Rob Carver on Trend Following, Skew, and the Total Portfolio Shift | Systematic Investor | Ep.375

Episode Overview

• The episode explores the nature of trend following returns, debating whether they constitute a true "edge" or a "risk premium" paid for shouldering risks others avoid.
• It provides a detailed guide to building and validating systematic trading strategies, covering robust backtesting, the pitfalls of selection bias, execution timing, and position sizing.
• The hosts analyze the critical trade-off between static position sizing (which can increase positive skew) and dynamic volatility targeting (which yields a higher Sharpe ratio and better long-term growth).
• The discussion culminates with a significant potential shift in institutional investing, as major funds consider replacing traditional Strategic Asset Allocation (SAA) with a more holistic "Total Portfolio Approach" (TPA), creating new opportunities for systematic strategies.

Key Concepts

• Edge vs. Risk Premium: A core theme distinguishing a true "edge" (something not easily replicable) from a "risk premium," which is compensation for taking on risks, often rooted in behavioral biases, that other market participants are unwilling to bear. Trend following is argued to be a risk premium.
• Backtesting Methodologies: A discussion on the dual, often conflicting, purposes of backtesting: predicting future performance versus accurately simulating the past. Common methods suffer from selection bias, creating an overly optimistic view of historical performance.
• The "Gold Standard" of Backtesting: A more robust approach involves a rolling process over a large set of potential strategies to test the selection method itself, rather than just picking the final strategies that performed best historically.
• Static vs. Dynamic Position Sizing: A detailed comparison of two sizing methods. Static sizing (fixed at entry) can lead to greater positive skew by letting winners run in high-volatility environments, while dynamic sizing (volatility targeting) produces a smoother return profile and a higher Sharpe ratio.
• Sharpe Ratio vs. Skew: The conversation concludes that the higher Sharpe ratio from dynamic sizing is superior, as it allows for leverage to be applied, ultimately leading to a better long-term compound annual growth rate (CAGR) that outweighs the benefits of higher skew.
• Volatility Symmetry: The concept that upside and downside volatility should be treated equally for risk management, as large price moves are inherently risky and can reverse quickly, regardless of direction.
• Strategic Asset Allocation (SAA): The traditional, rigid institutional approach to portfolio construction, characterized as a "box-filling" exercise where managers allocate capital to siloed asset classes.
• Total Portfolio Approach (TPA): A newer, more holistic framework for institutional asset allocation that evaluates every investment based on its contribution to the entire portfolio's risk and return, breaking down traditional asset class "walls." This presents a major opportunity for strategies like trend following.

Quotes

• At 2:27 - "whether trend following is an edge or a risk premium." - Rob Carver introduces a recent topic of discussion he had on social media, framing the debate around the source of returns for trend-following strategies.
• At 3:12 - "You're only making money because other people are uncomfortable taking the kinds of risks that you're taking." - Rob Carver explains his view that returns from widely available strategies like trend following are a "risk premium"—compensation for shouldering risks others avoid.
• At 16:57 - "My question is, what does a solid, reliable robustness testing framework look like?" - Niels Kaastrup-Larsen reads the first listener question of the episode, setting up the main discussion.
• At 22:03 - "It's not going to tell you how well you would have done in the past, because you're basically selecting the strategies that did the best with the data that you've got." - Rob Carver explains how selecting top-performing strategies from a backtest creates an inflated and unrealistic picture of historical performance due to selection bias.
• At 22:23 - "...the real kind of gold standard way of doing this is you start with say a thousand strategies and you basically do a rolling process where you... sub-select from those strategies depending on the performance you've only seen in the past." - Rob Carver describes a more robust backtesting method that simulates the process of strategy selection over time.
• At 25:31 - "Trading costs should be in there from the very start. There's... no point even considering things that you can't make money with before slippage." - Rob Carver stresses that transaction costs are a critical, non-negotiable factor that must be included from the earliest stages of strategy testing.
• At 46:21 - "...it's not worth doing fixed-vol [static] position sizing because the additional skew you get does not pay you for the loss in Sharpe, which is substantial. So you end up with a lower CAGR basically." - Rob Carver concludes that for maximizing long-term growth, dynamic volatility targeting is superior to static position sizing.
• At 49:47 - "My concern with this is that returns are a coin flip, pretty much... you're just a coin flip away from those massive profits becoming massive losses." - Rob Carver argues for treating upside and downside volatility symmetrically for risk management because large moves in one direction can quickly reverse.
• At 56:22 - "I like to think of it as a series of boxes. So you start off by saying, 'Well, I've got this big box and in it I need to put asset classes in different sizes,' and then you open up those boxes and you put other stuff inside." - Rob Carver describes the traditional, siloed Strategic Asset Allocation (SAA) approach used by institutional investors.
• At 1:00:54 - "'One portfolio, one goal: maximize total return within a defined risk budget. Asset classes don't matter; only contribution to total outcome does... This is portfolio construction without walls.'" - Niels Kaastrup-Larsen quotes an article defining the philosophy behind the Total Portfolio Approach (TPA).
• At 1:01:09 - "'For trend followers, TPA is the best chance we've ever had to be judged on what matters: our ability to deliver value at the portfolio level. This is our moment if we are ready to own it.'" - Niels Kaastrup-Larsen highlights the opportunity the Total Portfolio Approach presents for systematic strategies.
• At 1:02:14 - "I'm a little bit skeptical because it does sound a little bit management consultancy... I'm also as a quant struggling with the fact there's not really any formal definition of how you do this." - Rob Carver expresses his cautious optimism about the TPA concept, noting its vague language but acknowledging its potential.

Takeaways

• To maximize long-term growth, prioritize a higher Sharpe ratio over positive skew by using dynamic volatility targeting and applying appropriate leverage.
• Adopt a more robust backtesting process that focuses on validating your strategy selection method over time, rather than just picking the best-performing strategy from a single historical dataset.
• Always include realistic trading costs and slippage in your analysis from the very beginning; a strategy unprofitable with costs is not a viable strategy.
• Treat upside and downside volatility with equal caution, as large upward moves indicate a high-risk environment that can easily and quickly reverse.
• Frame alternative strategies like trend following based on their diversification and risk-adjusted contribution to a total portfolio, aligning with the institutional shift towards a Total Portfolio Approach (TPA).
• Be cautious applying trend following to short, intraday timeframes, where higher costs and the prevalence of mean-reversion can severely erode profitability.
• Internalize that consistent returns from trend following come from the discipline of shouldering risks that others are behaviorally unwilling to accept, not from a secret formula.