Liquidity, Leverage, and the End of Safety | Systematic Investor | Ep.369

Summary

• Safe Assets Redefined: The podcast discusses the evolving perception of what constitutes a "safe asset," highlighting the changing role of US Treasuries and the increasing importance of gold as central banks diversify their reserves.
• Gold Market Dynamics: Gold's recent price surge is examined, with insights into its role as a safe asset, its liquidity, and the structural changes in the market, including central bank buying and the financialization of gold through ETFs.
• Monetary Policy Uncertainty: The discussion touches on the Federal Reserve's potential shift in operating targets from the Fed funds rate to alternatives like triparty repo, reflecting structural changes in money markets and the implications for market participants.
• Retail Investor Impact: The influence of retail investors on market dynamics is explored, particularly through increased trading volumes in short-dated options and ETFs, raising questions about market noise and pricing behavior.
• Inelastic Market Hypothesis: The podcast delves into the concept of inelastic markets, where flows and the composition of market participants can significantly impact prices, challenging the notion of market efficiency.
• Trend Following Strategies: The discussion highlights the ongoing debate over the optimal number of markets for CTAs to trade, with recent research suggesting that alternative markets have become less profitable, emphasizing the importance of managing market impact.
• Complex Adaptive Systems: The potential for improving trend following strategies by considering the interconnectedness of markets is discussed, suggesting that understanding causal relationships and market networks could provide a competitive edge.

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. Welcome or welcome back to this week's edition of the systematic investor series with Mark Ramsinski and I Neils Castro Larsson where each week we take the pulse of the global market through the lens of a rules-based investor. Mark, it is fantastic to be back with you this week. I it feels like it's been a while. Um can't remember when we last spoke, but uh how are you doing? I'm doing well. It's fall foliage season up here in New England and uh trees are turning color. It's a bright blue sky, so it's it's a it's going to be a great day today. >> And I'm talking with you. >> Yeah. >> Oh, that's very kind of you to say. Um I I I've heard I've never been to New England at the time this time of year, but I've heard that it is really spectacular the way uh the uh the leaves turn and and and with all the woods you have around you. >> Yes, it's a great time to be up in New England. >> Good. Well, it's a great time to be listening to podcast because you have provided a solid lineup of topics. It's not that it's not that the world is not giving us anything to talk about, I have to say at the moment. So, we'll be tackling those some of them quite big topics. Um, I think important ones really. Um, but before we dive into the main topics and actually the next section might be a little bit that might be a little bit more meat on than what we usually do because uh I think you got some great points. um also lined up for this section. Um I'd love to hear what's kind of been on your radar. What are you finding interesting at the moment? And it could be quite a number of different things. Uh we don't have to just stick to one or two. Sure. There's two things that really uh have fascinated me right now. Uh one is just the uh uh issue of what is a safe asset because we usually think of that as US treasuries as our safe asset and I think that the sense of what is a safe asset is changing. Uh now what does that mean is is that in a crisis or if you need cash most investors would buy US treasuries. Okay. But in some sense there's no such thing as an absolute safe asset. It's all relative. And we'll sort of say that the relativity of what is safe is changing. A perfect example is is that look at French debt. Uh would you consider that a safe asset right now? >> Probably not. So uh if you look at uh UK debt, is that a safe asset? You know, because usually you think of sovereigns as safe. I don't know. We got a government shutdown in the US. We're, you know, reaching high levels of debt to GDP. Is the US a safe asset? Treasuries? It's not that's not clear either. And so, the reason why I'm studying this or why this is important is because we've also been thinking about gold. And uh we've reached $4,000 uh dollars an ounce in gold. You'll say, "Well, why is this gold going crazy?" You know, some would say, "Well, it's just a bubble." Uh, and they'll say, "Well, gold shouldn't be going up because inflation seems to be uh tamed relative to what it was two years ago." So, there's no rational explanation for why gold should be going higher. But then what you look at is is that uh what is the central banks doing with their reserves? They're actually buying up a lot of gold right now to increase their reserves in their in their foreign uh uh foreign currency reserves. So what they're doing is a diversifying uh out of some of the traditional safe assets and putting it into gold. And this is fundamentally different than what we saw in the 1990s where they were actually uh reducing all of their gold exposure. Now what that means is is that gold is acting like a safe asset. U now we know that safety empirically because we'll sort of say it's uncorrelated with risky assets and you know that does better in a crisis to some degree. Uh it also is a good inflation hedge. But more importantly is is that if you think that the traditional assets are less safe, then you're going to look for some other alternatives to diversify into. And that seems to be gold. It's very liquid. Uh it may have as much liquidity as the treasury at at times in the cash market. And so we'll see that relatively intelligent buyers, central banks are buying gold. And what we actually see that this speculative exposure in the commodity uh commitment of traders from large speculators their long positions have actually been declining over this period. So you can't sort of say that there's speculative excess from uh from large buyers. It actually is from other groups and I think it's a different perception of what uh what what role gold will serve in a portfolio. Can I pause you here and just maybe ask a few questions around that? Um when you go back to the say the 70s and you just look at a chart um and actually this was something I picked up um this morning from an article that uh the Wall Street Journal had um about gold. And um they have this long uh long-term chart of gold going back to the 70s. And there's clearly a couple of there are three periods where gold the gold price really rise significantly. One was sort of 1978 through 1980. Um then you had um and I it's not precise what I can see here but then you had the time um starting around the great financial crisis. Um so it may have started in 2007 probably lasted uh until I don't know 2011 thereabouts. I think prices continue to move higher and then of course we have now um again where gold prices are really moving higher. So, so my question to you is um is there anything that you can think of that are kind of the common ground between those three periods? I.e. is it just quote unquote uncertainty that drives prices of gold? Is it something else? Is it a weak dollar? um I haven't looked at the charts of the dollar whether what it did during these periods of time or is it something else because I think then that begs the question is this time different because both after the massive surge from around 600 all the way up to 3500 thereabouts back in uh in the 70s. um you know prices came down subsequently quite dramatically actually all the way down to um I think um 500 or something like that which is of course around the time when the central banks were selling gold interestingly enough and then it goes up again um we reach around 2500 2600 uh during the GFC then prices go down again um not as dramatically but pretty pretty meaningfully and then of course we have this big round up. So I I think a lot of investors are now thinking okay we have a great runup but if history is any guide um is this you know something that is just temporary and we might see a massive correction again in gold price. I'm just trying to tie these things in together to see whether you feel or think or or if there is something that makes this rally different from the other ones we've seen of this magnitude. I'll answer this in two ways. First, let's look at what is the relationship between fundamentals and gold. And a reality is that we find is is that you know you expect if real rates are higher gold price should should go down. Okay that works sometimes but not always. We expect that there's this is supposed to be an inflation hedge. It is sort of but then the link between when inflation occurs and when goes uh gold goes up is not a not that strong. So uh the link between uncertainty we find that if uncertainty goes up maybe look by the VIX or some uncertainty index you know gold will also go up but it's not always as strong as what we would like. So so it seems as though that the characteristics of what are the factors that drive gold is always at a state of flux. So now what does that mean for today? This is that it seems as though that there's a strong uh demand for for gold. Is this a bubble? Hard to say. You know, 20% move in in let's say last couple of weeks is seems truly abnormal. Uh should the price of gold come down later on or are we in a fundamentally different era? Uh you know that's that's harder uh harder to call. Now the reason why is because there are structural changes in the behavior of the gold market than what we saw prior. Okay. One is is that we have now the central bank uh buyers and central banks are are are are sort of not price sensitive. They're they're doing their actions for other reasons other than profit motive. Okay. So so so that's taking out a lot of gold. there are certain uh uh countries that want to hold gold because the safe asset US treasuries may not be safe if let's say that you're on the wrong side of geopolitical issues relative to the uh uh US or western governments. Okay. So if you're uh you know Russia, China, you know, some other countries, you want to buy gold because you certainly can't say, well, I'll put put some of my reserves in treasuries and keep them at the Federal Reserve uh Bank of New York. And then finally, we'll sort of say that there's been more of a a uh uh financialization of gold. What I mean by that is that it used to be that you could you could maybe hold gold cash, you know, in the actual bars, but that was really expensive. You had gold futures, but most investors were not able to buy gold. Now we have, you know, ETFs available in a number of different forms. Some are, you know, you actually have gold certificates as opposed to gold bars. But what you're finding out is it's a lot easier for people to use that. And if you buy it in ETF form, you know, you can use that as as collateral, which is key to being a safe asset. Also, the CME, for example, allows for gold to be held as collateral for margin. So, if more institutions allow for gold to be used as collateral for loans, then it has more characteristics to the safe assets. So there's a structural change to this market that's going on that impacts how people will use gold in the future. Yeah. No, I think that that's right. And I think that one of the topics that I think we'll come back to in a second that I find personally to be probably quite important in this respect and that's this whole thing about ETFs, right? You you and I are old enough in this industry to remember that when back in the '9s, for example, the way people uh reported on the um managed future CTA industry was this monthly printed magazine called M, managed account reports I think was the Yeah. And then I also remember and this was like it had a green color and it was you know something you look forward to and this is also where you could see the you know um performance tables they were not available on the internet you had to wait for them like two or three weeks after month end to get your the performance numbers of the uh competition but I don't know if you remember Mark but suddenly Lois Pel who were the editor um they started publishing a new magazine called ETF F exchange traded funds. And I just remember back then I thought, why are they doing that? Why are they spending time on this? You know, managed futures is much more important. And boy, was I wrong. I mean, the the whole ETF world is just incredible. And I think this is where I find it interesting because here's the other thing. So, let's talk about we talked about gold. It's up uh when I looked at the the the screen up 46% this year and you think, "Wow, that's great. That's really must be one of the best performers. Then you look at platinum up 77%. Palladium up 63%. Silver up 59%. Okay. Copper not bad. 22% up. So So my my question to you is, is this a gold story? Is this a metal story? Is this the quote unquote beginning of another commodity super cycle that we thought would have come or expert thought would have come a few times by now? Is you know is is that what's at play here or is it just uncertainty? People are not sure about their safe assets. How do you how do you think about that? Well, I think we're going to talk about this a little bit later when we talk about complex adaptive systems and connectedness and networks, but but in some senses is that this is a gold story, >> but gold cannot be viewed in isolation. You have to sort of say that it is connected with other stuff and in some sense you can sort of say that well you know if gold gets expensive and people view that it's that it's let's say higher than what they think is appropriate or fair value then they'll say well maybe I should look for a substitute well the substitute might be platinum palladium or silver so that there spillover effects in others is it's sort of let's say that you could have one is your core market and then you have satellites around the core that that get pulled along by the behavior of one. And this is constantly what we're seeing in a lot of different uh markets and that's the idea and that's fundamentally to the idea when you think about uh about a network of markets is is that there might be a shock or a driver in one market but there are spillover effects to others that they they get pulled along and so there's a a pull effect which is occurring in those. Now if those other markets are less liquid the pull effect could be much greater because there might be a for example industrial uses there's less volume of uh trading so flow will matter and so consequently that that you could have a bigger impact on some of these uh satellite markets relative to the core which is still gold. >> Yeah. No very true. Now the again I know we're going to be talking around these topics later on as well but just one thing before I forget it. Um you you you said there are questions about you know what is a safe asset and you talked about uh the importance of liquidity for example that the gold market has a lot of liquidity. Now, of course, this is a completely biased uh comment, but and and this is something we've talked uh about over the years uh on on the podcast, and that is uh you know, should we actually think differently? Should we start to think differently about what does this really mean in a sense that instead of safe assets, should we think about safe strategies? And does the safety of a strategy for example come from being adaptive instead of long only being diversified? So it's not just dependent on one outcome. Um being liquid instead of being tied up in just one thing as you mentioned government debt for example. Um I know it's a stretch because everybody can work out listening to this that oh that actually fits trend following. So, so I know it's completely biased, but I actually think there's some validity to it, um, that these strategies because of the way they're put together and what they consist of in many respect to me feels a lot safer than, as you said, French debt, UK debt, US debt for that matter, um, or something else uh, for that matter. um don't know if you want to talk about it now or >> Yeah. >> but I just wanted not to forget it. >> So there's some of the researchers who have worked on the issue of what is a safe asset, you know, come up with an analogy and they said that a safe asset is like a good friend. They're going to be there when you need them. Okay? So you can depend on them. So let me put this way. If I need, you know, uh, safety and I got to get out of risky assets, then I could sort of say there's the liquidity available in treasuries that I could buy and sell what I want at a fair price. And it's sort of and in that sense, it's a good friend. Okay? But as we could sort of say with all of your friends, some of your friends could be fickle. Okay? They may not be there when you eat them. Okay? They may uh disappear on you. So, so because of that we always have a set of friends. You don't you have more than one friend. We diversify our friends. So when you think about just as that we think about that we want to have diversification in our friends, we want to have diversification in these good friends called safe assets. We might also want to diversify across strategies to provide ourselves some uh some some downside. Now, it may be a silly analogy, but I think it's a one way to think about what are you looking for from, you know, your good friend investment. So, you want it to to stay stable when you need it most. >> But Mark, >> you might not need more than one friend. >> Well, I think it's the perfect analogy because you know what they say about the trend, it is your friend. So, there you hit it right there. I think you hit it right on the nail. Okay. Well, this is of course tied into one of the uncertainties and why some people say gold is going up is for example the uncertainty about you know Fed independence i.e. the Fed as a whole and you pointed out there was an interesting speech which I also heard about I didn't hear the speech I didn't read the speech uh from the Dallas Fed Lori Logan tell us about that why is that important >> so Lori Logan has been a president for the Dallas Fed for for not a long time but uh she's been out there for a while but she came from the New York Fed where she was running the open market desk so so it's probably you know our top expert and and we'll call them the plumbing of operating targets. So, how does the Fed actually do what it's supposed to do? And you know what she said is that we're probably going to be in need for new operating targets beyond Fed funds. And she she in her speech, she goes through what that the operating targets has changed over time. we've non-borrowed reserves, you know, we've we've looked at different forms of of money. Uh and then, you know, we've, you know, provided different signals. So, up until 1994, we didn't really the Fed never really gave any signals of what their actual policy was is that you would just have to, you know, figure it out for yourself. So, uh so we use the Fed funds as our our operating target by the Fed. But the Fed funds rate is is now different than what it was, you know, a few years ago. And number one is is that the Fed engages in ample reserve management. There's more than enough reserves available. And because there's ample reserves, this is that they don't need to uh to actually sort of go out and borrow reserves to meet their reserve requirement. So they get paid interest on their reserves that they hold in the Fed. So they they could hold excess because they're uh because it's not a a true cost. So consequently, right now the Fed funds market is actually you know driven by you know some foreign banks who are you know uh buyers and then the providers which would be the federal home loan banks. And so what happens is is that as a operating target the market is actually shrunk. it only trades about hundred billion dollars, you know, a day and it doesn't represent the true money market rates that people are paying. So she said that well you know given these structural changes the Fed is going to have to change that that they're going to have to have a new operating target and that operating target well it could be sofur which is you know the substitute for liebore or they said that probably a better measure would be you know uh triparty repo overnight repo so it's collateralized with with uh treasuries so it is a risk-free rate and that using that as our operating target for the Fed or moving to that will uh better enable them to be able to manage you know uh liquidity and flows in a crisis perhaps send better signals for what the Fed is doing and also be more representative of where the market is trading for short-term funds because the amount that trades in overnight triparty repo might be in in the in the trillions. >> Would that not and again I I' I've heard about this recently as well, but not in any great detail. Would that not introduce somewhat more quote unquote uncertainty or volatility into the setting of quote unquote the Fed funds or whatever we going to be calling it? Well, the uh triparty repo is is probably more volatile than uh than Fed funds rate. Okay. But it also is more representative of the market. So, so you know it will be a measure that has more volatility >> but at the same time because it's a deeper more liquid market if the Fed says this is what we're going to use as our operating target it will reduce some uncertainty because it'll be a clearer signal both as a receiver of the signal of where the market is at for short-term funds and as well as a sender of signal that okay if this is what we're trying to manage or target that then that then it's it's clear that uh to all of those involved what that represents. So now this gets into the plumbing of of of money markets and plumbing of finance. But we still got to realize this is that what is the driver of everything we do and you know it is the short-term interest rates. So what the Fed targets in the short term is going to have a massive impact of what's the cost of you know margin what's the cost of collateral what's the cost that we might face and then there's so many other interest rates that are keyed off the operating target. So for a lot of laymen you'd say like well okay instead of calling it fed funds you know be looking at uh you know this triparty repo or how does that change my life? It may not. But for people who count their pennies every day on what their financing charges and what the signals that they receive from the Fed, this becomes important and it's not something that's going to change immediately, but it's something they keep on the radar screen that structural changes is causing the Fed to change their behavior and that's going to then impact on the behavior of other market participants. Now, speaking of other market participants, we're also going to touch on um retail and what's changing in that, but is there anything else you wanted to talk about in terms of monetary uncertainty and the summary of economic predictions? Is there anything or do you want to jump to talk a little bit about um kind of what's going on uh in terms of of of the uh the retail market? Well, there's two things I want to talk about uncertainty and one uncertainty that is uh uh is uh overbearing on the market and another type of uncertainty that I call a little scary because we'll call it ignorance uncertainty. Now the monetary uncertainty is is is that uh is that you can use the uh SEP which is a summary of economic projections which comes out you know quarterly and it tells you what the Fed you know uh president or fed banks that they where they think rates are going to be in the future. Okay. Now the whole idea of providing these uh steps is that that then it should reduce uncertainty because then we have a clear idea of what they think the forecast of the future path of uh of you know fed funds rate or where the future path of rates are going to go. Now, so you say like, oh, this should reduce uncertainty because by giving more information to the marketplace, then they know what's going on and they know what's going on in the head of the Fed. Now, if you look at the September uh SAP that came out, it is that the Fed forecast of what interest rates are going to be over the next year are all over the map. They got people actually some raising rates, some keeping the same, some big move down uh lower or not. So in an effort to provide clarity on what the Fed is thinking, they've now told us that they have no idea what they're thinking. They have a high a high high amount of uncertainty. And that sort of has an impact on all of other trading. If you're saying this is the central banks have no idea what they think the rates should be or what they'd like them to be, well then that's going to cause a lot of difference between buyer and seller opinions and it's going to cause more volume. So, so that's just hanging over the market. Now, the other issue that that you know scared me is that there was an interesting uh paper from the IMF. Okay, now I I I I need to I need to get a hobby if I'm spending my time on reading some of these papers, but it's called perceptions of public debt and policy evidence from crosscountry surveys. So what the IMF did is is that they did a survey of 27,000 respondents and they were asking them some simple questions about the relationship between spending, taxes and deficits and the impact on uh on you know deficits and uh and debt. So they said okay if spending increases what will happen to deficits? Okay. And then they ask the other question, your spending decreases, what happens to deficits? Then they ask the same question about taxes and then deficits. And you sort of say like if I told you spending increases all things equal, what do you think is going to happen to deficits? You know, I'm not going to put you on the spot, but I my guess is that with almost 100% accur accuracy, you'll say if spending increases, deficits will also increase. Now the scary part when you look at this it's of the 27,000 respondents is that just over 50% of the people got this right. Okay. >> So if you ask if taxes increase what will happen to deficits again you know some countries are better than others because they broke it down by countries. But in many cases you know it's just over 50% that got it right. So, you know, this is a scary because your average person has no idea what is the link between spending, taxes, deficits, and ultimately the amount of debt that we have outstanding. And if that if we don't understand that basics and then you say we've got a lot of debt outstanding, the likelihood that we're going to have a credit crisis is going to be a lot greater just because we don't have the knowledge to understand what are the linkages that that drive debt in the world. >> Yeah. No, absolutely. Well, let's jump to something that became very top of mind during the last crisis and that's actually the power of uh retail. I think sort of during the pandemic, we started to see the first signs of how um retail investors um back then in a in a few meme stocks really had a big impact uh in the market, but this has changed dramatically since then and it continues to change uh not least with the uh amount of new products that are being um issued. Um, tell me where your thoughts are uh on this and I'll add a few thoughts as well. >> Well, my initial thought is is that I'm not sure. So, now you have a lot of people who are trading and I think the thing that really scared me if you look at our our uh very shortdated option e expirations is that uh you before 2020 there was daily volume of about you know 20 million contracts. Now it's it's it's well over 60 plus uh million. So you have this huge impact from you know short-term option trading. We have a tremendous amount of flows into ETF. And so so when you think about it is is that those flows that it go in can also flow out fairly quickly. So that's going to have a big mark market impact. And it generally has been a view that that the retail traders or retail investors you know are either you know last to get in you know uh you know sort of mismarket moves uh are you know if uh researchers would sometimes refer to them as noise traders that they add noise to the market. And so the question comes in is is that if we increase the amount of noise, how does that change people's behavior and models, how does that change pricing behavior? We do know that simple the simple fact is is that that if you use prices as signals of value, but if noise increases, then those signals are going to get distorted. And so the question comes in is is that we know this is going on now how do we adjust our behavior because of that and that's that's an ongoing issue and for research. >> Yeah. No actually I think this is actually very important and I think that u this is a key topic that I think many of our colleagues in this uh um industry um think about uh in terms of the data they use and so forth. I was thinking about this also in light of the recent interview that Jim did uh with the co-founder and CEO of Robin Hood um Vlad Tenev uh where they sat down and and he talked about some of the new uh things they're rolling out um and of course they were very much kind of in the in the forefront of getting retail back in the market so to speak with you know free commission quote unquote free commission uh trading and and so on and so forth. Um but of course now they're adding um other things like um prediction markets where you know it's not just about financial markets. You can you know uh bet on college basketball or or whatever it may be. And of course, oddly enough, being Danish, um when I watch television in Denmark now, um I would say about almost half the advertising on television is purely from betting firms. Um and of course, this has been sports betting. Um so I mean it's real. Uh I'm not so sure it's healthy uh to give people too many um bedding tools uh so to speak. Um but it's definitely big part of what's of this revolution and and as you say it will add at least noise if not something else. And then kind of going back to our um to to the maybe the next uh point you brought up in your notes um which is something that Andrew and I touched on briefly only briefly a couple of weeks ago uh which is this thing about inelastic uh markets and how flows um impact markets. So I'd love to hear your thoughts on this because we didn't do a a great job in terms of going into the actual details. we just talked about and referred to a launch interview uh between the FT um and the chairman of CFM who had become a very or has become a very uh big proponent as I understand it of this inelastic market hypothesis. So you probably know much more about this than I do. So what are what are your thoughts on this and how does it tie into some of the things we just talked about? Well, just to close the loop on their on the retail issue. It's uh it's interesting that Terry Duffy, the you know, head of this CME had a uh podcast where they talked about their you know roll out of their you know venture with uh FanDuel. So the idea to get more retail investors to to trade at the CME. So, so this intersection between uh we'll call it betting markets, prediction markets and traditional futures markets uh that they're getting more closely aligned. And so in one level is that this is part of you know uh further innovation in financial products and and what we'll sort of say is a very competitive business. You know the finance has been very good at providing innovation. The issue is always is that not every innovation is good and you know we'll sort of say that uh uh some innovation will have unintended consequences that we need to be aware of. Now talking about the this inelastic trading which is which was uh one of the topics for your last podcast and I think it's it's very important because the idea is is that uh from inelastic trading is markets are not efficient that in reality is that market uh can be inelastic or the elasticity changes across markets because of the volume that you trade or the flows that you trade have an impact on price and that volume in a given period of time might be actually be very large relative to the volume that you usually play uh uh look at in a in a time packet. So therefore it it could be a really have a strong impact that causes more volatility in markets and similarly is is that we need to look at the actual players in the market because their elasticities will be different from player to player. So if you take a mutual fund that has a a focus in stocks, if they have flows that come in, they're going to have to invest in stocks. A hedge fund might be uh focused in a specific sector. So they have capital to put to use but their ill uh elasticity is going to be based on what is their mandate or of the objective of their fund. So if you think about it is that the market is filled with different agents or different market participants each that have different objective functions and because their objective functions are different they may not always be able to provide capital at a given point in time in a way that would keep the market efficient. So hence is is that uh the composition of the market matters and because the composition is affected by the flow flow matters and flow will then affect prices. Think it from the retail uh perspective is that if this represents a different set of flows or the flows come at different times of the day or represent uh uh trades based on a different set of beliefs or expectations then that could have an impact on price which could cause it to differ from what you might think is the efficient price. >> Yeah. you know, speaking about um before we jump on to um something we normally get done with in the first 1015 minutes um which is the the trend following update, but this is great. This is fun. Um you talked about financial innovation and all of that stuff and and and kind of how it relates to to the retail space actually. I think also financial innovation has been part of one of the headlines that I just caught and I'm sure other people did which is not some topic necessarily that I know a lot about but I do remember um and maybe this was kind of a a result of hedge funds alternative investments not doing great a few years ago. I'm not I can't remember exactly but suddenly this thing called trade finance popped up and oh yeah this is great. I mean you can lend um you know you can invest in these funds that you trade finance kind of like an you know like a hedge fund type strategy and you'll get very steady very decent maybe doubledigit returns. So to me I've you know I I feel it was mentioned as some kind of low risk strategy. what could possibly go wrong when you loan money to people who can't get their trade financed uh elsewhere. Um but of course this week we hear about something called first brands and its bankruptcy and then you start seeing some of the fallout uh for example and again I'm just quoting the news so I'm not making any judgment here but there was a UBS fund that turned out to have 30% of its portfolio tied to the failed first brand group. Um you have Jeff as far as I can tell from the news flow also being um impacted by this. Um again maybe these maybe the financial losses are not too excessive compared to other things but but certainly reputation wise you can quickly um lose out. So sometimes these things and and I think this might only be the beginning. I'm sure there are many other funds strategies that do something like this and and there might be um more to come. But it just shows or it reminds me of this um you know how these narratives um can have a big impact in terms of how products are being positioned, how they're sold. Um but things like again going back to our little world trend following where yeah, you see the volatility every day. So that's why people don't really like it. But it's rare that we have any really bad surprises. I I can't really think of any in the last 35 years that I've been part of this where something happened that you wouldn't expect. I mean, you expect volatility in in these strategies. So um but um anyways I don't know what where I wanted to go with this other than to comment that these financial innovations are not always good. >> Well uh trade uh trade financing or factor financing has you know been around for hundreds of years. It's not a new innovation and and a lot of people think >> it's the packaging though Mark right. Yes, it's everybody thinks well it's offers you a stable uh returns but then you pref what could go wrong. So uh so banks were very much involved in uh we we'll call it trade finance and and to some degree you know factoring this is you know bread and butter you know uh but it's actually very uh you know people intensive and uh there's intensive credit work because if you say I'm going to uh you know uh lend against inventory >> at some point I'm going to have to send an accountant out to some warehouse and I'm going to have to look what's in their warehouse and in case of first brands that they're in auto parts. They do windshield wipers. Someone's going to have to count all of the windshield wipers in the warehouse and he has to find out is that okay is that my collateral or is you use that collateral for five other different loans. This has been going on for traditional uh you know futures for a very long time because we'll sort of say that working for the merkantill exchange in the in the 80s at one time this is that what you find is is that there was a whole department that you have to do is like you have to go out to warehouses and actually check to see like where do you have the warehouse receipts is there you know livestock in uh at the delivery point is there grain in the grain elevator is that you have to actually do all of this and it's it's actually very expensive to do this. So, and the one thing you need to remember about lending is is that you need a lot of good loans to make up for one bad loan. But the important part of futures that I think that people, you know, sometimes forget is that what is the tremendous innovation that's been associated with futures markets since its inception with daily marktomarket. This is just that that you have to settle up every day in terms of your margin. If prices go up, you know that uh and you're happen to be on the short side, you might have to be required to post more uh more more margin funds. And so so that's done on a daily basis. And so uh you know a lot of this lending wouldn't happen if let's say that you actually had to you know you know you know we need if we knew exactly what the collateral was and what and what margin had to be posted associated with on a daily basis. It's a little bit of stretch but I think that this is important to to to say how markets differ and structurally. >> Yes. And and not to take any shine away from the futures markets because I love them, but I'm sure you remember also that there have been occasions where wasn't there a point and I forget which metal it was where they discovered that actually the metal was not in the bags in the warehouse. It was like you know scrap metal rather than >> yeah nickel >> copper or nickel. Yeah, it was nickel. So anyways, not perfect but a lot better than many other many other >> there was the C classic case of you know like the uh uh salad oil or soybean oil where you know actually what happens is is that they put they said they had the collateral and it was in a you know big tanks. And so what happens is is that so people would usually test for whether there was actually the collateral by dipping a stick in and sort of saying okay is is the oil there? Well, what happened is they filled the tank with water which is heavier. So that was on the bottom. So if you tested from the top you sort of said oh there's there's the oil there. You know it it uh it it's it's legitimately there when it didn't exist. So, so there are some vast stories of fraud going on, you know, in in even in the futures markets. >> Absolutely. Absolutely. Okay. All right. Let's move on quickly to a quick update on the trend following uh side. I mean um Alan mentioned last week um that it was a tremendous month of September. Um, we're fortunate that this momentum seems to have continued pretty strong uh so far this week uh into uh Q4, which I'm always thinking of Q4 as not a bad quarter for trend following. I'm not entirely sure, but I don't have any data necessarily to base it on. Um, but as I said, I think um the the so far things are are are moving nicely. Um again with the momentum in some of these uh markets we've talked about continuing what I specifically just wanted to mention uh about September that I find or found to be really nice is that you know we live in a world where there's so much talk about AI and how these new innovations like technologies are going to change everything including making it really difficult for old school trend uh strategy investment strategies like trend following to to uh to make money and flourish and all of that stuff. But then you see gold up 10% 10.2% I think it was in September. That's the largest monthly move since the introduction of the futures market in 1974 and it just provides a great opportunity for old school trend following to really um capitalize on that. So even these old style uh strategies I think um you know are so relevant today as relevant as they've ever been um frankly in my mind. Quick run through of the numbers. So we are using numbers as of Tuesday this week uh the 7th because they haven't been published yet yet for the uh for the eighth but 50 off to a good start in October up 1.22% now up 1.68% 68% for the year. After so many months of uh having negative um numbers uh year to date, we're now for the Btop 50 at least into positive territory. Stock gen CTA index up 1.19% down a fraction still 1.54% for the for the year. Stocken trend up another 1.6% up only sorry down only 71 basis points uh as of Tuesday. and the short-term traders index still struggling a little bit but up 73 basis points in Septe in October down 4.42% or 2% uh so far. I will add to that that I think yesterday was a very strong day for CTAs. So some of these numbers uh may be very close to flat uh if not positive by now. Um in the traditional world of course uh there's no comparison. I have to uh completely admit 1.1% up already on for the Msei as of last night. Um up 19.1% for the year. uh US uh S&P US aggregate bond index up 20 basis points in October um and up 4 and a.5% so far this year and the S&P 500 total return up 1% uh as of last night and up 15.98% so far this year. [Music] Now, we have gone quite long in our um quote unquote um early uh part of our normal conversation. So, maybe with another 20 minutes or so left of our conversation, Mark, I will let you um guide us which of these topics that you mentioned to me uh you wanted to deal with because I don't think we're going to get through all of them. So would you mind um telling us where we're heading now in the conversation? >> Sure. There there are probably two issues that I want to uh try to talk about. One was is a nice piece of research from Quantico the the CTA which looks at uh alternative versus traditional assets which is an ongoing discussion we've had in the past but I think that they they're added to the uh uh to the discussion. And then second is talk a little bit about uh this uh you know uh networks and complex adaptive systems because this is an issue that I've been spending a lot of time on and I think that I want to you know if anything maybe provide a little bit of teaser for what the research I'm working on what I'm trying to achieve and tell you why this is a hard problem but if I solve it it actually could have have big benefits. So >> Okay. Cool. Very good. So let's talk a little bit about the idea that uh what this research that uh I was reading out that came out of in the last week or two uh two weeks. So traditionally in the futures has has been this big issue is how many markets should you trade? Should you trade more or less markets? And so, uh, there is probably one group that says, "Let's stick to a core group, keep the most liquid markets. That's all you need to do to, uh, to be a good CTA trend follower." And the other group has been said is that no no you want to add a lot of these what they call alternative which are sort of sort of the smaller more esoteric futures or other markets that you could trade because that's where the you know no pun that's where the gold is that that that's that this these are the hidden opportunities. So, and so what happened is is is that uh you know Quanica did the research and what they showed is is that that you know that these alternatives for a good 10 years was adding a significant amount of uh value uh value added to the portfolio that they had high sharp ratios and that they were uh uh low correlated. So that the combination of the two sort of you know provided a nice tailwind for trend followers. But now more recently this is that they said this that those performance of those uh alternative markets has been less than what we'll sort of say that the core markets are the more traditional assets. So the performance has declined and so now it has been more of a not of a tailwind but it's been more of a headwind that having more diversification we're adding these alternative markets has had a negative impact. So then of course the issue is that well what's the optimal number that you should have and uh you know that's the age old question of what what what we uh what we're seeing and I sort of sort of said that they didn't really touch on this but I think it's the issue is is that the behavior of bunny flows from trend followers to different markets will have an impact on the efficiency of that market. So notice we talked earlier in this idea about the inelastic uh uh you know uh market hypothesis. This is that what we're saying is that markets are not always elastic. Is that the flows matter? Well, if you had for a long period of time more and more CTAs entering in these less liquid markets, these alternative markets, by definition, is is that their flows are going to impact the the behavior of those markets such that where they could have been profitable before, they could become less profitable now because the composition of the market has changed. So is this what what we often talk about as market impact? >> Yeah. And and so this is the really important part that uh uh uh you know especially as you get larger which are those are the CTAs that you would uh that institutional investors or even retail investor that some of these are are becoming larger and larger. They become billions of dollars. Now a a large trend following CTA that h has a billion dollars of actual cash their notional value is going to be a lot larger. So their market footprint or market impact is going to be a lot larger. And I probably would sort of say that when we look at all the back testing that that's done you know you could have the perfect back test but you also have to you know account for your market footprint. you know what is the impact of what your trading has been and that we'll sort of say is is that the uh it's not the cost of the bid ask spread it's not the trading cost it's the market footprint or impact that really drives performance and so the battle of a CTA is not now as much trying to find out what is the next model to find trends I'm not sort of saying that that's solved. But we have a pretty good idea of what we think how we can identify signals. We can identify what is a trend. You might sort of say that sometimes very long-term does better, sometimes short-term does better. Sweet spot is the intermediate. You could sort of talk there are slight different ways of doing this. But you know the the big battle from a research perspective and from uh you know a success of a CTA is how can uh they reduce their market impact their market footprint while still adding more assets under management. So as I grow my footprint gets larger and now I got to fight this growth versus the uh the uh market impact effects. So so this is what the research battle is all about right now. Now given what you just said and I don't know if this um can be concluded but isn't there a big risk now with the popularity that these alternative markets attracted not just from more managers doing it but of course also from investors um you know buying into the narrative so to speak. Isn't there a chance um that this has had permanent damage that we have too much money now in those markets and they're simply not able to on an average basis, let's call it that, cope uh with these um much larger flows to to avoid uh having a negative market impact. Now I'm fully aware there will be times where the trends are just so strong that market impact is overcome but that's why I wanted to say on average that at least um perhaps too much money now um is chasing uh these market or is that a step too too far um to go? Well, uh, you can answer it two ways. You know, I could say yes, there is too much money following it with, uh, with similar strategies. And so, a number of large brokerage firms, you know, some of the French banks, uh, for example, have now CTA trackers, you know, uh, you know, large investment banks also have trackers. what they do is they sort of they run uh you know trend following models and then they sort of look to see like where is the big flows going into. So they anticipate where flows are going into. So it's almost as though that uh we know that you have a big footprint. We know that you have uh you know you're you're you're disturbing the system. So what we're going to do is track you so we could then be able to anticipate that and then be able to trade either with or against it. So So there's a feedback in the old days, Mark. >> Right. In the old days we called it front running, didn't we? >> Uh oh, heaven forbid we would say something like that, but I had an interesting discussion back in uh John Henry. They say like we're and and it was sort of a cheeky comment. He said like John would joke why are all these brokerage firms why do they want to come down here and want to have us see our business? Why do they want to have uh uh uh have us trade with them and why are they willing to do this at just such low prices? Now he knew full well what they were thinking. They said well they wanted to see their flow our flow because then they can sort of say like well if I have that wouldn't break the law but but let me put this way it gives me a huge advantage if I see when large CTAs would be coming in with large orders and and that even if I don't profit from it if I know that the freight train is coming down the track and I know to step off the track for a while because they're going to get hit by the train. That is the tremendous advantage you could have visav the other competitors who who might be trading in the marketplace. Yeah. And and of course I mean the fact that uh data uh audit audit data whatever it's called is sold and and and firms today are profiting from buying that data from various uh platforms. Um and you it's it's a real thing. And of course you and I know that in the press um relatively often you're going to see these articles where so and so investment bank is out saying oh if the S&P does this then CTAs will have to sell you know 80 million worth of equities you know whatever. So, yeah, it's it's definitely a thing. And um yeah, not as as I'm sure people uh know from from listening to me in the past that I'm not a great fan of of the um of the of the shops that we place our trades with, whether or not there are Chinese walls or not, that they they they they are so public about these things. Well, the the the important part in in this one is is that you know we spend a lot of time talking about okay that the we'll sort of say that the sweet spot for most trend followers is sort of intermediate trend you know a couple weeks so that you know that long-term is also very good too but short term not so much but I would sort of say if you're uh a larger and even if you're a smaller CTA is that that all of the research or or we'll say that every CTA is a short-term trader. And what I mean by that is is that how you actually execute your orders, so how you uh allow your orders to enter the market, how you trade, how you sort of uh impact or try to minimize your impact on flow has a hu will have a appreciable impact on your performance. Now when you think about it is is is that CTAs will have you know great doubledigit years. There's other years in which you're you're going to have single digits or you you you'll have modest returns. If you can be able to cut your market impact costs by 1 to 2% that in some years could represent a significant portion of your overall returns. And this has an impact even as though that you know people will test models based on okay I'm going to execute market on close. Well market on close still has a market impact because you know it it is a market clearing price and you get the price on close but that doesn't mean that it doesn't have market impact relative to what the price may have been a half hour earlier. And so I would probably sort of say that when you're doing some equity trading, we spend a tremendous amount of time is is that we are looking at uh you know shorter term trading about like what do you do in the first 10 minutes of trading? What do you do in the first half hour? You know how do you VWAP the trades? What happens half hour before the close? What happens 10 minutes before a close? What happens at the close? So we could spend you know in a complete uh you know podcast on just the uh micro structure of markets and how you have to behave even if you're a trend follower that's looking at longer term trends on this topic. One thing I want to clarify, you talked about how a lot of people think uh I don't know if it was your opinion or whether just a general observation is that a lot of people think that kind of medium-term is kind of the sweet spot for trend following. All all I just want to say is that that's not what our research show. Um and so I just want to make that clear. Um I think it's a common um understanding that well maybe short-term is a bit too short so you have too many transaction costs. So over time um you can see that the short-term trading you can just see it in the in the socken short-term traders index. I mean it hasn't made money for you know you know a long long time. Um and then you can look at sort of longerterm uh trend following and yes it's been the most profitable in in our research but of course there's also a cost to it maybe a little bit more volatility sometimes higher draw downs but so so so that's what we our data finds but I just want to say that these things change over time and there certainly was um up until the last 2 three years um some nice opportunities in the quote unquote medium-term space when when we look at it. But the last two or three years, probably medium-term has been the hardest hit of of these kind of different speeds of trend following. And I think from my recent travels um last week, um I think a lot of investors are are waking up to that. Um that and and and maybe you shouldn't pick a manager that is too focused on uh and too set on a specific time frame. Um but actually um you know being adaptive even when it comes to speed um is quite important. That's a that's a side topic. So I don't want to go down that road. I do want to go down. >> Okay. >> I I was going to say that you're absolutely right for a longer term perform uh long-term high return performance. The longer term trends do better. Albeit you're going to have to take some more you know risk to to do it. But the the key point that you make is is that no one's strategy in trend following world always does well. So so if ever there was the reason for diversification it's it's because nothing works all of the time. So as we see with this alternative versus traditional assets alternative does very well. No it's not so well. So that's why I always think in terms of this uh you know sort of a three-dimensional uh diversification is style timing and markets. You got to sort of say like how do you how do you make sure you fit over different time horizons? How do you fit across different markets and then slightly different styles? You got to diversify. >> Yeah, you got to diversify. Okay. So, the last topic we're going to get to is um what you mentioned you wanted to spend a little bit of time on as well of of course I should have my buddy Rich here for anything that mentions the word complex adaptive systems. That's kind of his um his uh one of his pet peeve peeve that he he loves to talk about. Um and knows a lot more about than I do. Um, so tell me where we're going with this and and because you said it it it it is potentially something that is very very um important. Well, we'll sort of say the the tremendous benefit, but then the tremendous uh we'll sort of say uh potential problem with trend following is the fact that uh you know trend following is very good about isolating exactly what it looks at and then sort of throwing out all of what they consider extraneous information. What do we mean by that? Is that you don't care about what the fundamentals are. All you care about is price signals. Okay. Um the big issue in finance is always what we call now causal inferences. What are the causes of what causes mark uh what are the causes for why markets move? A trend follower says I'm not interested in causal inference. All I care about is is prices are going up or down. I'm a reactive. I'm not looking for the fundamentals. Okay. And finally, we'll sort of say the trend follower says like, you know, if I'm putting a trend model and and you know, there are variations. So, I'm not sort of saying this picks everyone. If I'm looking at the trends in gold, you know, I don't really care what happens to the dollar at the same time. I don't sort of say like, well, what happens to the dollar will have an impact in how I trade gold. I sort of say, you know, I I isolate this and I look at it as as an independent market. I isolate and forget the fundamentals. I isolate and say I don't look about causal inferences. I just do what I do very well, which is just to pick up the signals and then execute on it. Okay, that's that's the you the reason for being and why it is successful. So now the question is is it but can we improve and make this better? So the whole idea of uh of thinking in terms of a network is is that or a complex adaptive system is is that well if I'm looking at the gold market doesn't the dollar have something to do with what's going on in gold. So if there's a trend in dollar that it may tell me something about what the or have an impact on what will happen to the gold market. So let's go back to our idea of flows. Flows out of the dollar may flow into the gold market. Okay. The behavior of the gold of the of the dollar market may have something to tell us. It may be, you know, sort of causal prior to what might be happening in the gold market. And so if I look at this as a system, as a network of markets, that those markets may be interrelated and that that that the influence of one market because of its flows in and out, because of its behavior, because of its volatility will then have an influence on another market. So we have to think of this as a more richer complex system. This is not an easy problem to deal with. So, you know, so I'm not saying I solved it, but I think that that's what we want to try to say is that if you could sort of find those connections and realize that they're nonlinear, they're episodic. So, they don't happen all the time. So, which means you're going to need a lot of data and a lot of computing power. You're going to have to use some sort of let's say complex, you know, sort of machine learning techniques to ex extract this information. But if you could do that, then you can create an edge that may not have existed before. So that's what we think that we're trying to look at in a and a I want to leave the listeners with the idea that should you look at markets in isolation or should you sort of see like what is the connectedness across markets and then if you think that there are they are connected which I do then is say is there a way that you could maybe find a way to exploit that connectedness. Yeah. But just to be clear here, Mark, though, I mean, isn't that a something we've all always known and a lot of people have? I I wouldn't say a lot, but there are certainly managers out there today who does not just uh generate their signals based on an individual market uh move. They will do cross-sectional momentum analysis or whatever we define it as. um may maybe the challenge is still to find something that um we can because these relationships change. So again that's part of the problem. Um so so maybe we you know we can become better at it, more precise at it know when these um you know connectivenesses are are you know are changing or breaking down uh etc. Um but I don't know that it's new uh that there are relationships that can be exploited by CTAs because I think some people do that. We don't at Don we don't but >> but but certainly and also this principal component analysis type stuff that might have an influence as well. You >> you're absolutely right. This is a this is not a new problem. So, so obviously it's not I don't want to sort of uh people think that okay I'm the first person to discover this. We do this with some time series when we look at whether markets are co-integrated. So that's you know one simple way to do it and it's whether are two markets related by or they are they co-integrated. Okay. >> But we're sort of saying is that we're not looking at just the co-integration which is we're looking at at the entire system. And second of all, this is say like well we you know most CTAs will spend a lot of time looking at what is the correlation across markets and do I need to have both of those markets in the portfolio. So how do markets cluster or you know you could sort of say it's principal component is cluster analysis you know hierarchical clustering you know uh of uh or or how markets are connected. But the problem comes in is is that or or what we think is the problem is is that that is part of the portfolio construction optimization problem. What you want to try to do is is think in terms of not correlation but causal relationships >> and also you want to think about how you integrate predictions with the optimization. So this is an area that's you know somewhat obscure. It's people have been writing about it. This is that they that what they call it uh uh decision focused learning or what they call is this is that uh you know uh that what you have to look at smart we generally look at smart prediction and then we optimize but we need to put the two of those together and sort of think in terms of how we optimize and predict at the same time. So, this is the problem. You know, if someone has solved this, more power to them, you know, but, you know, this is what's keeping me up at night. >> Sure. Well, that's that's uh that's perfect. Uh Mark, thank you so much for really a a wonderful um bouquet of topics uh that we covered uh today. And if people listening like myself really appreciate uh all the uh time and work you do in prep preparing for these conversations, do head over to your um podcast platform of preference um and leave a rating and review and show your appreciation for Mark and and all the other co-hosts by the way that show up every week um to hopefully produce some um useful um and educational conversations. Um, you can of course also share uh the podcast with your friends. I think I created a a link once called toptraders.com/share. That link probably will allow them to sign up uh and listen to it. Now, next week, uh Alan is joining me, but we will be joined by a special guest, a previous guest, um and um and I'm sure we'll get into some topics uh that we have touched on before, of course, but in much more detail. Um, so I'll leave you a little bit in suspense to find out who it actually is. Um, but I think you're going to love him. And uh, if you I was just going to say if you have some questions for Alan and I and the and the special guest, but it's not really meaningful because you don't know who the special guest is. So, let me skip that and just say that we um, love you coming back every week listening to us. And of course, you can also sign up for some weekly and monthly trend following updates uh, from me and uh, and from Rich. So, uh, by all means, head over to the website and see what's available from Mark and me. Thanks ever so much for listening in this week. Uh, we look forward to being back to with you uh, in about a week's time. And until next time, take care of yourself and take care of each other. Thanks for listening to the Systematic Investor podcast series. If you enjoy this series, go on over to iTunes and leave an honest rating and review. And be sure to listen to all the other episodes from Top Traders Unplugged. If you have questions about systematic investing, send us an email with the word question in the subject line to info@toptradersunplug.com and we'll try to get it on the show. And remember, all the discussion that we have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there's a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Thanks for spending some of your valuable time with us and we'll see you on the next episode of the systematic investor. [Music]