What Makes an Alternative Investment Truly Valuable? | Systematic Investor | Ep.364

Episode Overview

• The episode analyzes the current market environment, where rising long-term bond yields coincide with signs of a weakening economy, potentially creating favorable conditions for trend-following strategies.
• It explores the concept of deep diversification, moving beyond asset classes to include structurally different markets for the same commodity (like regional carbon markets) and diversification of the trading process itself.
• The hosts advocate for a trading philosophy centered on simplicity and robustness, favoring simple price-based rules over complex, over-optimized indicators.
• The discussion delves into the evolution of the hedge fund industry, highlighting the significant decline in overall volatility driven by institutional investor preferences for smoother returns and the resulting impact on strategy design.

Key Concepts

• Market Environment: A key divergence is occurring where long-term government bond yields are hitting multi-year highs while economic data weakens, signaling potential market stress and opportunities for trend followers.
• Deep Diversification: True diversification involves trading a wide array of uncorrelated markets, including niche, structurally different markets for the same underlying asset (e.g., regional carbon markets vs. EU carbon markets).
• Process Diversification: A robust portfolio can be built by blending different trading approaches, such as combining strategies that let winners run with those that take profits, which diversifies the investment process itself.
• Simplicity in System Design: Robust and resilient trading systems are built on simple, "derivative-free" rules (e.g., price breakouts) rather than complex, calculated indicators, which helps avoid over-optimization.
• Asymmetry vs. Smooth Returns: There is a core trade-off between letting winning trades run to capture "punchy," asymmetric returns valuable in crises, versus taking profits to create a smoother return stream with lower drawdowns.
• Decline in Industry Volatility: The hedge fund industry's average volatility has plummeted from over 20% to below 5% due to the influence of institutional investors who prioritize stability and avoidance of career risk over maximizing long-term compounded growth.

Quotes

• At 4:57 - "I noticed that earlier this week, UK bonds, 30-year bonds hit the highest yield in 27 years... I think even German long yields have sort of been ticking up and hitting some, maybe not 27-year highs, but certainly highs over a long period of time." - Niels Kaastrup-Larsen highlighting the unusual and significant rise in global bond yields.
• At 19:14 - "Now, a CO2 molecule is the same everywhere in the world, but all of these markets are trading differently." - Moritz Seibert explains that despite the underlying asset being identical, different regional carbon markets provide valuable diversification because they are uncorrelated.
• At 29:39 - "...removing complexities from a trend system is a good thing." - Moritz Seibert states their core belief that simplicity is key to building robust and resilient trading systems, avoiding the pitfalls of over-optimization.
• At 44:46 - "what you want is really that punchiness... that's actually quite valuable, you know, to be there and then really have these punchy returns that help investors with other investments in their portfolio." - Moritz Seibert highlights the unique benefit of trend following during major market dislocations.
• At 1:06:15 - "institutions today are really just optimizing for some kind of average return. They don't want to be too far away from instead of optimizing for, 'How do we compound the best over the next 40 years?'" - Niels Kaastrup-Larsen critiques the institutional mindset that often prioritizes avoiding short-term tracking error over maximizing long-term wealth.

Takeaways

• Effective diversification goes beyond asset classes; seek out structurally different and uncorrelated markets, even for the same underlying commodity.
• Prioritize simplicity and robustness in trading system design, as complex indicators can lead to fragility and over-optimization.
• The ability of a strategy to deliver large, "punchy" returns during market crises is a key value proposition that can be diluted by premature profit-taking.
• Understand that institutional pressure for lower volatility has fundamentally changed the hedge fund industry, creating opportunities for strategies that retain their asymmetric return profiles.