of the assets that you're diversifying so this is the point we're talking about here sometimes you're going to pick up more exposure sometimes But you I mean you're allocating to them for a risk factor. So how do you reconcile all of that? >> So so I think it is the the time horizon that we're talking about in this >> time. Absolutely. Absolutely. So so it it actually the entire right time horizon and habitat. Right. So if you think about the the those capital market assumptions these are about the 10ear horizon. >> Exactly. >> Right. and and in that horizon the natural fluctuation of equity. In fact, what you should do is you should like what we advise a lot of retail people and a lot of actually you know stick with those numbers have those allocations go and play golf right you know allocate for equity long-term don't be for for the long-term allocation which is what the CMA model is designed for which is looking at long-term growth right the the what's happening in the the the next three months is completely irrelevant from their perspective and you are just going to ride this out and you should go and play golf and just ignore Trump uh and you should ignore whatever COVID we should just go and and enjoy your positioning all the time and what what we are seeing as you say is that those active traders not just CTAs but multistrats and you know other macro hedge funds and so forth they are playing in a different time horizon than you they're playing at the three-month horizon that for you you know is almost invisible and it's very uncolored and that's the reason why over time they will be uncorrelated. So you you might be a situation that like right now you are long equity and the CTA is long equity or the hedge fund is you know this micro hedge fund is long equity but that risk is going to change so much and you know in a month's time they will be negative. So don't worry about it too much. you should the way you should think about you know in that that part of the the if you're thinking about in term of of alpha that alpha is almost distinct to what you are doing from an allocation perspective and that's why um it is a uncorrelated to what you're doing and b is very additive to your portfolio and I think that's kind of the way that a big allocator should think about that um and the actual positioning right now you would use it in terms of modulating things some small changes in your long-term allocation. So like the trading that you would do from your CMA, you kind of want to modulate it by by trend but and or systematic strategies but uh but in terms of alpha, you just think of it as almost an independent play. >> Yeah. Yeah. Well, it's true because that's effectively what the CTA allocation is doing for you. It is uh tactically adjusting your portfolio while as you say, you're you're gone playing golf. It's uh increasing your exposure to equities if they're trending higher and reducing it if it's trending lower. >> Yes, absolutely. Um so I mean to be honest it was an it was an an experimental thought process. I don't think anybody um I I don't expect the allocators or the consultants who are running those CMA I don't think Morgan Install or Vanguard will all sort of shift to my methodology. I'll be very surprised. Right. But but I think it's it's important to understand like the tools of the trade that you have at your disposable at disposal if you're an allocator. And you know we normally think of of trend as as like outside that that universe that you're living in. But you actually might want to consider in embedding it in in into your process. Not just actually not just CTAs but a lot of the systematic systemat and and you know we do embed some systematic process. So for example, you will manage your FX exposure, right? A lot of the if you are uh an Australian allocator and you you have uh structural um structural FX exposure in the USD then you would want to hedge a lot of that risk and you will manage it in a systematic fashion. Okay. So, so some systematic strategies like FX hedging are part of the way that you embed are embedded into your process. Okay. And uh there's a great paper by van Hemtt um about the best ways to hedge FX exposure. So there's a there's a really nice paper um I'll can send you later um about doing this as an allocator. How do you embed a systematic strategy? And you know, FX edging is like the simplest one, but already there is a lot of stuff that you can do with it. Um, and CTA is just another tool of a trade that you might want to think about embedding into your crowds. >> Yeah. Very good. And what's the name of your LinkedIn blog on that one? It's >> uh what's cooking this one? Yeah. >> Very good. Good. So far, we we've gone we've gone over a bit on time, but uh that's all good. Um, so Neils will be back next week. Um, I'm not sure who's with them, but send in your questions for for Neil's. Um, great to have Yo on this week. Thanks very much, Yo. Um, and for all of us here, from all of us here on Top Traders Unplugged. Thanks for tuning in, and we'll be back next week uh with more content. >> Thanks for listening to Top Traders Unplugged. 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