Diversification is more important than ever! | Systematic Investor | Ep.385

Episode Overview

• This episode connects the macroeconomic shift in central bank behavior—specifically the move back to gold—with the technical mechanics of Trend Following strategies.
• It provides a detailed breakdown of how professional CTAs (Commodity Trading Advisors) manage risk, specifically explaining why funds with similar strategies can produce vastly different returns based on "speed" and volatility sizing.
• The discussion offers critical frameworks for investors to understand "Crisis Alpha," the difference between price-based and economic-based signals, and how to position portfolios for a potential commodity supercycle.

Key Concepts

• Structural Shift in Gold & The Dollar A fundamental change has occurred since 2011 where central banks became net buyers of gold, moving away from purely financialized assets to "basics." This shift, combined with a potential weakening of the US Dollar (flirting with its 200-month moving average), suggests the conditions for a true commodity supercycle. In these cycles, tangible assets typically outperform nominal currency.

• Price-Based vs. Economic Trend Following While often correlated (40-50%), these strategies diverge during shocks. "Economic" trend following relies on fundamental data (GDP, inflation), which is often delayed or subject to revisions. "Price-based" trend following relies purely on market movement. In volatile regimes like 2022-2023, price-based models are superior because they react instantly to changing realities, whereas economic models often lag behind the actual market pricing of risk.

• Volatility Targeting as a Risk Mechanism Professional CTAs view assets as "units of risk," not dollar amounts. If an asset's volatility doubles, the position size should mathematically be cut in half to maintain constant risk. However, the speed of this adjustment matters. Managers who adjust volatility estimates slowly in 2022 captured more of the bond crash profits, while those who adjusted quickly were shaken out of profitable trades too early.

• Drivers of Return Dispersion Investors often wonder why two Trend Following funds have different returns in the same year. The dispersion is driven by three idiosyncratic engineering choices:

  1. Speed: The lookback window (how much history is used). In 2022, very short and very long speeds worked; medium speeds failed.
  2. Market Universe: Broad funds catch trends in niche markets (Platinum, Cocoa) that narrow funds miss.
  3. Risk Calibration: Whether the fund reduces size during volatility spikes.

• Crisis Alpha and Geopolitics "Crisis Alpha" is the ability to profit from market distress. It requires high liquidity, adaptability, and a lack of directional bias. As the world moves toward deglobalization and geopolitical tension, markets experience "dispersion" (some go up, some go down) rather than uniform movement. Trend following thrives here because it is designed to exploit the transition of prices from one equilibrium to another.

Quotes

• At 0:04:48 - "It just shows you people are looking for value and they're going back to basics in some sense." - Discussing the massive increase in central bank gold purchases as a shift away from financialized assets.
• At 0:09:09 - "Positive returns come from big trends, and you need to be exposed to these big trends. And it's how much risk allocation you have to them that differentiates relative performance." - Explaining that winning depends on holding the specific asset that is trending, not just the asset class.
• At 0:11:45 - "As the volatility of assets goes up, using a traditional CTA approach, you would actually reduce your positions." - A critical explanation of how professionals manage risk versus aggressive gamblers.
• At 0:26:46 - "The difference is really in that input. ... Economic trend signals... [are] about measuring things like growth... compared with price-based strategies, they're roughly 40 to 50% correlated." - Clarifying the distinction between fundamental macro investing and pure price trend following.
• At 0:27:31 - "Price trends can better capture some of the themes at different points and more aggressively than say a macro trend, which can sometimes be slow or get the macro wrong when things change." - Highlighting the advantage of price-action trading during rapid market shifts.
• At 0:29:56 - "These decisions that each individual CTA makes... the number of markets you trade, the risk allocation, your volatility sizing, position sizing... all of these are idiosyncratic decisions... there's no right answer." - Exploring why manager performance varies wildly even within the same category.
• At 0:32:53 - "It turns out that shorter windows and longer windows worked the best... The worst time horizons were around 7 to 9 months... right in the sweet spot of many CTAs." - Revealing specific performance data on "speed" during the 2022-2023 market cycle.
• At 0:41:52 - "We don't talk about dollars. We don't talk about notional value. We talk about risk. And we allocate risk... We think about every asset as a unit of risk." - Defining the core philosophy of Managed Futures: prioritizing risk allocation over capital allocation.
• At 0:51:07 - "Bond volatility went from like an average of about 4 to an 8... If you are doing volatility sizing and you do it very slowly... you maintain a bigger exposure to the actual trend and capture more of it." - Explaining the technical nuance of why "slower" risk management outperformed during the bond crash.
• At 1:04:10 - "Crisis alpha is finding opportunities during periods of market dislocation and distress... it's about being adaptable, it's about being liquid, and avoiding bias." - Redefining Crisis Alpha as a structural advantage during regime changes.

Takeaways

• Beware of "Replicators" in Commodity Cycles Avoid funds or products that only trade major benchmarks (Gold, Oil) if you are looking to capitalize on a commodity supercycle. The massive returns often come from smaller, less liquid markets (Silver, Cocoa, Platinum), which "replicator" products usually exclude.

• Price Action is the Best Hedge Against Shocks In environments defined by sudden shocks or "headline risk," do not rely on economic data (GDP, employment) to guide decisions. Price adjusts instantly; data lags. Prioritize strategies that react to price movement to protect capital during regime shifts.

• Scrutinize High Returns During Volatility If a manager posts massive returns during a high-volatility shock, check their risk management. If they didn't reduce position size as volatility spiked, they may have simply taken on excessive risk rather than exhibiting skill. True professionals trade smaller when markets get wild.

• Diversify Strategy "Speed" Do not rely on a single timeframe for trend following. As seen in 2022, the "medium term" (4-9 months) can fail while short-term and long-term models succeed. Effective portfolios should barbell these timeframes or use managers who diversify across them.

• Look for "Slow" Volatility Sizing in High Inflation In high-inflation regimes, volatility tends to be structurally higher. Strategies that are too quick to cut positions when volatility spikes may get "shaken out" of the best trends. Managers with slower volatility adjustment speeds are better positioned for these specific environments.

• Monitor the Dollar for the Supercycle Signal Watch the US Dollar's performance against its 200-month moving average. A break below this technical level is a historical trigger for genuine commodity supercycles, signaling a good time to increase allocation to tangible assets.