Skew, Convexity, and the Hidden Risks in Systematic Investing | Systematic Investor | Ep.370
Summary
Market Dynamics: The podcast discusses the increasing political influence on markets, highlighting how the stock market has become a significant driver of the US economy, with the stock market's size relative to GDP reaching unprecedented levels.
Investment Strategies: There is a focus on the shift in investment strategies, particularly the trend of high sharp ratio strategies that rely heavily on leverage and tail risk exposure, which can lead to significant vulnerabilities in market corrections.
Systematic Risks: The conversation emphasizes the hidden risks in systematic investing, particularly the reliance on negative skew and convexity, which can create the illusion of alpha but are actually highly correlated with market risks.
Market Intervention: The discussion touches on the role of central banks and political systems in suppressing market volatility and trends, leading to a perception of risk-free markets and encouraging risk-taking behavior among investors.
Opportunities and Arbitrage: The podcast highlights the potential for arbitrage opportunities by exploiting the discrepancies in risk measures and the inefficiencies created by high sharp ratio strategies, particularly in single stock factors.
Long-term vs Short-term Strategies: There is a debate on whether investment strategies should be optimized for recent market cycles or take into account long-term cycles, with a focus on the philosophical choices and optimization strategies for different market environments.
Future Market Outlook: The potential for inflationary cycles and the impact of AI on energy demand are discussed as future market drivers, with implications for investment strategies and market stability.
Philosophical Insights: The conversation concludes with reflections on the importance of understanding long-term market cycles and the psychological aspects of investing, emphasizing the need for self-awareness and a balanced approach to market dynamics.
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 Krup Larson. Welcome and welcome back to this week's edition of the systematic investor series with Alan Dunn and I Neils Castro Larsson where we each week take the pulse of the global market through the lens of a rules-based investor. Today is a very special episode as we are joined by Nicole Kajin who is not only the founder of Alpha Quest but actually also one of the very first guests we had on the podcast more than 10 years ago. So Nicole and Alan, it's really great to be bo with you both here today. I'm going to start with Uni Gold. How are things in uh in New York this morning? >> Uh excellent. A nice sunny sky. Uh mood is good. Uh yesterday we had the Robin Hood conference. All the big players were there getting their viewpoints. >> Yeah. >> Yeah. Another great day in uh in Magaland as they say. >> Fair enough. What about you, Alan? Uh how are things in Dublin? >> All good here. No, no bright sunshine here. It's pretty gray and overcast. But that aside, it's probably probably not unusual to report that. Uh that aside, all is good here. >> Yeah, it sounds a lot like Switzerland at the moment, I have to say. Anyways, uh we've got a solid lineup uh of topics. And since we have Nicole here, um I think I'm going to change the format a bit to just focus on some of these bigger topics that are so important instead of the uh sort of longer trend following update that we normally do at this stage. Um but just to mention that, you know, all is well in trend following land with all the stock gen CTA indices posting gains so far in October. But there are, as I mentioned, quite a lot of things we want to talk to you about, Nicole. Um, but I think it's important maybe to build a little bit of a a foundation um and why some of these uh topics are important and um I think it would be a good place to start kind of reviewing in in your um in in your view kind of the road to where we are uh today. Um, and maybe also for people to better understand what what may not I mean may not be different per se, but it certainly feels different to many people uh in terms of where we are, how the markets operate um and so on and so forth. So, can you take us back a bit and maybe start from there and then we'll slowly get into all the details? >> Sure, Neils, I'll try. Although I'm not an economist nor historian but I'll tell you a little bit of uh my experience. >> Yes please. So uh you know starting from u the late 80s and 1987 it became clear for the political system the governance in governance in America that uh markets needed uh more support and uh more guidelines in order to avoid 1987 type of uh situations to happen. uh then you had the the internet bubble uh 01 to 03 which was a you know difficult period for the markets and there was another layer of you can call it political interventionism in the markets and then finally you had the GFC which was quite an intense event where uh the the the Fed and the Treasury had to intervene even more in the markets and what you see since then uh is that the political influence on of on the markets are becoming stronger and stronger. Now to to to give that context where the buffet ratio so if you see the importance of the stock market in the US economy is becoming bigger and bigger. So if you think of the buffet ratio which is the size of the stock market relative to GDP long-term average for that ratio is that the stock market is about 70% of the size of GDP. Today we we're over 200%. So effectively the stock market has gone from becoming the tail of the dog to becoming the head of the dog. So the the US economy is actually driven by the stock market. So 1% return in the stock market is giving you 2% of GDP in in new liquidity and that's very very very influential. uh now this is not like a the timing of the injections of liquidity and the influence of the Fed and you know in today's case you see Trump you know being very active that the rates have to come down even in a strong economy with full full employment uh the timing of the influence and the pressure is even more significant because it's happening whenever there's a correction so the stock market has gone from being the risky asset with high returns to effectively becoming a new fixed income. In the US, no one speaks about equity risk. It's effectively what are you missing out when you're not in the market, when you're not taking market risk. So, it used to be that as you're getting closer to your retirement age, you would be more into fixed income. Today, it's basically the the the fear or the sense of any type of risk in the market is gone. Market is today risk-free. um you listen to Warren Buffett uh I would say is the main cheerleader for the stock market and if you're wise and you have a long-term perspective you can be rich by just holding the market and that we don't look at the corrections and that's that's the message don't look at the daily ups and downs that's quite meaningful right so the the fact that everyday uh retail I mean the ownership in the stock market has increased substantially in this period as well so as the US stock market as a percentage of global stock market. The US is about 60% of global stocks today. Uh very few stocks are 50 60% effectively technology the max 7 are about 40% of the of the market of the market cap. So effectively there's a concentration happening the US part of the world the the US stock market as part of the US economy and all that is basically supported by the political apparatus of the US and and the central bank. In that context, trend followers have been the have had a headwind. Obviously, uh trends are very quickly reversed. Um and typically the trends that you see when there's uncertainty in particular when the market is going down or you have inflation uh all all these things are basically being controlled and suppressed by uh the political system. You know the idea today is you can create as much economic growth as you want without any inflation. That's the conclusion that we can reach uh based on the last 40 years of market history and the data set proves this right. So if you're only looking at the last 40 years you say this is true. We can just print money and there's no consequence anywhere. As you know uh financial history goes further than back and there are consequences and today the the debate is slowly in the in the more elite parts of the market you know uh you see you start to hear that there's a debasing trade going on in the US dollar right so uh you cannot create this type of environment without uh an effective devaluation or effectively a mass massive tax on wealth uh which is what's going on so in the hedge fund world. Um there's a lot of let's call it value creation that investors perceive. Uh there's a lot of alpha in particular the large platforms uh seem to be creating very high sharp ratios on hundreds of billions in assets. Uh that alpha I mean I'm sure we'll get into it for us the surrogate factor that explains all these alphas is not skill but tail risk exposure. So although you you know these platforms are allocating to very diverse PMs and these PMs are highly diversified and they have standalone very high sharp ratios um the reality is that all these alphas locally look uncorrelated and they look like alpha but in reality when you take into account you will see that they're actually all highly correlated to each other and to the market. Uh so the trade is not only the market going up. Uh so the S&P has analyzed 16% a year over 16 years and uh 25% over the last 3 years. It's that mean reversion is the the real bubble that would say that there's a the confidence to buy the dips or to trade equity long short that everything is going to mean revert and everything is going to converge. We're in an equilibrium which is stable forever and the market are are priced as such. >> I am I get everything you said. I completely um see these things and and observations and even to me um and I think the three of us I I wouldn't say we're the same age. I'm probably the oldest of the three of us but um it seems to me that a lot of people have you know the experience that you just described. However, if we zoom out a little bit further, I I wonder again if this intervention that we see whether it really is that unprecedented. It's unprecedented in the sense that now we're seeing it and maybe it's coming from a specific source, but I I wonder if if we haven't seen this before, if we we went back further in in history and and politicians getting involved with central banking and and and all of that. So, I'm I'm not dismissing uh that this is what's happening right now. Um but I wonder if it's just part of a bigger cycle and we have to uh as you may also believe at some point we have to kind of clear the air and and we can start again. But I think also for for the younger uh group of investors uh they obviously have never experienced what uh we have seen in like as you mentioned in 1987 and and so on and so forth. So, I mean it will be super interesting. You um you touched on on the word inflation. Maybe we'll get to that uh in more detail, but you also mentioned uh the word uh the word sharp ratio. And I'd love to pass it on to Alan actually to uh to uh ask you a little bit about um this and some of the other metrics that that you find to be um relevant for the discussion both those that people shouldn't rely on and those people should rely on uh a bit more. So if if you don't mind Alan uh jump in here. >> Yeah sure. Well, you mentioned the very high sharp ratios in the u in the pod shops and obviously they post a high sharp ratio in aggregate and then at the individual level as well as you're saying and it's definitely something I see as well speaking to investors I will I might show them a a quad macro strategy with a 6.7 sharp which looks very respectable and they say yeah that's not that interesting we we typically look for one sharp and above as a minimum. Um so there's there's kind of this baseline expectation now that that anything below that is is uninteresting regardless of the correlation profile. Um so maybe talk to us a little bit about you know what's the shortfall of that thinking for a start and and then maybe secondly you mentioned tail risk exposure I mean so maybe just elaborate on that a little bit more why why sharp is obviously not capturing that tail risk exposure. Yeah. Uh uh thanks for the question. So Neil's 100% that this is not like an end of the world scenario. It's just a cycle. And the current investor uh >> mindset is that this is the full market cycle that we we were seeing. In reality, we're not. That's the only question. Which means the tilt of risk and exposure and leverage that they're allowing themselves to have is just different uh than if you took the whole market cycle into account. So, uh, typically out of this situation, it's not the end of the world. It's just an inflationary cycle that comes and it comes 100% of the time. There's no way you can have this amount of debt and not end up uh and continuing to print money without uh without inflation as a stabilizer. So, how does this relate to sharp ratio? If investors are becoming greedy in terms of the quality of the returns that they're getting uh and they're rewarding high sharp ratio strategies by allocating to them. So effectively investors are not only chasing high returns, they're also chasing high sharp ratios. What that encourages um managers to do is to expose themselves to uh more hedged components of risk. So the trends are typically in the delta 1 markets and if you take the delta 1 markets and you hedge more and more principal components of risk, you will end up with things that have less trends but are more mean reverting in nature that are less liquid and require more leverage to achieve a certain level of volatility. So if delta 1 markets on trend following gives you a sharp ratio of.3 or 04 you say instead I'm going to be trading spreads on these markets and inter relationships you're removing the trend component. The trend component is at the highest level the most macro. Now what that gives you is say hey you know I'm going to actually remove or maybe 50% of my portfolio is going to be hedged. And in the macro world, it could be that you're, you know, two times long, two times short. In the fixed income world, you had the situations of, you know, the LTCMs where you you're you're basically 100 times leverage, but very very with very accurate hedges and you think risk is zero and VAR is very very low. Today, the same type of scenario is happening in the single stock world. So PMS that are required or are being encouraged to achieve high sharp ratios are designing strategies where they're hedging 70 80 90% of the volatility o of uh their book and effectively are exposed to very very distant alphas. Right? So these things that look like very uncorrelated to anything that seem to be purely noise without any trends are amazing markets because they're uncorrelated in everyday life you seem to be trading you're creating new sources of liquidity it seems by hedging 90% of the risk. So what ends up happening is uh if you want high sharp ratio you effectively need to have high leverage and today if you go to the large brokers um I won't mention any names but you can you can get 30 times leverage on single stocks because the hedges are so accurate and that's the expectation from the platforms. uh they basically create these independent entities that are fully leveraged and uh 30 times is available but they're typically more like 20 times leveraged. The cash is kept in house and the PMS are able to have these uh extremely leveraged portfolios with very very independent risks. Now the danger of that as you know is that the slightest change in volatility, the slightest change in correlation will lead to very quick changes in liquidity as well. You don't have banks there anymore that are committed to providing liquidity. The liquidity is provided by other PMs and the liquidity all comes in at once and all leaves at once. So you see platforms that have zero correlation to the market you know uh citadel millennium balasni and then uh you see that in everyday life amazing sharps but then you have a situation such as co and all of them are down 20 30 35% intra months although they're uncorrelated how could that be right so uh the sensitivity to leverage is very very high and this the risk of this market regime is that it creates the incentive to take these massive amounts of risk that are not captured by volatility and there's a self-reinforcing cycle. There's a reflexivity in the market where because the high sharp ratio attracts capital. You go on and you add to your current position. So if you're 10 times leverage, every dollar that you make, you have to go on and put on $10 of new positions. you're creating a self reinforcing cycle in mean reversion or in convergence. Um, and if the Fed is there to provide uh the safety net, the market put you don't have to pay for that hedge, then you're convergence trade is highly profitable for a long period of time and it becomes you're taking massive risks without be being aware of the downside. Now in the context of the economy, you're effectively you can make more money playing the markets than trying to be productive in the economy, right? So it becomes hey like why should I work? I can make more money being long bitcoin or uh you know buying hedge funds and trading or shorting options as a matter of fact. It seems like money is coming out of nowhere and that's that's where we are. >> It's interesting. I mean you mentioned obviously co and as you say in March 2020 um obviously the basis trade uh got stressed and we'd had the Fed push being exercised again but but since then you know 2022 we had a significant correction in equities we had SVB in 2023 we had the N carry unwind in 2024 tariffs 2025 you know you might you know if you're defending the pod shops or these high sharp strategies they've come through those periods every time. Um were those instances different to what we saw in co were was the real risk not exposed in those um kind of risk off periods? >> Those were more organized like and gentle corrections that happened over time co happened almost too quickly for these firms to adapt. M >> uh so it's and then remember in 2022 all these partops also have trend following momentum components and momentum did very well in 2022 so effectively they had a little bit of a hedge from a liquidity perspective they were not as stretched uh and were not as uh desperate for liquidity uh in a short period of time as in 2020. Now the fact that there's been no crisis means the risk is steadily increasing >> means uh versus 2020 versus 2022 today I'm going to say we're in a much more leveraged place in the PMS in the platforms into the PMS and investors confidence into these platforms and investors confidence into the stock market. So all that creates uh uh vulnerability because any change of market perception uh will require like a lot of adjustment and a lot of liquidity. >> So the status quo is not really a status quo. You're actually increasing risk as you continue to make these high sharp ratios. >> Yeah. Just I just want to ask I mean in relation to what you said at the outset about you know the Fed port and I mean we have seen a shift in markets in the last few years. was um you know a kind of a demand constrained economy. Now it's more supply constrained and you know fiscal dominance you mentioned the debasement trade so that wasn't there a few years but now it's more fiscal dominance as you say the financialization of the economyy's got even greater which would argue in favor of like if the econ if if the stock market falls 20% now as you say it has a huge impact on GDP so the the Fed has to react to that at the same time you've got fiscal dominance so it's kind of hard to see okay is what's the endgame it's just runaway inflation is that the endgame The endgame um historically if you look at the uh market cycles of all the big empires the endgame is always to try to give people paper in exchange for physical things. So you try to keep the physical commodities in your pocket and give other people and then you try to impose the paper with the strength of your military on other countries that you invade. thing um in today's world uh the US doesn't have much room for expansion right uh I mean you got Russia and China and India that are quite um strong countries from military perspective it's unlikely that we're able to expand into their territory to effectively sell paper to to a new population in the US uh if you look at the size of commodities uh let's say the Goldman Sachs commodity index relative to the S&P it's at the lowest level it's ever been and it's been at that level for about 25 years at this point so very close to that low um what could happen is um you have AI being 40 50% of the economy right now AI depends on energy and if the AI market cap is 50% of uh the stock market you know and you don't have the energy apply for that. Sooner or later, all these players as the projected earnings go into real earnings actually have to go and build uh all these uh massive platforms, they will have to get the energy and the energy unfortunately you cannot print. you will actually have to buy real commodities or whether it's uranium, whether it's whatever it is, there's going to be a real world infrastructure to support AI where today today AI is more of an idea uh and of a projection and the reality in the real world and how it's actually implemented is not really fully taken into account. So you can very easily see that the AI demand for energy will trig will trigger a massive inflation in certain limited assets. And once investors see that you can have returns by investing in nuclear energy or in certain energy sectors, you're going to have a massive flow because it's a diversified return source. Today you're seeing, you know, you're already seeing like a massive boom in these uh nuclear stocks. uh you're also seeing gold almost doubling in you know in price in a in in a couple of years you're you're seeing very abnormal price moves uh I would say it's the tip of the iceberg relative to the move that has happened in uh in the AI stocks but that's typically the the natural step both historically and if you just look at the present moment it's a natural dem the demand of AI is going to become an energy demand and there's no one there to to be able to supply it so we're going into very far way we're speculating on energy stocks that with new technologies at a very massive scale. So there's a there's an incredible dependence uh and a vulnerability to any type of surprise. If these small nuclear reactors are not what we expect, then AI has to basically collapse 70 80%. The valuations would have to collapse. >> Yeah. I mean, I think we should maybe um continue a little bit down the road in terms of Okay, so we have the sharp out there, but actually you you're looking at uh you know, other things that you think are better ways of looking at risk. Maybe you can expand a little bit on on that and also the words skew and convexity from the very first conversations we had. Nicole, I think there is a bigger audience who understand it. But feel free to just give a short explanation uh as you move through this topic uh because it is important for people to understand uh especially uh when when we talk about the risks of convergent uh portfolio uh construction and and so on and so forth. There's an incredible opportunity in the market today bigger than the market and mortgage crisis of uh the GFC. Uh the fact that convexity and skew are not in everyday language and volatility is effectively people are measuring risk in one specific way really the risk is not there. Volatility today does not measure risk. So standard deviation of returns. If I tell you that there's a stock which is going up 5% a day and there's another stock which is going up 1% a day, volatility of both is actually zero. There's no difference in the risk where obviously for example the the risk of the stock which is going up 5% a day is higher than the risk of the stock that's going up 1% a day. So there are major major uh blind spots in the main risk metric that people are using today. So where does skew and convexity come into into play? If you're a PM and you're designing a portfolio and you're designing a hedge, uh your your volatility uh your volatility cap, your volatility budget is dependent on standard deviation of returns and uh correlation. Um low low volatility and high correlation between your longs and your shorts creates an opportunity to basically leverage as I said 30 you know 30 times on stocks. When you look at the option market, there's something very different. The buffet ratio. So when the econ when the stock market is large as a percentage of the economy, the skew of the S&P becomes very negative. The skew means the volatility on the upside versus the volatility on the downside are very different. If you look at the skew, the rolling skew of the S&P today, it's the most negative ever. So the options market knows that when the market starts to go down, the liquidity is going to dry up faster than ever before. Volatility is going to go up faster than ever before. Yet this is a fact which is disregarded by the majority of hedge funds, by their risk managers and by the investors that are allocating into hedge funds. So the perception is you're generating alpha and this alpha is based on skill. The reality uh we have shown in our research that alpha and high sharp ratio are 80 90% correlated to negative skew. So the more imbalanced your volatility is if you're willing to underwrite to make less money on the upside and lose money faster when you're when you're losing you're willing you're able to create a high sharp ratio strategy very easily. So um the market is skewed. It means downside volatility is higher than upside. Convexity is a measure of uh nonlinear risk on in both directions. So you can have something effectively you can be long options both on the upside and the and the downside. Convexity is effectively volatility is going to go up faster on the downside versus upside or upside versus it's an asymmetry in volatility. uh both are in a market where the Fed has provided the Fed put are ways to create alpha without any perceived risk. So what happens uh from here the opportunity is if people are willing to underwrite tail tail risk in order to generate alpha and in order to generate high sharp ratios investors are willing to reward you for high sharp ratios because the risk is delayed. Everybody is going to do that. uh then there's an opportunity to go out there and to take almost I'm going to say to arbitrage the different measures of volatility uh and be able to be long volatility while actually generating returns. So if uh the market is willing to look at volatility to the measure of uh standard deviation of returns and um another measure of risk is standard deviation of price. So the the stock which is making 5% a day is a much more riskier stock than a 1% uh uh stock. You're able to basically uh find places in the market where you can actually be long insurance benefit from the tails by trading short-term breakouts in places where the different measures of risk are pointing in different directions. So when volatility is low relative to the other other measures of risk effectively trade short-term breakouts and that's something we have done and we've been able to generate very substantial alpha to the S&P and to the CTA index over the years by just not only trading momentum but trading momentum in all compressed uh regimes or in all compressed markets. Uh so it's a counterbalance from a from the benefit of this strategy is there's enough inefficiency that you can actually make money while you're buying insurance. And this is even in a market where there's been no major corrections. Now, if markets were to go back to their long-term means in terms of uh buffet ratio, in terms of uh volatility, in terms of tail tail events relative to uh to everyday events, then you would have like a massive uh shock and um rebalancing in markets where you could make a lot of money using this strategy. So uh this is this is the real imbalance I would say the real arbitrage in the market today is the ability to to buy insurance not through options but in delta 1 markets trading short-term breakouts when the volatility measures are not aligned. So ATRs versus standard deviation or it could be that you can see that a market volatility increases when the market is making new highs and new lows versus another market the vault compresses when it's making new highs and new lows. So there's all these different nuances within risk that can be measured and it's an opportunity uh to to to generate alpha with returns. Uh there's no uh no skill required in this. I would say that you know we do it I mean we've done it for 25 years but uh just through the descriptions I just gave anybody could go and replicate a good component of uh of this alpha. >> There's no doubt that and you alluded to it early on that that um you know the environment has changed in um you know in the last call it 10 15 years maybe and we can all speculate as to why that might be. Um I'd love to hear your thoughts but you also mentioned that uh say strategies like trend following um had been challenged uh during this period and of course if we broaden it out a little bit we could say that probably all CTA strategies whether you're short-term, medium-term, long-term have been challenged but at different times because you operate in the shortterm space and you mentioned short-term breakouts but I think also your your firm is evolving uh as the environment is changing as we have these new players in the market. I was going to ask you whether you could talk a little bit about first the changes you've seen from your lens but maybe then we can also go into why you think those changes uh have occurred and and maybe that ties in a little bit more to the to the pot shops or something else uh so to speak. But I'd love for people to understand um because it's so easy for people to throw out, oh yeah, it's been a difficult, you know, period of time. Question is, you know, has it or or why has it? Um and and what are the small differences between whether you're a short-term breakout manager or whether you're a long-term trend follower and so on and so forth. >> So, there's a large dispersion of returns within the CTA space. the you can look at the short-term CTA index. It's been losing money effectively since it was uh created. On the other side, a very long-term CTAs more like the benchmarks and the even the AQRS some strategies uh such as 12 months price momentum and longerterm strategies uh have actually managed to generate money. So if you decompose the returns today, the majority of the assets in the CTA industry are allocated to very very long-term CTAs with biases that reduce their ability to make returns during equity corrections. effectively um over the years the CTAs that have done well have attracted capital and they have continued to grow and they have continued to style drift into strategies that are more risk parity like and those are the ones who al although they're CTAs effectively by being very long-term they've had less trades and they've maintained long positions in fixed income uh and in equities those are the strategies that have done well Other CTAs that have done well are CTAs that have supplemented their momentum strategies with long equity positions or they have supplemented their uh their momentum returns with the V compression or basically volatility selling as a way to diversify away from pure momentum. So if you want to have a clear expect you know I would say surrogate factor again for the quality of the returns of a of a CTA. Uh convexity is the right benchmark. Effectively the more positively skewed the strategy is the lower the sharp ratio in the last 15 years. The more negatively skewed or less cap the less capable the strategy is in hedging equity returns typically the higher the sharp ratio. So today the mass of assets in the CTA industry have slowly drifted towards longer term I'm going to call them you know diversified or or style drifted CTAs and those are the ones that are more risk parity like they're the ones who have more carry trades they're the ones who are selling volatility they are the ones who are buying dips they're the ones who are trading spreads and the mean reversion of spreads those are the ones that have attracted assets so that's uh there are many dimensions s you can look at time frame the being short-term you're more long long convexity and you're very vulnerable to short-term noise um and that hasn't worked effectively being long volatility has been a horrible strategy in the last 15 years and so that's one factor uh let's talk about the government intervention in the 70s after the inflation of the 70s commodities became u subsidized in the US so farming and the oil industry have massive tax uh benefits and in order to suppress the moves in commodities. When that happened uh then FX in the 80s had big moves and then in the late 80s of course you had the suppression of volatility and countries used to prop prop their economies by lowering the value of their currency. uh then currencies became effectively more uh controlled and uh the the move uh then went into fixed income. Uh so first commodities got pinned, second FX got pinned in the 80s, fixed income got pinned in the '9s and early 2000s uh where interest rates went from 14% all the way to the negative. Uh now that fixed and then fixed income now is a little bit uh has the boundary of inflation hitting against it. So we're seeing signs of inflation. So there's less room to operate in the uh in the fixed income world to propel the economy. Finally, and the final barrier is of course stocks, which is where uh governments are are effectively acting, you know, stocks have become risk-free. So that progression uh you has led to style drifts in the CTAs with the ones that are looking to make money in the short term at the expense of being able to hedge equity correction. So the more you're trying to have a high sharp ratio today, the less you'll be able to handle the full cycle or the market correction uh when the market mean reverts to its long-term average in terms of valuation etc etc. So the sector allocation is a style drift. The time frame is a style drift. It means CTAs have more and more long-term. CTAs have also if you look at the returns of CTAs 80 90% are from long the long side effectively the short the short side uh doesn't make money very often and CTAs have been successful uh have also style drifted into long only strategies and you can replicate easily and you can see which ones have done that which ones have not so long versus short long-term time frame the asset class style drift u and then the long volatility versus short volat voltility style drift, right? So, should you be mixing mean reversion with momentum versus not? So, that's a little bit of the kind of the dimensions or the factors as I see them that explain the uh differential or the dispersion in the returns of CTAs. But if you want one factor, you're not into all these different things. uh look at the convexity or the amount of the skew of uh your CTA and it's typically going to tell you how well they're a complement to your portfolio but also what their sharp pressure should be in the recent environment. In the full cycle, a skew is not a predictor of returns in the full cycle. In the short-term cycle, it seems that negative skew is a predictor of returns. And that's a big confusion and that's a very very big risk when it comes to research. So the intelligence, the data that's coming in, uh all the new data sources, the alternative markets, um the ability to optimize way more than ever before have all been a justifications for CTAs to drift into negatively skewed strategies in the name of diversification. In reality, CTAs have gone from being long long-term tales to effectively being short tales in many, many different areas. So, if you look at the rolling skew of the CTA index, it's actually flat. CTAs are no longer a diversifier for portfolios. >> Now, I'm not an expert in skew like you are. However, I've got a just a couple of things that I wanted to um try out. Let's call it that. Firstly, I completely agree that in my career, I would say managers um and and by the way, I think we do need to sometimes distinguish between as you rightly say CTAs that have broadened their product uh with other types of strategies and then there is a small minority now which I would call kind of pure trend followers who are kind of living uh the way uh we did back in the 70s and the 80s and in the '90s and I think it's very important for people to understand understand that there is a difference. So I appreciate you highlighting these things. However, and it is true I think that um let's just focus on the trend followers because I think it's too difficult to with when you get into diversified strategies and all of that. I think it is true that we have become more long-term. But my point would be that we should because we are adaptive and we don't sit down. We maybe back in the 70s, the ' 80s, '90s, you would sit down by committee and say, "Oh, uh, we should be, you know, 25% short-term, 50% medium-term, and 25% long-term." It's not how it's done anymore. It's all datadriven. We want to use the data to tell us where to select the parameters and so on and so forth. So I'm I personally I'm not so concerned about the fact that we are more long-term because the data is telling us to be that. Of course if it changes and suddenly shorter term um horizons become more profitable as you rightly pointed out the short-term traders index has not made money for 15 20 years or however long it's been around. So there would be no sense in a trend follower to be a short-term trend follower. I just don't think that works. It's different what you guys do. I don't see you as a short-term trend follower in any way, shape, or form. So, so I'm not so concerned about the fact I'm also, and this is where I'm really out of on my on on deep water here because uh as soon as you start talking about skew, I I know I'm not at your level, but I wonder if this change in when you calculate the skew of CTAs and let's just call it the trend following index. I just wonder if the fact that maybe the equity market the way it has moved for such a long time basically going up for 20 years essentially whether that's part of the explanation as to why the skew number look different and then maybe you say okay trend following skew has to be measured against a much longer term horizon today than otherwise. These are just my thoughts. These are these are questions that we have to ask ourselves every day. And effectively what you're saying is should we optimize over the recent market cycle and over the factors that have made money recently versus keeping exposure to factors that have not made money in the short term but make money in the long term. So >> how do you define the short term here Nicole? Let's put it the 15 the 15ear cycle since GFC where the market has annualized 16% versus >> uh the normal market which is annualizing more 7%. >> Okay. >> And maybe uh yeah let's define the last 15 years in particular in reality uh CTAs just before 2022 had not made money since September 2003 other than the risk-free rate. So from 2003 up to 2022 the CT index only made the risk-free rate. So the question is a philosophical question is should you optimize based on the factors are working now or should you optimize on the 100year cycle or the 50ear cycle and effectively that's the choice and uh that's why when we talk about skew I'm I'm saying skew is the most different differentiating factor in the last 15 years whether you're long skew or short skew is going to be the difference in your sharp ratio so we use sharp ratio as a pred predictor of asset flows and we use sharp ratio as a predict predictor of market regime shift. What you're saying is that the market regime shift doesn't happen. We're saying the market regime shift is happening all the time. When you look at factors short term, PMs are chasing the factors that have worked recently. The platforms are allocating to the PMs that have made money recently. And there's a major there's a cycle there's a short-term cycle in the market that has become very intensified by effectively we try to allocate to the factors that have underperformed on breakouts when they start to do well. So effectively we're saying if value hasn't done well and value starts to do well again we're going to buy the breakout in value for example. Uh so it it's a philosophical choice but uh there's always a side the the choices that we're making today based on the wellperforming uh factors that's not a long-term optimization that's an optimization for the short term. Some people be so there's a risk to that. >> Yeah. And I just want to clarify I'm not suggesting that um you should optimize or the trend followers should optimize to the short term. I'm just saying that I at least for those who are pricebased only um we will pick up a change in market regime at some point if we are data driven. That's all I'm saying. Um we're not making a prediction as to when this regime will change or anything like that. Um but anyways too much from me Alan. Uh you I'm sure you want to this is not really where we um thought we were going to go Alan. So bring us back to uh to the plan >> just on the short term the breakout this idea I think it is an important one to talk about because I mean the the what you hear from CTAs themselves is that well they'll say look at the evidence you know short-term worked well in the 70s 80s and then consistently since then short-term trend following or breakout whatever you want to call it uh started to have degradation in the 90s or the 2000s to the point now where um when you account for the trading costs, the CTAs will say it it uh it does doesn't it's yeah they will acknowledge it has the superior skew but you know it comes at a cost and sorry I suppose the justification for that is you know markets have become more efficient back in the 80s you know people didn't respond as quickly to the news so social so fast breakout did work then so I mean do do you accept do you accept that narrative or or not. I mean, it's not just since the GFC, I suppose, is the point I'm making that it's been a kind of an ongoing trend since maybe the 1980s. >> Can I can I add one thing to that before you answer, Nicole, and that is >> because you've been able to deal with this change, which I think we probably all agree on because we could see it in the numbers. What were the things you saw? And what were the things without giving any secret source away which direction did you go? You already mentioned analyzing return streams rather than price. I mean I I would love to to hear more about how you've been able to navigate something that has been a headwind for other short-term managers. Frankly, >> well, the the main choice that we have made is that the way our factor exposure takes into account the long-term cycle rather than the short-term cycle. Effectively, we're still trading commodities, we're still trading FX, we're still trading fixed income and equities all the same way with the same risk allocation as opposed to a lot of manners say, hey, FX hasn't made uh money in the last as much in the 15 years. I mean, of course, you had the dollar yen trade recently, but uh we're choosing to allocate based on the factor uh exposure of the long-term cycle as opposed to the short term. Uh that's basically it. Now, what is happening in the short-term space is more intense than what you see in the in the CTA index. uh daily options has created the opportunity for people who are not convexity conscious to make a lot of money. Right? So effectively if you're underwriting daily options you can make a very very high sharp ratios in this regime. There's many nuances to that. If you look to at what happened in India with Jane Street, the accusation is that Jane Street was basically uh manipulating the cash market to have big moves because that triggered massive option purchases by the retail investors who were trying to have leverage plays into the market and effectively Jane Street was selling daily options to the retail market that was buying whenever there were daily moves. And effectively they're saying Jane Street was creating artificial moves in the daily market in order to trigger levered plays u by the retail by the uh retail market in India. So what has happened in the short-term space is that there in the very short-term space there's very high volatility and very high degrees of mean reversion. So if you look at the mean reversion models on the S&P, so if you trade the inverse of a volatility breakout, if the market is up a lot, sell it. If the market is down a lot, buy it based on daily returns. It's completely out of line with other markets. So there are very specific things that are going on, distortions that are short-term in nature that are happening today. And there's ways to you can get hurt by those or you can take advantage of those. But again, it's a you have to balance the short term for the long with the long term. But I'm just giving you these are very extreme. There's ways to make massive money basically uh being short daily options on the S&P because it makes you effectively more aligned with the market makers. for for us um we don't make those adjustments but we're trying to now at this point we're doing research on why should the two systems that are shortterm with the same time frame with the same skew one is losing a lot of money and one is making a lot of money. So there's very specific patterns uh happening in markets. So um as you know there's massive amounts of coal selling on the S&P. So people say I don't I don't care about making 15% a year. Uh I'm happy to make 10% but I want to have an extra 3% a year guaranteed by basically underwriting call. Now that creates the a certain type of mean effectively the S&P cannot go up as fast as it wants. It has like a massive price pinning mechanism and it has an effects on the upside volatility. So the the upside volatility is suppressed because of people say hey I lose nothing. I'm not taking risk by underwriting calls. So, there's weird distortions like that going on. And all of these distortions have long-term they're going to mean revert. It means if everybody's selling coals, effectively buying calls, you can go long insurance and actually get paid because the call implied volatility at this point is too low. So, I'm giving you market characteristics, but this has implications for learning or for research. for CTAs or purely that are purely quantitative. There's no right answer. The market regime shifts are harder to catch than uh we think the the adaptations uh the vulnerabilities are sometimes take years to show up. Um one very important thing to to understand the real vulnerability of long-term CTAs is to look at the returns without fixed income. effectively fixed income has provided a huge amount of positive skew and positive returns. And if you remove that from uh you know a CTA replica, you will see that the changes that long-term CTAs have made are actually much more meaningful on the convexity uh than we would think. And uh it it's highly likely that if there is a big uh uh you know a large inflation regime that fixed income will not be the positively skewed positive return contributor that it's been for the last 30 years. >> No if I can again as a as a trend follow I have to just raise my hand and say it can also be a nice contributor like in 2022 on the short side. So >> yeah just just throw that in. >> So those are long-term CTS. Now these long-term CTS have long bias, >> right? That's >> and longs have bottom picking bias. >> Yeah, different. I agree. >> Yeah, you're Yes. There's different different degrees of uh skew that we're dealing with. Yeah. Yeah. >> Yeah. No, absolutely. >> But very interesting uh uh the choices or dynamics and they're not these are not skill-based dynamics. their philosophical choices and optimizations optimization choices for which cycle we want to uh we want to be how optimized we want to be for the recent cycle versus the long-term cycle. >> Yeah. No, absolutely. Alan, maybe I have one more thing that I just wanted to uh pick Nicole's brain about and then if you have one uh final thing as well just in in uh in the interest of time. But I mean you we've touched a little bit around it. Um but I do think it's a fascinating area and I don't know much about it myself other than I can see the observation about all the money flowing into these pot shops. Uh and they're certainly not flowing into to the CTA space at the same degree. How can you turn that into an opportunity? I I see some risks, but as Alan pointed out, they have been through a couple of uh riskoff events and they've come out of it so far. But how how do you think this might or how how do you how are you thinking about turning this um new platform player in the markets into an opportunity? Can that be done? >> So the way I think of the platforms, I think of them as the LTC LTCMs of 2025. Okay, >> literally they're the ones who are underwriting massive amounts of tail risk with massive amounts of leverage in order to achieve uh short-term very short-term high sharp ratios. So the opportunity set is to actually look for places um in the same way that we looked for V compression in the futures markets and we traded breakouts and we generate both alpha and positive convexity relative to the CT index. There's a way to do this in the single stock world and on single stock factors. So uh looking for places where there's been abnormally high sharp ratios basically replicate as much as possible of the single stock factor universe and look for places where the sharp ratios have been abnormally high and bet on their mean reversions because the platforms have a very specific mandate and it's to cut off PMs that are losing money and to add to PMs that I have made money. So effectively the factors that have done well are uh being reallocated to and it's creating distortions in the market. What we will do is look for high sharp ratios on a time series perspective or cross-sectionally and try to short the high sharp ratios once the turnaround happens because we're short-term traders and we're relatively small at 2 billion. We can actually uh trade in a time frame which is not available to the large platforms and we can actually trade against them. So if the platforms have created self-reinforcing cycles of V compression in specific factors, we're looking to short that. So to me, uh that's the opportunity to make money even when nothing is going on, but also to make a lot of money when in case the market regime shifts. And uh the alpha the perceived alpha of these platforms is not purely skill-based. It's heavily heavily convexity reliant which means it's highly unstable. Uh and the you know that the allocation is based on sharp ratio. I think you mentioned um reflexivity earlier at some point and um obviously you're talking a lot about feedback loops you know obviously strategy is doing well attracting more capital then the strategy is then uh getting deploying that capital which is is a feedback loop um I mean I guess the question is when you know with any reflexive process there's an error that the market is making there's something that they're missing and at some point they identify and and and then uh uh you get a a rever reversion. So I mean in your mind in your kind of big picture framework what is that and and what what when do we revert to a more normal environment? We talked a little bit about inflation you know typically it would be a liquidity adjustment do you think it's it's it's it's that type of scenario again or you know problems in or is it overlever that just creates the problem in itself? Um the human apparatus is not designed to be efficient in the decisions that it makes in when it comes to investing. So the things that we in everyday life we go and we learn. Oh this is this type of behavior is positively uh rewarded in the markets you creating imbalances. That's why you have inefficiencies in the market. Our brains are not designed to uh to have a long-term perspective. They have short-term memory and uh that so these these inefficiencies that we created can be for them to be taken into account in our investment process requires data and requires data which is longer term than what most people look at and it also requires a certain degree of self-awareness. If you're the type of uh you're ambitious and you want to prove that you're the best PM ever and you want to raise money like right now, you're gonna make uh decisions uh which are less optimal uh for the sake of a short-term gain and uh so effectively you know in the same way that Warren Buffett has said hey you know buy and hold the US stock market uh and don't look at the turns. Uh every quant researcher has the ability to uh look at the long-term cycles and take those into account as opposed to uh more optimized on the data set which is available which is much more in the recent years right the data >> uh of the last 15 years every year we're exposed to you know exponentially more and more data right so uh it takes a certain amount of understanding of what is my thinking doing versus what is so I mean you I meditate because it allows me to experience life not through the lens of my intellect, not through the lens of my convictions and my beliefs but in a way which is much more uh stable although it doesn't agree with what I see every day right um so the crowd is a very safe place to be emotionally for humans so if everybody at a party is talking about what you're talking about you feel better about yourself and you feel safe yet you're in a very dangerous first place and that is the uh the cycle of counterbalance in the market and that's what as a uh you know as a long-term investor you have to be able to understand yourself and understand what is driving your perception of the world as you see it and to be able to neutralize uh the imbalances that your intellect gives you. I think that's a very uh good place to uh to stop it kind of uh and but also a very good place to bring you back at some point and and continue because that is uh obviously uh very interesting and not something you uh uh you come across with too many people in our industry. Uh Nicole, this has been uh fantastic and we very much appreciate uh you doing it and I would encourage everyone listening today. Uh in order to show appreciation to Nicole and Alan um for the time they spend in preparing for these conversations, head over to your favorite podcast platform, leave a nice rating and review. Uh we so appreciate this. Um next week I'm going to be back with Rich. Uh, so if you have any questions for Rich, then you can send them as usual to info@toptradersunplot.com and I'll do my best to bring them up. But from Alan, Nicole, and me, thank you so much for listening. We look forward to being back with you next week. And in the meantime, as usual, take care of yourself and take care of each other. 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.
Skew, Convexity, and the Hidden Risks in Systematic Investing | Systematic Investor | Ep.370
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 Krup Larson. Welcome and welcome back to this week's edition of the systematic investor series with Alan Dunn and I Neils Castro Larsson where we each week take the pulse of the global market through the lens of a rules-based investor. Today is a very special episode as we are joined by Nicole Kajin who is not only the founder of Alpha Quest but actually also one of the very first guests we had on the podcast more than 10 years ago. So Nicole and Alan, it's really great to be bo with you both here today. I'm going to start with Uni Gold. How are things in uh in New York this morning? >> Uh excellent. A nice sunny sky. Uh mood is good. Uh yesterday we had the Robin Hood conference. All the big players were there getting their viewpoints. >> Yeah. >> Yeah. Another great day in uh in Magaland as they say. >> Fair enough. What about you, Alan? Uh how are things in Dublin? >> All good here. No, no bright sunshine here. It's pretty gray and overcast. But that aside, it's probably probably not unusual to report that. Uh that aside, all is good here. >> Yeah, it sounds a lot like Switzerland at the moment, I have to say. Anyways, uh we've got a solid lineup uh of topics. And since we have Nicole here, um I think I'm going to change the format a bit to just focus on some of these bigger topics that are so important instead of the uh sort of longer trend following update that we normally do at this stage. Um but just to mention that, you know, all is well in trend following land with all the stock gen CTA indices posting gains so far in October. But there are, as I mentioned, quite a lot of things we want to talk to you about, Nicole. Um, but I think it's important maybe to build a little bit of a a foundation um and why some of these uh topics are important and um I think it would be a good place to start kind of reviewing in in your um in in your view kind of the road to where we are uh today. Um, and maybe also for people to better understand what what may not I mean may not be different per se, but it certainly feels different to many people uh in terms of where we are, how the markets operate um and so on and so forth. So, can you take us back a bit and maybe start from there and then we'll slowly get into all the details? >> Sure, Neils, I'll try. Although I'm not an economist nor historian but I'll tell you a little bit of uh my experience. >> Yes please. So uh you know starting from u the late 80s and 1987 it became clear for the political system the governance in governance in America that uh markets needed uh more support and uh more guidelines in order to avoid 1987 type of uh situations to happen. uh then you had the the internet bubble uh 01 to 03 which was a you know difficult period for the markets and there was another layer of you can call it political interventionism in the markets and then finally you had the GFC which was quite an intense event where uh the the the Fed and the Treasury had to intervene even more in the markets and what you see since then uh is that the political influence on of on the markets are becoming stronger and stronger. Now to to to give that context where the buffet ratio so if you see the importance of the stock market in the US economy is becoming bigger and bigger. So if you think of the buffet ratio which is the size of the stock market relative to GDP long-term average for that ratio is that the stock market is about 70% of the size of GDP. Today we we're over 200%. So effectively the stock market has gone from becoming the tail of the dog to becoming the head of the dog. So the the US economy is actually driven by the stock market. So 1% return in the stock market is giving you 2% of GDP in in new liquidity and that's very very very influential. uh now this is not like a the timing of the injections of liquidity and the influence of the Fed and you know in today's case you see Trump you know being very active that the rates have to come down even in a strong economy with full full employment uh the timing of the influence and the pressure is even more significant because it's happening whenever there's a correction so the stock market has gone from being the risky asset with high returns to effectively becoming a new fixed income. In the US, no one speaks about equity risk. It's effectively what are you missing out when you're not in the market, when you're not taking market risk. So, it used to be that as you're getting closer to your retirement age, you would be more into fixed income. Today, it's basically the the the fear or the sense of any type of risk in the market is gone. Market is today risk-free. um you listen to Warren Buffett uh I would say is the main cheerleader for the stock market and if you're wise and you have a long-term perspective you can be rich by just holding the market and that we don't look at the corrections and that's that's the message don't look at the daily ups and downs that's quite meaningful right so the the fact that everyday uh retail I mean the ownership in the stock market has increased substantially in this period as well so as the US stock market as a percentage of global stock market. The US is about 60% of global stocks today. Uh very few stocks are 50 60% effectively technology the max 7 are about 40% of the of the market of the market cap. So effectively there's a concentration happening the US part of the world the the US stock market as part of the US economy and all that is basically supported by the political apparatus of the US and and the central bank. In that context, trend followers have been the have had a headwind. Obviously, uh trends are very quickly reversed. Um and typically the trends that you see when there's uncertainty in particular when the market is going down or you have inflation uh all all these things are basically being controlled and suppressed by uh the political system. You know the idea today is you can create as much economic growth as you want without any inflation. That's the conclusion that we can reach uh based on the last 40 years of market history and the data set proves this right. So if you're only looking at the last 40 years you say this is true. We can just print money and there's no consequence anywhere. As you know uh financial history goes further than back and there are consequences and today the the debate is slowly in the in the more elite parts of the market you know uh you see you start to hear that there's a debasing trade going on in the US dollar right so uh you cannot create this type of environment without uh an effective devaluation or effectively a mass massive tax on wealth uh which is what's going on so in the hedge fund world. Um there's a lot of let's call it value creation that investors perceive. Uh there's a lot of alpha in particular the large platforms uh seem to be creating very high sharp ratios on hundreds of billions in assets. Uh that alpha I mean I'm sure we'll get into it for us the surrogate factor that explains all these alphas is not skill but tail risk exposure. So although you you know these platforms are allocating to very diverse PMs and these PMs are highly diversified and they have standalone very high sharp ratios um the reality is that all these alphas locally look uncorrelated and they look like alpha but in reality when you take into account you will see that they're actually all highly correlated to each other and to the market. Uh so the trade is not only the market going up. Uh so the S&P has analyzed 16% a year over 16 years and uh 25% over the last 3 years. It's that mean reversion is the the real bubble that would say that there's a the confidence to buy the dips or to trade equity long short that everything is going to mean revert and everything is going to converge. We're in an equilibrium which is stable forever and the market are are priced as such. >> I am I get everything you said. I completely um see these things and and observations and even to me um and I think the three of us I I wouldn't say we're the same age. I'm probably the oldest of the three of us but um it seems to me that a lot of people have you know the experience that you just described. However, if we zoom out a little bit further, I I wonder again if this intervention that we see whether it really is that unprecedented. It's unprecedented in the sense that now we're seeing it and maybe it's coming from a specific source, but I I wonder if if we haven't seen this before, if we we went back further in in history and and politicians getting involved with central banking and and and all of that. So, I'm I'm not dismissing uh that this is what's happening right now. Um but I wonder if it's just part of a bigger cycle and we have to uh as you may also believe at some point we have to kind of clear the air and and we can start again. But I think also for for the younger uh group of investors uh they obviously have never experienced what uh we have seen in like as you mentioned in 1987 and and so on and so forth. So, I mean it will be super interesting. You um you touched on on the word inflation. Maybe we'll get to that uh in more detail, but you also mentioned uh the word uh the word sharp ratio. And I'd love to pass it on to Alan actually to uh to uh ask you a little bit about um this and some of the other metrics that that you find to be um relevant for the discussion both those that people shouldn't rely on and those people should rely on uh a bit more. So if if you don't mind Alan uh jump in here. >> Yeah sure. Well, you mentioned the very high sharp ratios in the u in the pod shops and obviously they post a high sharp ratio in aggregate and then at the individual level as well as you're saying and it's definitely something I see as well speaking to investors I will I might show them a a quad macro strategy with a 6.7 sharp which looks very respectable and they say yeah that's not that interesting we we typically look for one sharp and above as a minimum. Um so there's there's kind of this baseline expectation now that that anything below that is is uninteresting regardless of the correlation profile. Um so maybe talk to us a little bit about you know what's the shortfall of that thinking for a start and and then maybe secondly you mentioned tail risk exposure I mean so maybe just elaborate on that a little bit more why why sharp is obviously not capturing that tail risk exposure. Yeah. Uh uh thanks for the question. So Neil's 100% that this is not like an end of the world scenario. It's just a cycle. And the current investor uh >> mindset is that this is the full market cycle that we we were seeing. In reality, we're not. That's the only question. Which means the tilt of risk and exposure and leverage that they're allowing themselves to have is just different uh than if you took the whole market cycle into account. So, uh, typically out of this situation, it's not the end of the world. It's just an inflationary cycle that comes and it comes 100% of the time. There's no way you can have this amount of debt and not end up uh and continuing to print money without uh without inflation as a stabilizer. So, how does this relate to sharp ratio? If investors are becoming greedy in terms of the quality of the returns that they're getting uh and they're rewarding high sharp ratio strategies by allocating to them. So effectively investors are not only chasing high returns, they're also chasing high sharp ratios. What that encourages um managers to do is to expose themselves to uh more hedged components of risk. So the trends are typically in the delta 1 markets and if you take the delta 1 markets and you hedge more and more principal components of risk, you will end up with things that have less trends but are more mean reverting in nature that are less liquid and require more leverage to achieve a certain level of volatility. So if delta 1 markets on trend following gives you a sharp ratio of.3 or 04 you say instead I'm going to be trading spreads on these markets and inter relationships you're removing the trend component. The trend component is at the highest level the most macro. Now what that gives you is say hey you know I'm going to actually remove or maybe 50% of my portfolio is going to be hedged. And in the macro world, it could be that you're, you know, two times long, two times short. In the fixed income world, you had the situations of, you know, the LTCMs where you you're you're basically 100 times leverage, but very very with very accurate hedges and you think risk is zero and VAR is very very low. Today, the same type of scenario is happening in the single stock world. So PMS that are required or are being encouraged to achieve high sharp ratios are designing strategies where they're hedging 70 80 90% of the volatility o of uh their book and effectively are exposed to very very distant alphas. Right? So these things that look like very uncorrelated to anything that seem to be purely noise without any trends are amazing markets because they're uncorrelated in everyday life you seem to be trading you're creating new sources of liquidity it seems by hedging 90% of the risk. So what ends up happening is uh if you want high sharp ratio you effectively need to have high leverage and today if you go to the large brokers um I won't mention any names but you can you can get 30 times leverage on single stocks because the hedges are so accurate and that's the expectation from the platforms. uh they basically create these independent entities that are fully leveraged and uh 30 times is available but they're typically more like 20 times leveraged. The cash is kept in house and the PMS are able to have these uh extremely leveraged portfolios with very very independent risks. Now the danger of that as you know is that the slightest change in volatility, the slightest change in correlation will lead to very quick changes in liquidity as well. You don't have banks there anymore that are committed to providing liquidity. The liquidity is provided by other PMs and the liquidity all comes in at once and all leaves at once. So you see platforms that have zero correlation to the market you know uh citadel millennium balasni and then uh you see that in everyday life amazing sharps but then you have a situation such as co and all of them are down 20 30 35% intra months although they're uncorrelated how could that be right so uh the sensitivity to leverage is very very high and this the risk of this market regime is that it creates the incentive to take these massive amounts of risk that are not captured by volatility and there's a self-reinforcing cycle. There's a reflexivity in the market where because the high sharp ratio attracts capital. You go on and you add to your current position. So if you're 10 times leverage, every dollar that you make, you have to go on and put on $10 of new positions. you're creating a self reinforcing cycle in mean reversion or in convergence. Um, and if the Fed is there to provide uh the safety net, the market put you don't have to pay for that hedge, then you're convergence trade is highly profitable for a long period of time and it becomes you're taking massive risks without be being aware of the downside. Now in the context of the economy, you're effectively you can make more money playing the markets than trying to be productive in the economy, right? So it becomes hey like why should I work? I can make more money being long bitcoin or uh you know buying hedge funds and trading or shorting options as a matter of fact. It seems like money is coming out of nowhere and that's that's where we are. >> It's interesting. I mean you mentioned obviously co and as you say in March 2020 um obviously the basis trade uh got stressed and we'd had the Fed push being exercised again but but since then you know 2022 we had a significant correction in equities we had SVB in 2023 we had the N carry unwind in 2024 tariffs 2025 you know you might you know if you're defending the pod shops or these high sharp strategies they've come through those periods every time. Um were those instances different to what we saw in co were was the real risk not exposed in those um kind of risk off periods? >> Those were more organized like and gentle corrections that happened over time co happened almost too quickly for these firms to adapt. M >> uh so it's and then remember in 2022 all these partops also have trend following momentum components and momentum did very well in 2022 so effectively they had a little bit of a hedge from a liquidity perspective they were not as stretched uh and were not as uh desperate for liquidity uh in a short period of time as in 2020. Now the fact that there's been no crisis means the risk is steadily increasing >> means uh versus 2020 versus 2022 today I'm going to say we're in a much more leveraged place in the PMS in the platforms into the PMS and investors confidence into these platforms and investors confidence into the stock market. So all that creates uh uh vulnerability because any change of market perception uh will require like a lot of adjustment and a lot of liquidity. >> So the status quo is not really a status quo. You're actually increasing risk as you continue to make these high sharp ratios. >> Yeah. Just I just want to ask I mean in relation to what you said at the outset about you know the Fed port and I mean we have seen a shift in markets in the last few years. was um you know a kind of a demand constrained economy. Now it's more supply constrained and you know fiscal dominance you mentioned the debasement trade so that wasn't there a few years but now it's more fiscal dominance as you say the financialization of the economyy's got even greater which would argue in favor of like if the econ if if the stock market falls 20% now as you say it has a huge impact on GDP so the the Fed has to react to that at the same time you've got fiscal dominance so it's kind of hard to see okay is what's the endgame it's just runaway inflation is that the endgame The endgame um historically if you look at the uh market cycles of all the big empires the endgame is always to try to give people paper in exchange for physical things. So you try to keep the physical commodities in your pocket and give other people and then you try to impose the paper with the strength of your military on other countries that you invade. thing um in today's world uh the US doesn't have much room for expansion right uh I mean you got Russia and China and India that are quite um strong countries from military perspective it's unlikely that we're able to expand into their territory to effectively sell paper to to a new population in the US uh if you look at the size of commodities uh let's say the Goldman Sachs commodity index relative to the S&P it's at the lowest level it's ever been and it's been at that level for about 25 years at this point so very close to that low um what could happen is um you have AI being 40 50% of the economy right now AI depends on energy and if the AI market cap is 50% of uh the stock market you know and you don't have the energy apply for that. Sooner or later, all these players as the projected earnings go into real earnings actually have to go and build uh all these uh massive platforms, they will have to get the energy and the energy unfortunately you cannot print. you will actually have to buy real commodities or whether it's uranium, whether it's whatever it is, there's going to be a real world infrastructure to support AI where today today AI is more of an idea uh and of a projection and the reality in the real world and how it's actually implemented is not really fully taken into account. So you can very easily see that the AI demand for energy will trig will trigger a massive inflation in certain limited assets. And once investors see that you can have returns by investing in nuclear energy or in certain energy sectors, you're going to have a massive flow because it's a diversified return source. Today you're seeing, you know, you're already seeing like a massive boom in these uh nuclear stocks. uh you're also seeing gold almost doubling in you know in price in a in in a couple of years you're you're seeing very abnormal price moves uh I would say it's the tip of the iceberg relative to the move that has happened in uh in the AI stocks but that's typically the the natural step both historically and if you just look at the present moment it's a natural dem the demand of AI is going to become an energy demand and there's no one there to to be able to supply it so we're going into very far way we're speculating on energy stocks that with new technologies at a very massive scale. So there's a there's an incredible dependence uh and a vulnerability to any type of surprise. If these small nuclear reactors are not what we expect, then AI has to basically collapse 70 80%. The valuations would have to collapse. >> Yeah. I mean, I think we should maybe um continue a little bit down the road in terms of Okay, so we have the sharp out there, but actually you you're looking at uh you know, other things that you think are better ways of looking at risk. Maybe you can expand a little bit on on that and also the words skew and convexity from the very first conversations we had. Nicole, I think there is a bigger audience who understand it. But feel free to just give a short explanation uh as you move through this topic uh because it is important for people to understand uh especially uh when when we talk about the risks of convergent uh portfolio uh construction and and so on and so forth. There's an incredible opportunity in the market today bigger than the market and mortgage crisis of uh the GFC. Uh the fact that convexity and skew are not in everyday language and volatility is effectively people are measuring risk in one specific way really the risk is not there. Volatility today does not measure risk. So standard deviation of returns. If I tell you that there's a stock which is going up 5% a day and there's another stock which is going up 1% a day, volatility of both is actually zero. There's no difference in the risk where obviously for example the the risk of the stock which is going up 5% a day is higher than the risk of the stock that's going up 1% a day. So there are major major uh blind spots in the main risk metric that people are using today. So where does skew and convexity come into into play? If you're a PM and you're designing a portfolio and you're designing a hedge, uh your your volatility uh your volatility cap, your volatility budget is dependent on standard deviation of returns and uh correlation. Um low low volatility and high correlation between your longs and your shorts creates an opportunity to basically leverage as I said 30 you know 30 times on stocks. When you look at the option market, there's something very different. The buffet ratio. So when the econ when the stock market is large as a percentage of the economy, the skew of the S&P becomes very negative. The skew means the volatility on the upside versus the volatility on the downside are very different. If you look at the skew, the rolling skew of the S&P today, it's the most negative ever. So the options market knows that when the market starts to go down, the liquidity is going to dry up faster than ever before. Volatility is going to go up faster than ever before. Yet this is a fact which is disregarded by the majority of hedge funds, by their risk managers and by the investors that are allocating into hedge funds. So the perception is you're generating alpha and this alpha is based on skill. The reality uh we have shown in our research that alpha and high sharp ratio are 80 90% correlated to negative skew. So the more imbalanced your volatility is if you're willing to underwrite to make less money on the upside and lose money faster when you're when you're losing you're willing you're able to create a high sharp ratio strategy very easily. So um the market is skewed. It means downside volatility is higher than upside. Convexity is a measure of uh nonlinear risk on in both directions. So you can have something effectively you can be long options both on the upside and the and the downside. Convexity is effectively volatility is going to go up faster on the downside versus upside or upside versus it's an asymmetry in volatility. uh both are in a market where the Fed has provided the Fed put are ways to create alpha without any perceived risk. So what happens uh from here the opportunity is if people are willing to underwrite tail tail risk in order to generate alpha and in order to generate high sharp ratios investors are willing to reward you for high sharp ratios because the risk is delayed. Everybody is going to do that. uh then there's an opportunity to go out there and to take almost I'm going to say to arbitrage the different measures of volatility uh and be able to be long volatility while actually generating returns. So if uh the market is willing to look at volatility to the measure of uh standard deviation of returns and um another measure of risk is standard deviation of price. So the the stock which is making 5% a day is a much more riskier stock than a 1% uh uh stock. You're able to basically uh find places in the market where you can actually be long insurance benefit from the tails by trading short-term breakouts in places where the different measures of risk are pointing in different directions. So when volatility is low relative to the other other measures of risk effectively trade short-term breakouts and that's something we have done and we've been able to generate very substantial alpha to the S&P and to the CTA index over the years by just not only trading momentum but trading momentum in all compressed uh regimes or in all compressed markets. Uh so it's a counterbalance from a from the benefit of this strategy is there's enough inefficiency that you can actually make money while you're buying insurance. And this is even in a market where there's been no major corrections. Now, if markets were to go back to their long-term means in terms of uh buffet ratio, in terms of uh volatility, in terms of tail tail events relative to uh to everyday events, then you would have like a massive uh shock and um rebalancing in markets where you could make a lot of money using this strategy. So uh this is this is the real imbalance I would say the real arbitrage in the market today is the ability to to buy insurance not through options but in delta 1 markets trading short-term breakouts when the volatility measures are not aligned. So ATRs versus standard deviation or it could be that you can see that a market volatility increases when the market is making new highs and new lows versus another market the vault compresses when it's making new highs and new lows. So there's all these different nuances within risk that can be measured and it's an opportunity uh to to to generate alpha with returns. Uh there's no uh no skill required in this. I would say that you know we do it I mean we've done it for 25 years but uh just through the descriptions I just gave anybody could go and replicate a good component of uh of this alpha. >> There's no doubt that and you alluded to it early on that that um you know the environment has changed in um you know in the last call it 10 15 years maybe and we can all speculate as to why that might be. Um I'd love to hear your thoughts but you also mentioned that uh say strategies like trend following um had been challenged uh during this period and of course if we broaden it out a little bit we could say that probably all CTA strategies whether you're short-term, medium-term, long-term have been challenged but at different times because you operate in the shortterm space and you mentioned short-term breakouts but I think also your your firm is evolving uh as the environment is changing as we have these new players in the market. I was going to ask you whether you could talk a little bit about first the changes you've seen from your lens but maybe then we can also go into why you think those changes uh have occurred and and maybe that ties in a little bit more to the to the pot shops or something else uh so to speak. But I'd love for people to understand um because it's so easy for people to throw out, oh yeah, it's been a difficult, you know, period of time. Question is, you know, has it or or why has it? Um and and what are the small differences between whether you're a short-term breakout manager or whether you're a long-term trend follower and so on and so forth. >> So, there's a large dispersion of returns within the CTA space. the you can look at the short-term CTA index. It's been losing money effectively since it was uh created. On the other side, a very long-term CTAs more like the benchmarks and the even the AQRS some strategies uh such as 12 months price momentum and longerterm strategies uh have actually managed to generate money. So if you decompose the returns today, the majority of the assets in the CTA industry are allocated to very very long-term CTAs with biases that reduce their ability to make returns during equity corrections. effectively um over the years the CTAs that have done well have attracted capital and they have continued to grow and they have continued to style drift into strategies that are more risk parity like and those are the ones who al although they're CTAs effectively by being very long-term they've had less trades and they've maintained long positions in fixed income uh and in equities those are the strategies that have done well Other CTAs that have done well are CTAs that have supplemented their momentum strategies with long equity positions or they have supplemented their uh their momentum returns with the V compression or basically volatility selling as a way to diversify away from pure momentum. So if you want to have a clear expect you know I would say surrogate factor again for the quality of the returns of a of a CTA. Uh convexity is the right benchmark. Effectively the more positively skewed the strategy is the lower the sharp ratio in the last 15 years. The more negatively skewed or less cap the less capable the strategy is in hedging equity returns typically the higher the sharp ratio. So today the mass of assets in the CTA industry have slowly drifted towards longer term I'm going to call them you know diversified or or style drifted CTAs and those are the ones that are more risk parity like they're the ones who have more carry trades they're the ones who are selling volatility they are the ones who are buying dips they're the ones who are trading spreads and the mean reversion of spreads those are the ones that have attracted assets so that's uh there are many dimensions s you can look at time frame the being short-term you're more long long convexity and you're very vulnerable to short-term noise um and that hasn't worked effectively being long volatility has been a horrible strategy in the last 15 years and so that's one factor uh let's talk about the government intervention in the 70s after the inflation of the 70s commodities became u subsidized in the US so farming and the oil industry have massive tax uh benefits and in order to suppress the moves in commodities. When that happened uh then FX in the 80s had big moves and then in the late 80s of course you had the suppression of volatility and countries used to prop prop their economies by lowering the value of their currency. uh then currencies became effectively more uh controlled and uh the the move uh then went into fixed income. Uh so first commodities got pinned, second FX got pinned in the 80s, fixed income got pinned in the '9s and early 2000s uh where interest rates went from 14% all the way to the negative. Uh now that fixed and then fixed income now is a little bit uh has the boundary of inflation hitting against it. So we're seeing signs of inflation. So there's less room to operate in the uh in the fixed income world to propel the economy. Finally, and the final barrier is of course stocks, which is where uh governments are are effectively acting, you know, stocks have become risk-free. So that progression uh you has led to style drifts in the CTAs with the ones that are looking to make money in the short term at the expense of being able to hedge equity correction. So the more you're trying to have a high sharp ratio today, the less you'll be able to handle the full cycle or the market correction uh when the market mean reverts to its long-term average in terms of valuation etc etc. So the sector allocation is a style drift. The time frame is a style drift. It means CTAs have more and more long-term. CTAs have also if you look at the returns of CTAs 80 90% are from long the long side effectively the short the short side uh doesn't make money very often and CTAs have been successful uh have also style drifted into long only strategies and you can replicate easily and you can see which ones have done that which ones have not so long versus short long-term time frame the asset class style drift u and then the long volatility versus short volat voltility style drift, right? So, should you be mixing mean reversion with momentum versus not? So, that's a little bit of the kind of the dimensions or the factors as I see them that explain the uh differential or the dispersion in the returns of CTAs. But if you want one factor, you're not into all these different things. uh look at the convexity or the amount of the skew of uh your CTA and it's typically going to tell you how well they're a complement to your portfolio but also what their sharp pressure should be in the recent environment. In the full cycle, a skew is not a predictor of returns in the full cycle. In the short-term cycle, it seems that negative skew is a predictor of returns. And that's a big confusion and that's a very very big risk when it comes to research. So the intelligence, the data that's coming in, uh all the new data sources, the alternative markets, um the ability to optimize way more than ever before have all been a justifications for CTAs to drift into negatively skewed strategies in the name of diversification. In reality, CTAs have gone from being long long-term tales to effectively being short tales in many, many different areas. So, if you look at the rolling skew of the CTA index, it's actually flat. CTAs are no longer a diversifier for portfolios. >> Now, I'm not an expert in skew like you are. However, I've got a just a couple of things that I wanted to um try out. Let's call it that. Firstly, I completely agree that in my career, I would say managers um and and by the way, I think we do need to sometimes distinguish between as you rightly say CTAs that have broadened their product uh with other types of strategies and then there is a small minority now which I would call kind of pure trend followers who are kind of living uh the way uh we did back in the 70s and the 80s and in the '90s and I think it's very important for people to understand understand that there is a difference. So I appreciate you highlighting these things. However, and it is true I think that um let's just focus on the trend followers because I think it's too difficult to with when you get into diversified strategies and all of that. I think it is true that we have become more long-term. But my point would be that we should because we are adaptive and we don't sit down. We maybe back in the 70s, the ' 80s, '90s, you would sit down by committee and say, "Oh, uh, we should be, you know, 25% short-term, 50% medium-term, and 25% long-term." It's not how it's done anymore. It's all datadriven. We want to use the data to tell us where to select the parameters and so on and so forth. So I'm I personally I'm not so concerned about the fact that we are more long-term because the data is telling us to be that. Of course if it changes and suddenly shorter term um horizons become more profitable as you rightly pointed out the short-term traders index has not made money for 15 20 years or however long it's been around. So there would be no sense in a trend follower to be a short-term trend follower. I just don't think that works. It's different what you guys do. I don't see you as a short-term trend follower in any way, shape, or form. So, so I'm not so concerned about the fact I'm also, and this is where I'm really out of on my on on deep water here because uh as soon as you start talking about skew, I I know I'm not at your level, but I wonder if this change in when you calculate the skew of CTAs and let's just call it the trend following index. I just wonder if the fact that maybe the equity market the way it has moved for such a long time basically going up for 20 years essentially whether that's part of the explanation as to why the skew number look different and then maybe you say okay trend following skew has to be measured against a much longer term horizon today than otherwise. These are just my thoughts. These are these are questions that we have to ask ourselves every day. And effectively what you're saying is should we optimize over the recent market cycle and over the factors that have made money recently versus keeping exposure to factors that have not made money in the short term but make money in the long term. So >> how do you define the short term here Nicole? Let's put it the 15 the 15ear cycle since GFC where the market has annualized 16% versus >> uh the normal market which is annualizing more 7%. >> Okay. >> And maybe uh yeah let's define the last 15 years in particular in reality uh CTAs just before 2022 had not made money since September 2003 other than the risk-free rate. So from 2003 up to 2022 the CT index only made the risk-free rate. So the question is a philosophical question is should you optimize based on the factors are working now or should you optimize on the 100year cycle or the 50ear cycle and effectively that's the choice and uh that's why when we talk about skew I'm I'm saying skew is the most different differentiating factor in the last 15 years whether you're long skew or short skew is going to be the difference in your sharp ratio so we use sharp ratio as a pred predictor of asset flows and we use sharp ratio as a predict predictor of market regime shift. What you're saying is that the market regime shift doesn't happen. We're saying the market regime shift is happening all the time. When you look at factors short term, PMs are chasing the factors that have worked recently. The platforms are allocating to the PMs that have made money recently. And there's a major there's a cycle there's a short-term cycle in the market that has become very intensified by effectively we try to allocate to the factors that have underperformed on breakouts when they start to do well. So effectively we're saying if value hasn't done well and value starts to do well again we're going to buy the breakout in value for example. Uh so it it's a philosophical choice but uh there's always a side the the choices that we're making today based on the wellperforming uh factors that's not a long-term optimization that's an optimization for the short term. Some people be so there's a risk to that. >> Yeah. And I just want to clarify I'm not suggesting that um you should optimize or the trend followers should optimize to the short term. I'm just saying that I at least for those who are pricebased only um we will pick up a change in market regime at some point if we are data driven. That's all I'm saying. Um we're not making a prediction as to when this regime will change or anything like that. Um but anyways too much from me Alan. Uh you I'm sure you want to this is not really where we um thought we were going to go Alan. So bring us back to uh to the plan >> just on the short term the breakout this idea I think it is an important one to talk about because I mean the the what you hear from CTAs themselves is that well they'll say look at the evidence you know short-term worked well in the 70s 80s and then consistently since then short-term trend following or breakout whatever you want to call it uh started to have degradation in the 90s or the 2000s to the point now where um when you account for the trading costs, the CTAs will say it it uh it does doesn't it's yeah they will acknowledge it has the superior skew but you know it comes at a cost and sorry I suppose the justification for that is you know markets have become more efficient back in the 80s you know people didn't respond as quickly to the news so social so fast breakout did work then so I mean do do you accept do you accept that narrative or or not. I mean, it's not just since the GFC, I suppose, is the point I'm making that it's been a kind of an ongoing trend since maybe the 1980s. >> Can I can I add one thing to that before you answer, Nicole, and that is >> because you've been able to deal with this change, which I think we probably all agree on because we could see it in the numbers. What were the things you saw? And what were the things without giving any secret source away which direction did you go? You already mentioned analyzing return streams rather than price. I mean I I would love to to hear more about how you've been able to navigate something that has been a headwind for other short-term managers. Frankly, >> well, the the main choice that we have made is that the way our factor exposure takes into account the long-term cycle rather than the short-term cycle. Effectively, we're still trading commodities, we're still trading FX, we're still trading fixed income and equities all the same way with the same risk allocation as opposed to a lot of manners say, hey, FX hasn't made uh money in the last as much in the 15 years. I mean, of course, you had the dollar yen trade recently, but uh we're choosing to allocate based on the factor uh exposure of the long-term cycle as opposed to the short term. Uh that's basically it. Now, what is happening in the short-term space is more intense than what you see in the in the CTA index. uh daily options has created the opportunity for people who are not convexity conscious to make a lot of money. Right? So effectively if you're underwriting daily options you can make a very very high sharp ratios in this regime. There's many nuances to that. If you look to at what happened in India with Jane Street, the accusation is that Jane Street was basically uh manipulating the cash market to have big moves because that triggered massive option purchases by the retail investors who were trying to have leverage plays into the market and effectively Jane Street was selling daily options to the retail market that was buying whenever there were daily moves. And effectively they're saying Jane Street was creating artificial moves in the daily market in order to trigger levered plays u by the retail by the uh retail market in India. So what has happened in the short-term space is that there in the very short-term space there's very high volatility and very high degrees of mean reversion. So if you look at the mean reversion models on the S&P, so if you trade the inverse of a volatility breakout, if the market is up a lot, sell it. If the market is down a lot, buy it based on daily returns. It's completely out of line with other markets. So there are very specific things that are going on, distortions that are short-term in nature that are happening today. And there's ways to you can get hurt by those or you can take advantage of those. But again, it's a you have to balance the short term for the long with the long term. But I'm just giving you these are very extreme. There's ways to make massive money basically uh being short daily options on the S&P because it makes you effectively more aligned with the market makers. for for us um we don't make those adjustments but we're trying to now at this point we're doing research on why should the two systems that are shortterm with the same time frame with the same skew one is losing a lot of money and one is making a lot of money. So there's very specific patterns uh happening in markets. So um as you know there's massive amounts of coal selling on the S&P. So people say I don't I don't care about making 15% a year. Uh I'm happy to make 10% but I want to have an extra 3% a year guaranteed by basically underwriting call. Now that creates the a certain type of mean effectively the S&P cannot go up as fast as it wants. It has like a massive price pinning mechanism and it has an effects on the upside volatility. So the the upside volatility is suppressed because of people say hey I lose nothing. I'm not taking risk by underwriting calls. So, there's weird distortions like that going on. And all of these distortions have long-term they're going to mean revert. It means if everybody's selling coals, effectively buying calls, you can go long insurance and actually get paid because the call implied volatility at this point is too low. So, I'm giving you market characteristics, but this has implications for learning or for research. for CTAs or purely that are purely quantitative. There's no right answer. The market regime shifts are harder to catch than uh we think the the adaptations uh the vulnerabilities are sometimes take years to show up. Um one very important thing to to understand the real vulnerability of long-term CTAs is to look at the returns without fixed income. effectively fixed income has provided a huge amount of positive skew and positive returns. And if you remove that from uh you know a CTA replica, you will see that the changes that long-term CTAs have made are actually much more meaningful on the convexity uh than we would think. And uh it it's highly likely that if there is a big uh uh you know a large inflation regime that fixed income will not be the positively skewed positive return contributor that it's been for the last 30 years. >> No if I can again as a as a trend follow I have to just raise my hand and say it can also be a nice contributor like in 2022 on the short side. So >> yeah just just throw that in. >> So those are long-term CTS. Now these long-term CTS have long bias, >> right? That's >> and longs have bottom picking bias. >> Yeah, different. I agree. >> Yeah, you're Yes. There's different different degrees of uh skew that we're dealing with. Yeah. Yeah. >> Yeah. No, absolutely. >> But very interesting uh uh the choices or dynamics and they're not these are not skill-based dynamics. their philosophical choices and optimizations optimization choices for which cycle we want to uh we want to be how optimized we want to be for the recent cycle versus the long-term cycle. >> Yeah. No, absolutely. Alan, maybe I have one more thing that I just wanted to uh pick Nicole's brain about and then if you have one uh final thing as well just in in uh in the interest of time. But I mean you we've touched a little bit around it. Um but I do think it's a fascinating area and I don't know much about it myself other than I can see the observation about all the money flowing into these pot shops. Uh and they're certainly not flowing into to the CTA space at the same degree. How can you turn that into an opportunity? I I see some risks, but as Alan pointed out, they have been through a couple of uh riskoff events and they've come out of it so far. But how how do you think this might or how how do you how are you thinking about turning this um new platform player in the markets into an opportunity? Can that be done? >> So the way I think of the platforms, I think of them as the LTC LTCMs of 2025. Okay, >> literally they're the ones who are underwriting massive amounts of tail risk with massive amounts of leverage in order to achieve uh short-term very short-term high sharp ratios. So the opportunity set is to actually look for places um in the same way that we looked for V compression in the futures markets and we traded breakouts and we generate both alpha and positive convexity relative to the CT index. There's a way to do this in the single stock world and on single stock factors. So uh looking for places where there's been abnormally high sharp ratios basically replicate as much as possible of the single stock factor universe and look for places where the sharp ratios have been abnormally high and bet on their mean reversions because the platforms have a very specific mandate and it's to cut off PMs that are losing money and to add to PMs that I have made money. So effectively the factors that have done well are uh being reallocated to and it's creating distortions in the market. What we will do is look for high sharp ratios on a time series perspective or cross-sectionally and try to short the high sharp ratios once the turnaround happens because we're short-term traders and we're relatively small at 2 billion. We can actually uh trade in a time frame which is not available to the large platforms and we can actually trade against them. So if the platforms have created self-reinforcing cycles of V compression in specific factors, we're looking to short that. So to me, uh that's the opportunity to make money even when nothing is going on, but also to make a lot of money when in case the market regime shifts. And uh the alpha the perceived alpha of these platforms is not purely skill-based. It's heavily heavily convexity reliant which means it's highly unstable. Uh and the you know that the allocation is based on sharp ratio. I think you mentioned um reflexivity earlier at some point and um obviously you're talking a lot about feedback loops you know obviously strategy is doing well attracting more capital then the strategy is then uh getting deploying that capital which is is a feedback loop um I mean I guess the question is when you know with any reflexive process there's an error that the market is making there's something that they're missing and at some point they identify and and and then uh uh you get a a rever reversion. So I mean in your mind in your kind of big picture framework what is that and and what what when do we revert to a more normal environment? We talked a little bit about inflation you know typically it would be a liquidity adjustment do you think it's it's it's it's that type of scenario again or you know problems in or is it overlever that just creates the problem in itself? Um the human apparatus is not designed to be efficient in the decisions that it makes in when it comes to investing. So the things that we in everyday life we go and we learn. Oh this is this type of behavior is positively uh rewarded in the markets you creating imbalances. That's why you have inefficiencies in the market. Our brains are not designed to uh to have a long-term perspective. They have short-term memory and uh that so these these inefficiencies that we created can be for them to be taken into account in our investment process requires data and requires data which is longer term than what most people look at and it also requires a certain degree of self-awareness. If you're the type of uh you're ambitious and you want to prove that you're the best PM ever and you want to raise money like right now, you're gonna make uh decisions uh which are less optimal uh for the sake of a short-term gain and uh so effectively you know in the same way that Warren Buffett has said hey you know buy and hold the US stock market uh and don't look at the turns. Uh every quant researcher has the ability to uh look at the long-term cycles and take those into account as opposed to uh more optimized on the data set which is available which is much more in the recent years right the data >> uh of the last 15 years every year we're exposed to you know exponentially more and more data right so uh it takes a certain amount of understanding of what is my thinking doing versus what is so I mean you I meditate because it allows me to experience life not through the lens of my intellect, not through the lens of my convictions and my beliefs but in a way which is much more uh stable although it doesn't agree with what I see every day right um so the crowd is a very safe place to be emotionally for humans so if everybody at a party is talking about what you're talking about you feel better about yourself and you feel safe yet you're in a very dangerous first place and that is the uh the cycle of counterbalance in the market and that's what as a uh you know as a long-term investor you have to be able to understand yourself and understand what is driving your perception of the world as you see it and to be able to neutralize uh the imbalances that your intellect gives you. I think that's a very uh good place to uh to stop it kind of uh and but also a very good place to bring you back at some point and and continue because that is uh obviously uh very interesting and not something you uh uh you come across with too many people in our industry. Uh Nicole, this has been uh fantastic and we very much appreciate uh you doing it and I would encourage everyone listening today. Uh in order to show appreciation to Nicole and Alan um for the time they spend in preparing for these conversations, head over to your favorite podcast platform, leave a nice rating and review. Uh we so appreciate this. Um next week I'm going to be back with Rich. Uh, so if you have any questions for Rich, then you can send them as usual to info@toptradersunplot.com and I'll do my best to bring them up. But from Alan, Nicole, and me, thank you so much for listening. We look forward to being back with you next week. And in the meantime, as usual, take care of yourself and take care of each other. 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.