Episode #310: Kathryn Kaminski, AlphaSimplex, “When You’re A Systematic Investor, Your Process Makes The Decision”
Guest: As Chief Research Strategist at AlphaSimplex, Dr. Kathryn Kaminski conducts applied research, leads strategic research initiatives, focuses on portfolio construction and risk management, and engages in product development. Dr. Kaminski is a member of the Investment Committee. She also serves as a co-portfolio manager for the AlphaSimplex Managed Futures Strategy. Dr. Kaminski co-authored the book Trend Following with Managed Futures: The Search for Crisis Alpha (2014).
Date Recorded: 4/14/2021 | Run-Time: 55:47
Summary: In today’s episode, we’re talking all about trend following and managed futures. You may have heard the phrase “crisis alpha” before, and Kathryn is the person who coined that phrase. We start with hearing what it was like for her to study at MIT under the legendary Andrew Lo. Then she explains why trend following works during a crisis and uses last year as an example.
As we wind down, Kathryn explains some misconceptions about trend following and talks about why it’s so important to have a process driven investment approach.
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Links from the Episode:
- 0:39– Sponsor: Masterworks– Use Promo Code “MEB” to skip their 15,000 person wait list
- 2:09 – Intro
- 2:58 – Welcome to our guest, Kathryn Kaminski
- 3:44 – What led her to become an investor
- 5:17 – Studying investing with Andrew Lo while pursuing her PhD
- 6:33 – Trend following, managed futures and crisis alpha
- 8:36 – Why trend following isn’t more widely adopted
- 10:05 – A historical perspective on trends over centuries
- 12:25 – Trend Following with Managed Futures: The Search for Crisis Alpha (Kaminski)
- 14:27 – What trend following looked like during the pandemic
- 19:42 – The Great Fiscal Experiment (Kaminski)
- 23:26 – Portfolio construction, dispersion, strategies and managers
- 25:14 – Crisis or Correction (Kaminski)
- 26:18 – Return Dispersion (Kaminski) and What Worked in COVID-19
- 26:25 – A detailed view of Kathryn’s strategy
- 28:57 – Common misconceptions about trend following
- 33:53 – Capital allocation and why people’s portfolios don’t often reflect what they really want
- 36:32 – Which institutions invest heavily in managed futures
- 41:38 – Best practices for investors stepping into the trend following space
- 44:59 – The most non traditional markets that Kathryn has traded
- 46:01 – Reflection of 10 Years In Trend Following (Kaminski)
- 49:00 – Ways to catch your own blind spots in investing
- 52:17 – What Kathryn’s thinking about as she looks to the horizon
- 54:11 – Her most memorable investment
- 55:58 – Learn more about Kathryn; alphasimplex.com; Crisis Alpha; A Multi Centennial View of Trend Following (Kaminski)
Transcript of Episode 310:
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Meb: What’s up, everybody? We have an awesome show for you today. Our guest is the chief research strategist at AlphaSimplex, where she’s also the co-portfolio manager for the firm’s Managed Futures Strategy. Today’s episode we’re talking all about trend following in managed futures. You may have heard the phrase “Crisis Alpha” before and our guest is the person who coined it. We start with hearing what it was like for our guests to study at MIT under the legendary Andrew Lo. Then she explains 800 years of trend following returns, why it works during a crisis and uses last year as an example. As we wind down, she covered some misconceptions about trend following and talks about why it’s important to have a process-driven investment approach. Please enjoy this incredible episode with AlphaSimplex’s’ Kathryn Kaminski. Kathryn, welcome to the show.
Kathryn: Hi. Great to be here. I’m excited.
Meb: Where do we find you in almost Tax Day 2021?
Kathryn: Well, I’m in Boston, Massachusetts. So, way up. We’re starting to get some springs. So, that’s exciting.
Meb: Well, you were MIT grad, I believe. Was that home for you originally or you went to MIT and stayed?
Kathryn: Yeah, I’m actually from Nashville, Tennessee. So, I’m a Southerner. I grew up in the south but moved to MIT for college and graduate school. And I came back. I then moved to Sweden and then came back to Boston. So, I’ve been in a couple places.
Meb: Well, if you say, “Y’all,” I won’t hold it against you. Because I did part-time in North Carolina, right down the road. And I’ve kept all of my draw, despite being in California for almost 20 years now. You’re a trend follower through and through. When did you get that bug? Because at MIT, you’re electrical engineer, right? The hard one? When did you get bit by the finance bug?
Kathryn: So, I was really into engineering. And then I did my first internship in a French bank on a quantum desk. And it was really exciting. And I thought, “Wow, this is cool. The finance is actually very nerdy, so I got to do this.” And then I went to do a PhD at MIT, in operations research and started working with Andrew Lo, who is a quant finance guru. And so I got really sort of came in the back way from the bond side. But I also grew up with a mom who’s a financial planner. So, we talked about the stock market at the dinner tables. So, I’ve sort of always loved the financial markets in some way.
Meb: What was your family’s approach to the markets? Were they Buffett people, were they traders? How did they think about it? It’s always fascinating to me to hear how the dinner table discussion actually went?
Kathryn: Yeah, my mom was really into technology stocks. And so she would talk a lot about technology stocks back as early as the ’90s. She talked a lot about Qualcomm, a lot about Apple, and I was really interested in those type of themes and how people can be long-term growth investors. So, she was definitely interested in growth, something that I think was a good call, especially 30 years ago.
Meb: My mom is probably the best investor I know, absolute … buy and hold investor who has no problem holding things for decades. So, we definitely got that side from her. Talk to me a little bit about Professor Lo. I remember one time I was hearing him give a speech. And he did an experiment and the specifics are lost on me. But he was trying to get people to guess the value of an item in a box. Have you ever seen him give this speech?
Kathryn: Yes, I have.
Meb: Okay. I didn’t imagine it. And it was eerily scary how close the audience got and the item at that time was, it must have been an iPod. But anyway, was he a trend follower at that point? Was it a managed future’s interests? Give me the origin story.
Kathryn: So, when I started working with Andrew at MIT, I did my PhD on rules and heuristics that investors use to make decisions. So, I was really interested in why do people use these rules? And when do they work? And what do they not work? So, I spent a couple of years with Andrew studying different rules, like stop-loss rules and things that we would try to use to make decisions when decisions are difficult. And so by the end of my PhD, it’s pretty clear that trend following is one of the greatest rules-based trading strategies out there. So, for me, it’s definitely philosophically aligned with what I was interested in is how do you disentangle decision from emotion? And is it good? Or is it bad?
Meb: You’re one of my favorite authors, you don’t know this, but you are, you’re very prolific and put out a great deal. And it gets pretty nerdy quick, which is a compliment, you know, I was an engineer too. But talk to me a little bit about how you think about, like, what is trend-following managed futures” mean to you? You say trend following in my mind, and you could have it’s like saying the puppy. It could be a Great Daney, it could be a Beagle, it could be a Pit…like, it’s very differentiated, despite the general concept, in theory. Tell me a little bit about what it means to you. And then also use that as a jumping-off point to start talking about crisis alpha a little bit.
Kathryn: So, trend following is such a cool strategy, because I think it’s so hard to make decisions about what to buy, what to sell, and when. And what we really try to do is use lots of different techniques to measure where the market’s going across multiple different horizons. So, we combine those views to try and understand, okay, where our market’s moving. And so in some sense, we’re really trying to understand not why something is happening, but what is happening, and where are we going. And so for me, this is really exciting because the market has so much power, it’s basically the representative of what all of us are doing. And so if we can be good at measuring that, and following that, the market has wisdom. And in certain times, it helps us to see when things are changing, that we either don’t want, don’t like or don’t expect, and particularly don’t like. So, that’s when it’s very interesting to me. So, in periods where there’s a lot of turbulence, a lot of uncertainty, trend following is a very good strategy, because frankly, it’s not that fun to make a decision about what’s going to happen tomorrow, when you’re faced with an election, when you’re faced with the Brexit vote, when you’re faced with chaos. And I think for us what’s interesting as systematic investors with trend, and we trend is following where the market’s moving. And the market has sort of collected wisdom. And that’s what we believe is that we should follow the market over time.
Meb: When you think about the general concept, it sounds so simple, the most often discuss, you could call it a long term moving average 200 day, a breakout 12 months or whatever it may be. It sounds so simple on paper, what is the difficulty? Why is trend following not used by 100% of people out there? I just did a poll on Twitter, I said, “Do you use trend following investment approach?” And not surprisingly, the vast majority said none. “What do you allocate in volume?” The vast majority said zero, and then zero to 20 was the next, that added up to like 90%. What do you think from such a simple concept, where does it get so difficult? Where does it get so complicated?
Kathryn: Well, I think the problem is the devil is always in the details. And we all know that. So, when you need to actually think about trying to measure trend across multiple different horizons, multiple different markets, with all the subtleties of trading those markets, particularly in the futures markets, which is where we trade, it’s not an easy strategy to implement, it requires constant measurements and aggregation of information. And really, it requires a lot of quants savvy’s ability to put all that together. And so at the end of the day, it’s very easy to replicate what happened in the past, but it’s very hard to do a good job, in terms of not making the details, getting the details right. And that is something I’ve learned over and over again, when I talk with investors, it’s quite a complicated strategy if you want to get every detail correct.
Meb: People don’t like low batting averages when it comes to investing, they like the things that, you know, they make a trade 90% of the time, it’s right. And trend following often doesn’t have the sort of Ted Williams-esque batting average, you know, it tends to often have much bigger winners and a lot of like little paper cuts, as far as losses. We’ve published a fair amount of historical research on trend following, but you’ve done studies that make mine look laughable in duration as a comparison. So, taking some back 30, 50 years on one hand, but you put out some work that goes back, not just one century, but more than one. Talk to us about the inspiration for that research and your wonderful book.
Kathryn: So, I think what was interesting for myself and Alex when we were thinking about writing a book on trend following, we wanted to start with a historical perspective. Of course, we had to do a lot of hand waving and say, “Okay, assume this, assume that.” But it was really fascinating to go back 800 years and look at asset returns, and try and understand are there trends in prices and returns over long decades of time? And what we found is yes, there are trends and the trend type strategy does work relatively well over decades and centuries of time.
Meb: Tell the audience where did you source this sort of data? What was the data? What did the portfolio look like 800 years ago? I like to quote the Talmud when I talk about investing strategy. So, that goes back 2000 years, but what sort of commodities or markets were you talking about?
Kathryn: So, some of the earlier contract prices were things like rice prices back to 1100. But there were also many commodity prices and bond prices as early as the 1600s. So, really, there’s a lot of information about the value of different things over time, granted the trading and the transaction costs. We all need to wave our hands around to talk about trading during the French Revolution. But there’s still things that were bought and sold. And so there’s a provider called Global Financial Data that provides very long history data where you can examine values of some of these assets over longer time histories. And with a lot of assumptions, you can at least think about what it could have potentially been like to trade a strategy like that, over time.
Meb: Give us the broad takeaways, what was the condensing a 500-page book, which, listeners, we’ll add to in the show note links. I’m rounding up, I think it was only 490. But condensing this into a podcast, what was some of the takeaways?
Kathryn: The key takeaway for our book was more about thinking about when does trend following work. And it was a focus on crisis alpha and trying to understand why trends occasionally exist that can be profitable. And also to think about how do you use trend following strategies in your portfolio. So, once you understand when trend works, then you can think about why it does have portfolio benefits to classic traditional investments. And it’s really one of the only strategies out there that has that conditional correlation, and also has been able to do really well in periods of extreme stress. And when fundamentals, frankly, are challenged, and I think a lot of investors, despite that it’s not a high Sharpe ratio strategy, the ability to add diversification is huge.
So, in times, like, 2008, in times like Q1 last year, in 2020, and times like the energy crisis in 2014, those are periods where people’s portfolios are challenged. And I think that’s when the strategies tends to do well. And there’s some simple reasons for it. It’s a strategy that does well when things are more predictable in markets. And when are things actually measurably more predictable, it’s when people are stressed. And when there’s some sort of change that is very challenging. I mean, I think last year is a perfect example of that, there were some phenomenal trends. Now they were hard to take and definitely difficult to react to, in the moment. But a strategy that’s systematic doesn’t ask the question why, it asks the question what. And so what’s happening is very different question to ask, then why is it happening. And should I do this? And so I think that’s where it’s quite a fascinating strategy to watch is that we tend to not have a problem doing something different just because the world is changing.
Meb: There’s so many behavioral challenges with following a trend following strategy that people really struggle with. But likewise, there’s also a lot of behavioral challenges with following a buy and hold strategy that people struggle with. They’re slightly different. But one of the reasons that investing, of course, is hard. I love your quote, “When it comes to crisis alpha, everyone likes the alpha, no one likes the crisis.” Talk to us a little bit about last year. Trend following, like, many strategies goes through its periods of summer and winter. The global financial crisis was like the picture-perfect case for trend following and did an unbelievable job. Everyone got excited about trend following, and ’09, 2010 is somewhat, you know, zigzags for the last handful of years, and then seems to have been perking up over the last year. I guess a pandemic could do that. Walk us through what the last year has been like in the world?
Kathryn: 2020 was a very exciting year to be a trend follower, especially not to have to make active decisions, but to have the decisions be systematized. And part of a process was definitely a much easier place to be because it was a stressful environment. So, let me just go through last year because we saw some really interesting things. So, last year, we had many different themes. Q1 was the COVID crisis, Q2 was the recovery or sort of the reversal inequities, Q3 was the beginning of what would become a very powerful reflation trade that we were following. And Q4 was a little bit of uncertainty about the U.S. election, coupled with vaccine hopes and continuation in the reflation trade. This was a very prime environment for trend following, why? Because during a period of stress and change, things tend to be a little bit more persistent than what you would expect. And also information was being diffused and understood slowly.
So, it took people a long time to really understand that things were going to get better with COVID. It took people a long time to understand the impact on the basic demand-driven assets, like commodities. And that created a very smooth trend trajectory for many of the assets that we trade. So, let me just give some hints about what we saw, which was very helpful trades. So, in Q1, as an example, although we were hit as well, just like many with a long equity positions, we had short positions and/or at least short signals and energies were very good place to be, in terms of futures positions. And so that short energy trade was extremely strong in Q1 coupled with the fact that bond yields took a massive drop, so being able to be long bonds, as well during Q1 as well as short energies and short other commodities, like copper, and some of the base metals was a massively successful trade for trend.
So, put those net over net despite the losses in equities, those turned out to an overall positive performance for trend following. If the drawdown had continued, I think it would have been even more successful as a trend following, a crisis alpha environment. But then in Q2, we saw something happen. In Q2 we saw a very large shift in the markets from this crisis environment to the recovery. And so recovery for trend is a challenging environment because the new trends begin, where old trends disappear. So, we started to see the beginning of this weaker dollar trade. We also started to see this reflation theme start to emerge in commodities, and we saw equities recovering at the same time while bonds sort of laid stagnant. And so that environment was a little challenging as we had to start measuring where the market was going and moving in the direction of reflation.
So, Q3 and Q4 was really about the reflation, reopening trade, a period where commodities moved massively. The U.S. dollar sold off substantially, and we also saw equities roaring into the end of the year. So, last year was a very positive environment for trend. And this kind of highlights the way the strategy is so dynamic. Positive opportunities in Q1 were long bonds, short energy, short base metals. Q3 and Q4 was long commodities and long agricultural commodities in Q4. And Q3 was also precious metals, which also were moving quite substantially over the summer. So, we had a lot of different moves throughout the same year. Not just one trend, but multiple different trends that are changing throughout time.
So, going into this year, it’s been really exciting because the reflation trade has continued. But one thing has started to change the narrative for us, it’s that bonds have started to show short signals as early as the beginning of this year. And we started to see short views on bonds, looking at a steepening of the U.S. yield curve, something which is very challenging for a lot of other investments. So, for us, it’s been, as I said, very exciting. Lots of things going on, lots of new trends, lots of things that could change, where we end up later this year and into next year.
Meb: As you think about sort of the four main food groups that trend followers look at equities, bonds, currencies, commodities. One of the arguments that, I haven’t heard as much lately, but as a perfect use case, which you just described, is helping to hedge against rising interest rate environment, you know, in a world of negative-yielding sovereigns, the U.S. didn’t quite get there, this go around, who knows in the future, the ability to short bonds. Particularly for an investor who has a traditional 60, 40, U.S. opportunity set, and then eventually short U.S. stocks, if and when they ever roll over, they may never, we’ll have to have you back on in 2030 and see if we’ve ever had a bear market again, but seems to be a really complimentary and obvious approach to a portfolio that has a lot of bond exposure at these low yields. Does that make sense?
Kathryn: We just wrote a paper this week called the Great Fiscal Experiment. And the goal of this paper was really to think about what are we looking for going forward? And what are the opportunities set? Because some of my previous research on trend following over decades and centuries, like you said, we looked at inflationary environments. And so higher inflation is really good for increasing commodity prices, but it provides a lot of tailwind against bonds. So, bonds tend not to perform so well, despite higher carry an inflationary environment. So, in some sense, a lot of the things that we’ve been banking on for the last 20 years or 40 years, depending on how you characterize it could actually be challenging for a lot of investors. So, for us, there are actually a lot of opportunities out there in the environment where inflation could come. And actually one of the data points that we highlight in this paper is the fact that the CPI levels are much lower than what’s expected in the real-time estimates for inflation.
So, State Street has a statistics on real-time inflation, where they scrape prices from actual online purchasing prices. And the numbers for recent inflation numbers are much higher than those that you’re seeing from the Fed. And so that’s why a lot of investors are starting to say, “Well, wait a minute, what happens if we do have some inflation from all this spending? What happens as well, if bonds suddenly don’t go anywhere, or that we have rising rates at some point, in my portfolio, which has tons of bonds, just takes a hit.” That’s something we haven’t thought about since the 70s. And so I think for us as trend followers, it’s very exciting because we can short bonds, we think it’s interesting, we’ve actually seen positive short positions in the long-term U.S. yield curve, in the beginning of this year, something that is exciting because it doesn’t happen that often. But February really woke up the markets, it jolted everyone, and said, “Wait a minute, I know you forgot about this, but duration risk is real. And you need to worry, if you’re holding growth, it’s going to affect you. If you’re holding bonds, it’s going to affect you. And even if you have commodity exposure, it could be something inflationary inducing.” So, it’s really an interesting turning point we’re at right now, post coming out of this crisis.
Meb: I had forgotten about that State Street. It was price stats, I think is the name of it, right? Man, they bought them years ago. And it used to be a free site. I think it was some academics did it. I used to love going there, and then they paywalled it, I’ll have to see if we can get access to it.
Kathryn: It was some MIT guys.
Meb: Yeah, it was a brilliant approach to vote. I remember back in the day, people would message boards complain about inflation measures, talk about them. And then these guys came out and literally did it across the Internet. And they do it for two dozen countries or something. It’s really cool. Anyway, we’ll check it out later. Talk to me a little bit about how you guys think about putting it all together as a portfolio, there’s so many different. And I imagine and you can talk to this too, a year like 2020 probably had a lot of dispersion. I think you wrote a paper on this, maybe talk to us, about a little bit about the dispersion and different strategies and managers, because construction makes a pretty big difference in the outcome, particularly in the year, like last year.
Kathryn: This is a good point. In my book on “Trend Following,” we talked a lot about “Crisis alpha.” And in crisis alpha thinking about capturing crisis alpha, there are a couple of key themes that you need to think about, which puts you in a better position to do well in a moment of stress. So, the first is pure trend versus non-pure trend. So, when you start adding other strategies outside of trend, like carry and other approaches, they tend to be correlated during drawdowns, which kind of puts you behind if you’re trying to adjust to such a stressful environment. And second of all, it’s also important to be fast. So, the faster you move, the more likely that you’re focusing on sort of shorter-term moves. And you can actually get out of the way of difficult trends, like that equity move, but you can also jump on new trends that are forming in the wake of such an environment. And many of us know exactly what that means watching what happened in COVID. I mean, which companies outperform versus others, it was very clear differences, but you need to move fast.
And so being able to have systems that are faster, without getting head fake too quickly, is very important. So, those managers who were faster definitely had an advantage. And finally, it’s about volatility and how you measure it. If you measure volatility too slowly, especially in a COVID environment, you have some issues. For example, we wrote a paper last year called Crisis or Correction talking about the COVID environments. And what we found is that was the fastest, in terms of depth versus speed, depth versus length of that drawdown, it was really fast compared to how far it fell, compared to other crisis periods in history. And so you can imagine your ability to measure volatility and react to volatility also matters.
So, really, what three things? First trend versus non-pure trend. And then second, speed, and third, volatility. And so in our space, you can imagine just simple things like being very slow to adjust to volatility would mean that you wouldn’t realize how risky the world had become quick enough. For the case of speed, you wouldn’t adjust fast enough to what had occurred, particularly for the COVID event. And then finally, like, I said, trend versus pure trend. Pure trend has the ability to start moving with a new environment faster than say, some strategies that can get caught in the middle of it. So, those are the three things that we found. We have two papers, one was on returned dispersion. And then we also had another one that looked at what worked in COVID, and why.
Meb: And so how do you guys think about putting it into portfolio the big challenge with trend following for an individual and why they often will hire managers. There’s over 100 potential markets around the world, the trade in all sorts of different times on different exchanges and different rules, collateral and everything else. But also, is it a scenario? Talk to us a little bit about how you guys kind of put it together? The sausage gets made. Is it a scenario where you guys use one system across 50 markets? Do you use different timeframes and different systems? Are you updating them? Give us the good details.
Kathryn: So, that’s why I liked your question about complexity. It’s a very simple strategy to explain, but to implement, it requires you to trade across multiple different futures exchanges around the world at different time zones and with different regulatory environments, as well as requirements for collateral and other issues. So, it is not an easy strategy to implement just as an individual. And that’s what’s exciting about the field is that back 20 or 30 years ago, was a strategy that was a hedge fund strategy. It was something that was not explained well, that was seen as a black box that disguises something completely different, something very simple, but at the same time, to do all those things to be involved in trading all those exchanges is quite challenging. But today, it’s actually a strategy that is easily packaged into something that even retail investors can have access to. And I think that’s exciting. Because, as I explained before, there are very few strategies that did well in 2008. There are very few strategies that enjoyed Q1 last year.
And I think investors, it’s a nice complement to a lot of classic approaches. And so I’m glad that today, it’s actually something that many investors can invest in. The only challenge is holding it, you need to be a long term investor because you have years where there are no big trends or that equities do well. But trend following doesn’t. And I think that’s where investor education is so important, and understanding what the goal of this strategy is. I have way too many people that say, “Well, I’ll just buy it when a crisis occurs.” And I love that comment because I would love them to have my phone number and call me as soon as the crisis occurs, because I would love to rebalance my portfolio on that same day, too. So, that’s sort of one of the challenges that you have to let it go, let it run its own course.
Meb: There’s probably no more costly phrase and all of investing is, “I’ll just wait until dah, dah, dah.” We speak to investors that got out of stocks in 2009, never do invest again, all the behavioral games they play inside their head and the challenge people have that actually say, “Man, it’s hard for me to implement the system because I get a trade and I don’t want to make it.” And I say, “My God if that’s your problem, what’s the alternative? That you have no rules? That sounds infinitely more stressful to me than having an actual plan.” Having no plan sounds like an absolute nightmare. Talk to me a little bit about some of the misconceptions the way people think about trend following? You have sat on both sides of the desk, and allocator, a manager or researcher, and it probably heard all the same Prince’s, I can say it, as a trend-following manager dumb questions, but also the good ones. So, talk to me about some of the misconceptions. And it runs the gamut for me, not just retail all the way to big institutions. What are some of the big ones you consistently come across?
Kathryn: I think the biggest one I already talked about, which is timing, people think that they’re going to know, “I’m going to know when it’s going to be the right time.” And I feel like none of us, it’s always the right time to be investing.
Meb: The time that you should be investing is usually in the best time is when a particular strategy. This doesn’t apply to managed futures, but everything is when it’s doing poorly. But no one wants to invest in, right? Like, you crazy. It doesn’t work anymore. It’s dead. Same thing with stocks, you pick any bottom. Nobody wants stocks, and that’s usually the best time.
Kathryn: Exactly. And I think it’s the same for managed futures that you were highlighting before. Everybody in 2009, when the crisis was over, was like, “I’m going to buy insurance for the next crisis. I’m going to buy managed futures, I’m going to buy all the things that did good in that environment and expect them to do the same.” And that, as you can see is a big challenge because the strategy it’s going to move where the market moves. And if the market moves into crisis, it’s going to move with it. But I’m not going to be able to tell you what’s going to happen tomorrow. I can tell you where the market is moving today, but I can’t predict the future. And I think no one can. And I think that’s where there’s some misconception that people think, I’m going to know when it’s the right environment. That’s why I always suggest to people to buy and hold the strategy and think about it as something that’s just different and has a different approach to what they have in their portfolio already and finds different opportunities from what they’re already holding.
Another thing that’s interesting for us that people have a hard time to understand is being a systematic investor. When you’re a systematic investor, your process makes the decision. So, the decisions are made by your models that you design, and you follow the process. And so even when I was an allocator to trend following, that was the biggest thing that we were always asking questions about, how do you ensure that your process is making the decisions and make sure that there’s no discretion or ability for someone to just say, “Wait a minute, I don’t feel good about a particular trade or a particular environment.” And my personal experience with this trading managed futures strategies, it’s usually when I’m the most uncomfortable, and the most concerned, and my stomach hurts a little bit about the markets when the opportunities are often the best. And that’s what I’ve learned throughout many years of trading in managed futures is that oftentimes, when things are highly emotional, or the market is very stressful, it’s often then when there’s trends in the market, the market knows more than we think it does. It is the collective wisdom of all of our decisions. And that’s precisely when we feel the most uncomfortable, I’d say, where it’s probably the most useful to have a process instead of having an emotion, unfortunately.
Meb: It’s weird that people have a struggle with this concept of rules and process, when in reality, almost every investor allocates to passive strategies that are literally rules-based, market-cap-weighted U.S. stocks, small-cap stocks, small-cap value, bond indices, on and on and on. Those are all literally rules-based portfolios, some much more naive and poorly designed. I think I was musing with Jerry Parker once about why the people struggle with managed futures, and said, “Well, it’s probably the decision to call it managed futures in the first place.” That sounds scary anything trading futures is like a scary needs a rebranding is a different phrase. So, I’m not sure what that good phrase should be. But that’s something that seems alien or foreign to many investors, despite being a very thoughtful approach.
Talk to me about allocators. So, are people listening the investors? And I’m of the belief, if you were to write down on a piece of paper, you took the Soc Gen trend index or any handful of trend funds, blinded the stats, here’s your returns, volatility, drawdown, correlations. And you did it with stocks, bonds, foreign stocks, real estate, commodities, whatever, and you told people to select the allocation, and then compare it to what they actually do or put it in an optimizer, you end up with a very large proportion and trend or managed futures. Is that something you agree with? And then why is there such a spread between what people “would” say they should do on paper if they didn’t know the name of it? And/or what the optimizer would say and what they actually do? Have you solved that riddle?
Kathryn: Yeah, there’s some research, Alex Greyserman has done a little bit of behavioral research on this. And there’s some aversion, people feel more comfortable with stuff that they feel like they understand. And that makes sense to them. So, there’s definitely a bias to things like stocks and bonds, your vanilla and your chocolate. And so when you get to something like managed futures, it is a little hard sometimes for investors to understand exactly what it’s doing and why it’s doing it. And it’s not in their control, so they’re basically allocating to a strategy that is changing over time. And then they may not be able to predict. With bonds, you can say, okay, bonds went up, I made money, stocks went up, I made money, it’s a little easier to understand where the returns are coming from.
And that’s why, I mean, I guess in some ways, it’s why I like my job is because it’s a lot of fun to try and help people understand what we do in a way that they can actually attribute those positions to our returns. And that’s complicated. Because if you trade 100 markets, across multiple asset classes, and you’re going to a client, oh, cotton was a great trade. It’s more complicated. And so a version of complexity is definitely something that we all have, despite the fact that the strategy philosophically, I think, is very aligned with something that’s different from the way we tend to invest. We tend to want to hold on to our losers too long, and we tend to want to cut our winners too short. And what trend really does is it does the opposite of some of these behavioral approaches. And that’s precisely why it tends to work in certain environments because it’s not easy to make the type of decisions that it does.
Meb: There’s a great quote “Fearful with gains, hopeful with losses” describes a lot of investors. And there’s another area of this sort of concept of long volatility that applies in sort of start-up and angel investing where their exit is zero. So, the things that just go to zero, they have a lower batting average, but the big gains let your winners ride, the hack that they’ve come up with is that they’re just illiquid. No, they have to hold them for 3, 5, 10 years. And you have a similar system, maybe not as explicit as the managed futures rules. But it’s an interesting Venn diagram overlap. You know, I was reading a Goldman paper, I think it’s Goldman, I love to throw Goldman under the bus. So, even if it’s not Goldman, we’ll just call it Goldman, where they said, how much should you allocate to trend-following managed futures? And the optimizer said, like, half or some just enormous number, and then they said, “Sorry, we have to constrain the strategy because we all know that’s not realistic.” And in my head, I’m like, “What do you mean, it’s not realistic?” It’s a perfect example of this career risk, or people sort of modulating or bracketing in something, just because it feels scary to them are foreign, in many ways. What institution, you don’t have to say their name. But have you ever heard of any institution that ends up putting 25%, 50% in managed futures or trend?
Kathryn: I’m a big fan of equities plus trend, I think just combining equities and trend in your portfolio, if you can kind of close your eyes and put them together is a really positive thing. Because what tends to happen is people tend to compare to equities anyways. So, if you’re thinking about it that way, it’s hard to be better than equities. Because when equities are up, you’re supposed to do as well as equities. And when equities are down, you’re supposed to do better than equities. So, that’s kind of up all the time. If you’d ask me, I do see that there are some research papers that do show that managed futures is one of the best diversifier versus all other hedge fund strategies and other approaches. And I love that you talked about the differences in approach, too, because we tend to, and in my book with Alex, we talk a lot about the difference between divergent and convergent strategies. Divergent strategies have a lot of small losses and a few big gains, whereas convergent strategies have a lot of small wins and a few devastating losses.
So, things like equity returns are very convergent, that… And when you think about equity investing, it’s very positive most of the time until it’s not, whereas divergent investing, just like angel investing is kind of challenging a lot of the time until it’s very exuberant. And so I think those two approaches match very well together. And some of the best trades for us are really these big moves that you don’t expect. So, the massive bond move in 2019, or the short energy trade in Q1 last year, sort of these huge as you explain these companies that go public and make your balance sheet, as opposed to the little companies that you had a lot of hope for, but unfortunately, they don’t become the next big Facebook or Spotify or some other giant name in the tech space.
Meb: Coinbase today, Coinbase is the name of the day. I think we may be the outlier, listeners, if you know any institution that puts more than, say, a third in trend, hit me up, our default allocation is half in our, what we call our Trinity portfolios. And I think it is a perfect framing in my mind, you mentioned the equities and trend. And it’s such a good Yin Yang, because a traditional buy and hold portfolio even well-diversified globally, across stocks, bonds, real assets. The big problem with it is often, like, a 2020 problem is that when it hits the fan, it’s all correlated during recession, depression, bad times, market going down, and your human capital, which is the worst of the four, right? Unemployment went from, what, 3% or 4% to 15%, 20% in a heartbeat, at the same time your portfolio is going down. Seems the opposite of what you actually would want to be diversifying across for human capital. So, having that Yin Yang, and to me, 50/50 is a totally thoughtful approach. But I’m crazy. So, I don’t know any other institutions. But we’d love to hear from listeners if you know of any, I think 25% is the highest I’ve heard.
Kathryn: I see some with 20%. I think 20%, 25% is probably more sort of people who are really staunch believers who have managed futures. And then we do see some institutions that do 10% or so, but it’s really sort of a question of their appetite. There’s a lot of career risk, and I think that’s changing. But if you’re not just doing simple stocks and bonds, it’s much easier for you to explain what happened when you invest in stocks and bonds. I enjoy it because it’s a lot of fun working with investors about how to think about the strategy, but it isn’t as easy as the stock market went up, and so we made money.
Meb: We just need another ’08, ’09. And then everyone will rush back into trend or wait for trend to start to do well, and then rush back in. As someone who’s been on both sides of the table, how should our listeners, say, financial advisor, maybe say someone who’s a trustee or CIO at a big institution who wants to allocate to trend-following managed futures, what are some of the best practices? What should they look for in the manager and strategy? How should they think about it? Should they just allocate to one? Should they buy a basket of trends strategies? And let’s say their portfolio is just a traditional diversified global portfolio of buying old stocks, bonds, real assets, how do they go about it?
Kathryn: So, I think one of the key issues with trend is one of the biggest challenges is that it’s easy to get the correlation, it’s harder to get the same returns. That’s what that paper about return dispersion is, is that even though we have high correlation to the trends, there is a lot of dispersion across managers. So, you need to think a little bit more about what is the objective of each manager? What are the attributes of that manager that fit what I’m looking for? If you’re thinking about crisis alpha, you should think about how fast the manager is, how much non-trend strategies are in there that might affect the crisis alpha capture? And also just how they think about volatility, are they sort of a fast-moving? Do they move quickly? And that’s not always easy, like, we talked about before to measure those things. So, I think some of the more qualitative things is speed, purity of trend, and also volatility. The other thing that investors have to think about as they build a portfolio, one CTA or one managed future strategy gives you an exposure to trend. But if you add more than one, you can also have a basket of trend strategies to kind of smooth out some of the ride as well.
And individual trend managers do this ourselves. We try as best we can to mix many different approaches to try and robust defy our signals, to make our approach to measuring trends, the most clear, but, of course, just like anything, diversification always helps. Having a little bit of diversification in this face means that you have a smoother ride. So, when I see a lot of institutions, and a lot of managers will pick a couple of different trends, maybe one or two, some two or three, to try and deal with some of the dispersion that I’ve talked about. So, if you have two managers, then you end up with a little bit smoother of a ride than just say one. And you’ll notice, which is interesting is that they can both be very highly correlated to the index, but can have very different returns in a given year. And that is also sometimes challenging for investors because so much of what trends are very idiosyncratic.
So, the way that a trendy vaults, sometimes it’s easier to capture with different methods than others. So, for example, if you look at the features of trends, sometimes they’re very quick, sometimes they’re very long, sometimes they’re quick and then fast. And so really the way that you measure those could vary quite a bit from one model to another, and also from one manager to another. And so if you think about yourself, creating a rule to try and trade that it is hard, the same trends are captured, but perhaps sometimes that not at the exact same times, which means that you can have different results from one system to another.
Meb: What’s the most non-traditional market you guys have traded? Are you guys trade the carbon credits, crypto individual stocks? You mentioned cotton, some of the ags. I think onions are officially the only commodity that futures are banned on. What’s yours weirdest? Is there such a thing?
Kathryn: That’s a good question. We have a lot of requirements for liquidity and volume. So, some of the things that we trade, like lean hogs, for example, I always think is interesting to mention, or live cattle or feeder cattle and some of these other contracts are very probably one of the weirder ones that if you have to talk to people about. I’m short live cattle, what does that mean? And then I guess some of the, I think it’s more of the ag, some of the interesting contracts that are very different from your classic contracts. Although, we’re quite interested in some of these contracts, like Bitcoin. And thinking about some of these things, we’re just a little bit concerned about some of the volume and volatility in some of these markets. So, as they’re big enough, and as they have enough volume, we love to trade them.
Meb: As someone who spent a lot of time deep in the weeds with trends, anything you particularly change your mind on, you got a nice piece called something, like a 10 year retrospective on trend following. And we’ve seen some pretty different environments over the past 10 years, starting with the financial crisis, you feed to the fire right out of grad school to the last 10 years, and then a pandemic to boot. And then who knows what’s next. But how has your approach belief system change, if at all, anything that you’ve come to appreciate more today than maybe in the past, as far as what is really important or not?
Kathryn: What was the most interesting moments for me have been those really weird days where the world is going to change.
Meb: Oil minus 37? Is that what you’re talking about?
Kathryn: Actually, so the last year, so my two favorite points that I love, because I teach a class at MIT as well. And I like to talk to students, and I say, “Well, what does it mean that oil prices are negative?” So, that happened and they have to go read about it. And then also, I talked about what does it mean when the entire German yield curve is negative, all yields? And go think about it. And those were two really weird environments from a macro perspective. But I’d say from a trend following perspective, one of the weirdest times for me was the Brexit vote and the U.S. elections. Brexit vote was really strange because before the vote, I was 100%. Most people were 100% sure, there’s no way that they would vote leave. And what was interesting in the data is that the markets were actually signaling a Brexit leave, in the trend following positioning across markets.
And so imagine you’re a trend follower, and your system is saying, leave based on short, the sterling and a couple of other positions that hint at a leave. And you yourself, don’t believe it. That was very strange for me because it showed me the power of measuring where the market is moving and made me realize how little I was in comparison to those moves. And sort of this dichotomy of sort of how I felt, and what the market said, disagreed and what did that mean. And then when the leave vote actually occurred, it really changed. It was really phenomenal for me to think, “Wow, the market is this giant place, which knows more than me.” And that was very fascinating to me. And the same thing happened in several U.S .elections, where I was sure that I knew the outcome. And then the positioning in the markets did the same that I expected, but the outcome was different. And so that’s just sort of, again, being humbled by the fact that I’m one person and that the markets are really sort of an amazing body of knowledge with all the data that we can use. So, I think that’s what I’ve learned is sort of humility, I guess.
Meb: The markets have a way of teaching humility and just when people think they got it figured out, that’s usually when you get taken to the woodshed and lose a lot of money. You see a lot particularly on social media, the grandstanding chest-thumping. And for someone who’s been through it and has all the scars, as most older investors who’ve been through a few cycles have it’s a little cringe-worthy. You just like, “Oh, gosh, I know what’s coming to this person, there’s nothing you can say.” The interesting thing about trend, you know, you talk about is often when presented with a signal, particularly in the good times, people don’t want the party to be over. And I’m thinking of real estate in 2007. It was really like the first signal on the trend that rolled over before the equities market did. And I remember people are so caught up in making money and how easy it is, didn’t want to hear that. I’m not going to take this one. Maybe I’ll wait till it go back up, and then I’ll take it. And then next thing, you know, down 70, whatever the reeds did that year. Do you have any advice for people on how to not avoid the signals? But like it’s kind of you do or you don’t, I don’t know what the behavioral sort of act or advice is on implementation. But any thoughts?
Kathryn: You were reminding me of last year, because in January last year, we all knew the signs about COVID, we didn’t want to see it. So, I remember specifically, you talked about real estate being the first indication. We wrote a paper about a quants view of the coronavirus. And I think it was in March or April last year. And what was interesting in this is basically showed the markets knew, the markets were showing massive signals in commodities and bonds, but the equity market was euphoric. And basically, ignoring how dangerous this could actually be. I remember myself being in the same position personally thinking, “Oh, you know, it’s probably not a problem here. It’s a problem somewhere else.” But I was dead wrong. And I think the market was actually showing massive sell-offs already in energies and some of the things that are demand-based indicating that the first line of defense, that sort of demand was going to fall.
And that happened much before the market dropped. And I think I was reflecting on that in March, thinking, wow, the signs were there, I just didn’t see them, or perhaps even worse, I didn’t want to see them. And that’s why, like, the strategy for trend is that I don’t have to ask why, I just asked what. And so what was happening that was already building in our portfolio in the sense that we were already building this sort of demand shock into our positioning based on what was happening. Granted, we got stuck in the equity trade as well, just because the signals didn’t turn until it was obvious that things were not going to be okay. And so I think that February 21 day was the day where that all occurred. But before that, people were just going on as if nothing was happening. And I think, looking back, there’s an example of what can you do? I think that’s why you invest in managed futures because you don’t know when, and you know you may not be able to catch the science until it’s too late.
Meb: So, as someone who’s written a lot on our world, as we look out towards the rest of 2021, what are you thinking about? What are you excited about? Can you give us insight, any projects? Any new pieces? What are you worried about? What’s on the brain?
Kathryn: I mentioned a little earlier, I’ve been fascinated by monetary policy and what is going to happen. And I had a great quote in this recent paper, I said, “It’s kind of like you imagine you’re playing monopoly, and that you get to be the banker, and that you get to decide how much money you have. And then you get to pay with your own money. And you got to play with all the other bankers that have lots of money. And then you assume that nobody’s going to get mad, pick up the board and throw it at your face.” So, I’m a little nervous about it, just from a perspective of what we see in commodities, the moves in things like lumber, the moves in corn, the move in things that cost us something are huge. And so I’m definitely concerned about could we have inflation? If we don’t have inflation, what else do we have?
Last year, I was saying, we now have a system where monetary policy is about controlling things to get things the way you want. Now, we’re using fiscal policy, which is much more opaque. And when you hold something constant, you yourself know, as an engineer, something else moves instead. And that’s exactly what we saw last year, currency markets reacted, commodities reacted. And so I’m very interested to see what are the effects, there has to be an effect of us going to such a large amount of fiscal stimulus and pumping money into the system. I mean, I’m not an economist, so I’m fascinated, but I’m more interested in that something will change. And I like change. So, I think few strategies do. So, for us, we think this could be a great decade for managed futures, just like the ’90s.
Meb: You certainly had picked a rabbit hole to go down looking forward to see what you come out on the other side. Some great Galbraith quotes on sort of forecasting and I imagine monetary and fiscal policy, my goodness, that’s a hard topic. They have repercussions and the levers you pull, like you mentioned, intended or not consequences. I mean, you end up with some things like commodity prices, big determinant, Arab Spring, a lot of these real-world huge geopolitical implications. So, ping us when you finish, and we’ll chat about it again. What’s been your most memorable investment? Anything come to mind?
Kathryn: I actually think this short energy trade last year was one of my favorites. I mean, going from a situation where energy was at 70-something in January to negative, granted that was on a contract, that was a very near contract that was about to roll. Yeah. But I just think it was fascinating to say you have negative prices, you have to wonder how does that go in your system, like, does your code… How does it feel about a negative P? Like, that doesn’t compute. And so I’d say that was probably one of my favorites. My other favorite was when the German entire yield curve, including the 30 year went negative. That was also an interesting experience for me just kind of philosophically thinking, what does it mean to have all negative yields for 30 years?
Meb: It creates a whole new philosophical concept of money and banking and how things fit together. I don’t know what the result is.
Kathryn: It’s a good question to ask an MBA teacher, “Explain this. It makes no sense. Can you please explain this?” It’s very hard. It’s a weird world we’re in now. But we’ve been in a strange environment since ’08, I would say.
Meb: Always exciting in these markets. Kathryn, it’s been so wonderful. We could spend a lot of time together. I encourage readers, well, I mean, readers listeners will add lots of her papers and writings and book links to the show notes, mebfaber.com/podcast. You will not get a more in-depth, study than her 800 years study. Kathryn was the best place for people to find if they want to read more about you, keep up to date with your work, your ongoing, where do they go?
Kathryn: It’s probably best to go to the AlphaSimplexs’ website, where I’m the chief investment strategist and PM, there we post in our insights, all of our writings on these topics. And I also have a book on Amazon, which as you said, 488 pages of trend following reading, if you want to read a little bit more about crisis alpha on convergence, divergence strategies and sort of how to think about things from a trend following perspective.
Meb: Kathryn, thanks so much for joining us today.
Kathryn: Thank you for having me.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us firstname.lastname@example.org, we love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening friends and good investing.