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You're listening to Teip Today Show, we have a veteran of the finance industry, Mr. Neal Larson, with us. He also has been part of the hedge fund industry for more than 25 years. And throughout that period of time, he's implemented a trend following approach to investing. In this episode, we discuss how simulations of trend following work together in equities portfolio and how models are built on historical data perform in a year with a pandemic that we'd never seen before.

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So without further ado, here's our interview with Nail's.

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You are listening to the Investors podcast, where we study the financial markets and read the books that influenced self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to the Investors podcast, I'm your host, Dick brought us in, and today we bring back Neales Cost of Larssen to educate our audience about trend following and the financial markets. Welcome back on the show. Thanks so much to it's great to be back with you. Let's jump right into the first question here.

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Twenty to any has been an iconic year in the financial markets and we saw this brutal crash in the spring and then we had an unprecedented speed recovery since financial models are based on historical data.

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What happens when you have a year when something you've never seen before happens? And how did you experience 20 20 from a trend following perspective? I mean, you're absolutely right, stic 20 20 was indeed a different year than what we'd seen in the past, mainly in terms of the speed of how the markets initially crashed and then also the speed of which they recovered.

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So in many ways, a market environment like that poses a challenge for all investors, but not least systematic trend following strategies where we base our rules that we want to follow on historical data, as you said, Steve. So at dawn, where we have one of the longest track records in the world of more than 46 years, yet nothing like what happened in 2020 was in our data set. So you could argue that it would be unreasonable to expect us all any other systematic data driven strategy to make money in a year like that.

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Yet many of these strategies did. So I think it's fair to argue that the reason why many of these strategies were able to come out of 2020 with returns, say, between flat to up 10 percent or so for the larger trend followers is a sign of robustness of the strategy. Now, robustness of a strategy is is really hard to define, but I like to think of robustness when it comes to an investment approach as something that can deal with many different market environments.

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So even if our models had not seen these type of market moves before, because they only see the role price data and not the news headlines or the fear of what the pandemic could do to the world economy, they simply follow their investment plan. And so when exits of, say, long equity positions were triggered back in February, there were no hesitation. There were no second guessing the signals. And in our case, we had started the year very long, actually, in stocks because they were trending higher in 2019.

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But during the last week of February, once the uptrend had been broken, our models reduced their long exposure by about 87 percent in just a few days. And this, along with other changes in the portfolio, like going short oil, allowed us actually to deliver quite a strong return for our clients during March when they most needed it, and as a medium to long term trend for having a lot of changes in the direction of the trends like we saw in 2020 is actually not a great environment because we ideally need these trend moves to last months, if not years.

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So when when the market made a U-turn in late March, you know, this can actually be very difficult and painful for these type of strategies. And this is where things like your risk management systems have to show what they're made of and to kind of keep you out of too much trouble. So but maybe I can just finish off by saying that although 20/20 was a year full of new data for our models that they had not seen, it's actually a really interesting year from a research point of view because our research team can now get new ideas to look at us when something like this happens.

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And frankly, what has kept us going for more than four decades is really kind of consistent but incremental improvements to our trading models.

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I don't know if you could elaborate a bit more on that, because whatever you include, those new data for something like this happening, how is that being reflected in the model? Is it weighted like? Oh, I think last time we talked about you had a four to seven year track record. Does that mean that's just another year? Is there some kind of trigger set next? There's a pandemic. This will happen like how is another year that's so different included in a long series of year?

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So the system and the algorithm can learn from that. First of all, we don't do any A.I. stuff, so it's not necessarily that the algorithm changes or learned something from that, but when you design your models, at some point, you need to decide on your look back period in terms of the actual signals that you want to utilize. And in this case, you actually don't use all the 47 years per say of data. You kind of restricted to a smaller set of data.

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And therefore, 20-20 becomes one of, say, maybe 10 years in your actual data set when you pick the parameters. So it does have an influence. And in our case, we actually have a fully systematic approach to selecting our time frames and our parameters. Maybe I'll expand on that a little bit later, but that's actually how it gets incorporated into our model, you could say. Continue talking about twenty twenty, I mean, one thing that really stands out is how central banks have just bailed out the financial markets and it's easy to look back and say, well, we all expected that to happen.

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But I also think that many have been surprised by the magnitude that central banks pumped money back into the system. And I can't help but wonder how would the main asset classes have performed if the central banks hadn't showed up? And what would the implications be for a trend following strategy? I think you're absolutely right. I think that many investors have already forgotten what it felt like being in the markets just before March. Twenty third when equity markets were moving up and down by 10 percent in a day.

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But now, kind of 10 month later, in the cool light of of hindsight, people might say, oh, but why did the so-called crisis alpha strategies not do better in a year with so much volatility? And I get that. I think the 20 20 from the outside looks like a year. That would be absolutely perfect for a strategy like trend following. But when it comes to your point about the central bank bailout, I think the question investors need to ask themselves when they look at their portfolio, and that is what did I have in my portfolio that would have protected me had the central banks not shown up or if the central banks had failed in their attempt to stop the market crash.

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And when you look at a typical trend following strategy, I would say that most of us would have had kind of a perfect set of positions had the central banks not shown up or failed, because in late March we were short of getting short stocks, we were long bonds, we were short some commodities, maybe not gold and silver, to name a few themes. But unlike the risk parity funds that were just long different assets, but where the correlation broke down and therefore they really kind of failed to provide any protection.

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And so if you look at the benchmark like the stock general to Alternative Risk Premia Index, for example, it's down a lot in 2020, just like some of the really large risk parity strategies. Now, in my opinion, at least, this is not to say that these models don't work anymore. And of course, many of them have a fantastic track record. But back in March, there was a lot of speculation, at least that the Fed had to step in so aggressively, not least because they worried about some of these massively large risk parity strategies and what was happening to them at the time.

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Another thing to mention, by the way, about what could have happened had we not had the central bank bailout is a complete freeze in terms of liquidity in these markets. And, you know, you may know that most trend follows. We only trade on exchange traded futures markets. And just like we saw in 2008, the futures markets were fully liquid. And so there was no issue with execution of our daily orders, for example.

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And now I do know of some shorter term managers that experienced concerns about the liquidity. But of course, this is the kind of the downside of being super short term in your approach, especially if you grow your assets to big. You could also argue that it's not fair to categorize falling too narrowly. I mean, just like some stock investors in twenty 20 have crossed the stock markets and others have lost assured trend. Followers have shown very different results, too.

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And if I could just use the example again of stock investors, just like the don't just buy one stock trend, followers also don't use just one strategy. So how should we as investors think about a portfolio of trend following strategies?

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I've certainly heard many people say that when they look at trend following as a strategy or the space of trend followers, they would go, Oh, so I only need one to follow up because they're all highly correlated.

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And I mean, it's true that if you look at the returns of managers that have been around for a long time, their correlation is somewhat high, say point six to point eight, but even relatively high correlation. It does not mean that they generate the same returns. So you have some managers that are better generating really strong returns during good trending environments. At the same time, they could be really good at limiting their losses during the difficult times. But directionally they are heading in the same way and therefore they look correlated when you look at just the statistics.

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So, you know, there are a few things that really makes a huge difference between managers in our space.

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And I think 20 was a good example of this. In some ways you could divided into two groups. One is what you treat and the other one is how you trade. So if you're comparing to managers using exactly the same trend following rules, you can make them look very different from one another just by simply altering their portfolio weights, meaning the risk allocation in different markets and also which markets you include in the portfolio. So to put this into perspective, that there's no pun intended here, but there has been a trend the last few years that some managers have started to include what's called quote unquote, alternative markets, which are smaller, less liquid markets like some commodities.

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Let's talk about, say, power, or it could be emerging market bonds. It could be interest rate swaps. And I think that in some periods this has certainly been helping with performance of these managers. But I don't think that it helped in 2020 here. I think other things were more important, which kind of brings me to the other area of differentiation, namely how you trade, meaning how do you design your trend following system and you can break that into maybe four broad areas.

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So one is how your entries are designed. You know, a type of entry could be a breakout methodology or a moving average, it could be time, serious momentum. And so you need to think about the sensitivity, i.e. the speed of these type of entries. The other thing would be how you allocate initial risk and how you size your trade. So position sizing and then you have a category, I would call it exit strategies and also actually how you combine different types of exit strategies.

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And then maybe a last point would be how your systems and markets are mixed. Do you treat all markets using the same systems or do you vary that?

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So when it comes to system to sign, this is often where trend following managers are categorized in kind of the speed of their systems, you know, are your short term manager, which in my view might be a holding period of up to two weeks. And then you have kind of medium term managers, maybe one to three months holding periods, and then you have the longer term managers where usually the exposure is in the same direction to a market for many months and sometimes even years.

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So to me, it looks like speed of systems played a big role in determining your returns in two thousand and twenty. And one way you can see this is that many of the short term managers did really well in the initial phase of the crisis because they managed to get out of their stocks. They got short, so they captured a big part of the sell off. And where perhaps you can say that the longer term managers were bydesign slow to react, but then later in the year, the longer term trend follows, actually caught up and surpassed the short term managers to deliver an overall better return for 2020.

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So this just goes to your initial point. Not all trend followers are the same. And like in a stock portfolio, you really need diversification across different types of trend followers. And let me just finish off by saying that despite all of what we have just talked about, performance is very much dependent on the overall trend environment. So even if you come up with a really well thought out design, at the end of the day, any trend following strategy depend on the trend strength in the portfolio in order to generate returns.

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Now, that's obviously easy to say that any trend following program returns depend on trend strength in the portfolio. What is not so easy is to quantify and to visualize what trend strength looks like.

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But many years ago during the financial crisis, back in 2008, the firm that I founded and ran back at that time, we developed something called the Trend Barometer. And on my podcast page, the top traders on dot com website. Each day I published the percentage of markets in a, you could say, classical diversified trend following portfolio that are in some kind of a trend. And if you study the data of the trend barometer, it suggests that trading conditions are extremely difficult for trend followers when there are fewer than twenty five percent of the forty four markets in this portfolio that are trending.

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And maybe you have a kind of a break even sown in terms of performance, which is around 45 percent. But you could even make it a bit to say 40 to 50 percent, meaning you need about half the markets to be in some kind of trend in order to have good conditions. And what I've also noticed over the years is that if you have nine or more months in a calendar year with weak trends, performance of trend follows is usually negative for that year.

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And then you can flip it and say, well, the greater the number of months with more than, say, 60 percent of markets trending, the stronger the annual performance. But unfortunately, we have not seen that many strong month in the recent years. However, December of Twenty Twenty gave a very strong reading, which also confirmed the trend. Followers had a really strong finish to 2020 and actually for the year 2020 we had I think, six readings at or above 50, which also confirms that overall we had a positive performance for trend follows last year.

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Let's get back into the podcast. Now, let's be even more specific about trend following intuitively, I think a lot of our listeners might compare it to momentum investing, which is something they've recovered several times here on the show. Basically, that you have an asset with the price goes up and whenever it stops going up, you will sell your position and then buy into another asset that recently showed a strong price performance. But there's much more to trend following than that.

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Perhaps you could elaborate more and give specific examples on Rule-based trend following, including time frames and the number of trades executed. I think you certainly can drive parallels to momentum investing, because what helps us as trend follows identify trends is usually some kind of strong momentum or burst of directional volatility that often takes the markets outside of its current trading range. Right. So important to note, though, is that this can be to the upside as well as the downside, because we don't have a bias towards going long or short in a market.

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So in terms of ways of identifying trends, this is probably the easiest part of what we do because there are only a few ways of doing it. This could be via a breakout approach. I think that's probably the original way of doing it, where the price of an asset pushes above or below, say, its most recent 50 or 100 day high or low. It could also be a breakout of a volatility band. So this could be like a Bollinger band that the market pushes through.

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It could also be a little bit less certain, if I can call it that, like if two or three moving averages cross over. And also we have something that's very popular call time series Momentum, where you compare today's price with a price, say, again, 50 or 100 days ago just to see if the slope is going up or down. So I would say as far as to say that entry rules, as important as they are to make sure that you get into the position in the first place, they're probably not what sets to trend followers with the same investment horizon apart?

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What is more difficult, I think, is coming up with some really solid exit rules that on one side can get you out quick enough when suddenly you have a big reversal in the market like we saw in February of twenty twenty. But also they have to be slow enough to not take you out of the trend too early when a market is just having one of its normal corrections. And so this is why you often see managers combine trend following styles and exit rules in their overall strategy.

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So you also asked about trade frequency and this can be quite different from manager to manager. I would say had done capital. We would be classified as a long term trend follower. One of the reasons we have ended up using the longer term time frame, say, 12 to 18 months, is simply because they are better and they are more robust than, say, shorter term time frames. And one of the really interesting analysis, I think, that we do is to compare what time frames have worked best for each calendar year.

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And we do that going back about 30 years. By the way, we look at anything from, say, twenty days to about three hundred days in this study.

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And, you know, over those 30 years, you'll see that the majority of the years would have performed best if you used a time frame of around, say, 180 days to two hundred and forty days.

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But since we don't want to use discretion in our trend following program, we actually allow our model to recalibrate the parameters it uses on a weekly basis. We have done this since 2006, but from 1974, when we started trading to 2006, this couldn't be done. We didn't have enough computer power to making these calculations. So that was actually not a systematic process back then. Some firms still do it by investment committee. We just don't think that we would be very good at guessing what to select.

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So we prefer to use a fully automated approach. Now, regarding your other question about trade frequency here, I would say that in our case, I think investors who come to our offices are usually quite surprised how quiet our trading room is. And of course, sure, we trade twenty four hours a day because we have a portfolio of global markets, but we only need to do one adjustment trade per day per market. And since I mean, we trade about fifty five, fifty four markets in our portfolio and not all of them would even give a new signal to be adjusted.

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So on average, I think we do say twenty five trades per day. So it's really not a lot. And then in terms of the markets we've decided to trade, I mean as mentioned, they're all exchange traded futures contracts and a little bit of options. We also do because we do run a long, short volatility strategy as well. And the reason we prefer futures is, one, that they're super liquid and they are super liquid during crisis periods, which is very important.

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And we've seen a few times and we've also seen stocks and bonds and currencies become somewhat illiquid during these. And another benefit of trading futures is that they're cheap to trade. And finally, perhaps the most important part is that with the futures contracts, you don't have any counterparty risk with the bank since your counterpart is each of the futures exchanges you trade on. I'm trying to envision this Nel's going back to what you set up before, say, twenty five trades a day, does that mean that you are trading you always have twenty five active bats.

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Does it mean that. Well, that's per day and the time frame might be up to 180 days. How many active bats do you have. Our portfolio is always in the markets, and for the most part, we would have a small position or a big position for that matter, in all of the markets, because at the end of the day, our position is an expression of how we read the trends strength in each of the markets. So, you know, at the moment, for example, we could be generally quite short.

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The dollar, meaning we're long, the yen and the pound and the euro and so on and so forth.

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They may not have identical position size. That depends a little bit on each of the individual markets. So when I say we have 25 trades, that just means that, say, the euro, if we're short one hundred lots today, while tomorrow we actually may only want to be short ninety nine lots. So we do a small adjustment of the position size that's also impacted by our overall risk management system that sets the total portfolio risk. So if we see, say, volatility increases or correlation increase, we may do an overall reduction of all positions.

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But that's based more on the risk management of the system. Now we trade 55 markets and as I said, we would usually have positions in all 55. But to answer one of your questions is we actually treat all markets equal because our philosophy is that we don't know which market is going to be trending next. So we could never end up with 30 percent exposure in any one market. It's just not possible. So in theory, you could say that if we were fully invested in all of the markets, we would have about one fiftieth or fifty fifth exposure in each of the markets, meaning we can have the same exposure in live cattle as we can in the euro.

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But again, they're limited to how much that exposure can be. And I think this is one of the strength of trend following in general, because we're not really looking for how much money can we make. We're actually looking from the opposite side. We're looking at the risk we take. So we are first and foremost risk managers. So portfolio construction, risk management and all of that is actually a really important part of what we do.

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Interesting, so the low interest rate has been a challenge for many stock investors for a long time, and it just made it so much harder to achieve high returns if we expect the interest rate to be stable in the decades to come, but stable on a close to zero level, can we expect a trend following to regress to the same low yield levels?

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I mean, it's a really hard thing to predict returns and going back to my previous answer about why we treat all markets equal, because in some years you only need like a handful of markets to trend strongly and that's where you're going to get all of your returns from. But what I think you can say about the low interest rate environment is that first and foremost, it impacts the return on the cash that we're holding for our clients. Because if you invest in, say, I'll use this fund, which many European investors do for each hundred dollars, they invest, we only need about 15 billion or so to be put up as Martun on the exchanges that we trade.

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The remaining 85 percent is held in a safe cash management strategy. And of course, the returns of this 85 percent will be zero essentially if short term rates are zero. And this has, in fact, been the case for more or less since 2008. Right. So in our case, we decided back in 2007 that we would not include any interest income in our track record. That's normally something you see managers do. We just decided not to do it because it's not really our models that are responsible for this part of the return.

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So we actually only show, quote unquote, the true alpha that we've generated. And in terms of our trading models, we have not seen a lot of degradation of returns since 2006 despite lower interest rates. But for sure, some sectors have been quite tricky, like commodities and currencies. And frankly, equities have been quite difficult for trend followers to trade. But I'm not so sure we can pinpoint that cause to just low interest rates. Probably more likely.

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It's been the central bank intervention to keep GDP growth as steady as possible, not allowing for economic booms or for economies to go through recessions anymore. And I think the more important point your question raises, and that is what are investors going to do with their fixed income and bond holdings, as so many investors still have large portions of the portfolios in bonds? This is why I think trend following can be a really important component in any portfolio going forward.

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And of course, people would expect me to say that. But it's not really based on my opinion. It's based on all the evidence that we have to date. The correlation between stocks and trend following makes these two asset classes really a perfect match. And if you look at a simple portfolio of, say, 50 percent S&P or 50 percent MSCI, and then you take 50 percent following, not only do you get a much better return, you get it with much lower volatility.

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You get it will much lower drawdown. And that's really the magic of combining uncorrelated assets. And I truly hope that this will be embraced even more by investors going forward before it's too late. Now, let's talk a bit more about evidence and simulations, because I think to lovelessness, they know the concept about trend following.

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You've been here on the show and and educated all of us more about that. But your listeners have trend following as a core of the portfolio than I have very little to supplement their core equity portfolios. And I know that you've done simulations of trend following and how it contributes to the performance of various types of portfolios.

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Now, how would a global equity portfolio say the MSCI had performed if we included trend following strategies as 20 percent of the oil portfolio? I mean, if we look at the MSCI index as a standalone investment and, you know, we're obviously including more than 10 years of a massive bull market, you would have achieved an annualized rate of return of about, say, 10 percent since 1985. So over the last thirty five years, which is pretty decent.

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Now, we don't have an index of trend followers going back that far, unfortunately. But if I look at our own returns in our flagship program, it's been somewhat better, let's say about 25 percent better than the MSCI.

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But because the two investments have had pretty much a zero correlation, when you add trend following to the MSCI and you mentioned a 20 percent allocation, you actually still achieve a higher return than just the MSCI, somewhere between the MSCI and our own program. But it comes with better reduction in terms of risk, meaning it comes with the twenty seven percent. I think it was thereabouts in terms of your worst draw down. It goes down from I think the MSCI was at some point down about 55 percent.

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And by including, say, a 20 percent allocation, you can probably reduce that to say 40 percent or so. That's meaningful still, I think in a combined portfolio. And if we talk about the sharp ratio, despite all of its flaws, you do get a healthy increase of about twenty five percent in the shop. In other words, you get a high return with lower risk. And, you know, that's a big reduction for many people.

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Often what drawdowns in itself is important because it's often the drawdowns that causes investors to make really bad decisions because they end up, you know, not being able to stomach these losses. So a reduction in drawdown is important. And, of course, these benefits would even get bigger if you go for kind of a simple 50/50 allocation split between the mainly, again, driven by the zero correlation between stocks and what we do, for example. You sort of said it yourself, they're now talking about the jobs ratio.

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What have I got myself into? Right. If you look across the industry, the sharp ratio just so often quoted. But I also want to say then that it's a metric optimizing volatility, at least to many value investors. They do not find it valid because they don't see volatility as something that's necessarily bad. You know, if anything. Well, investors welcome volatility because it allows them to exploit Mr. Market. So what are your thoughts on the job ratio and some of the shortcomings?

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I mean, I completely agree with you on this point, right, Chope ratio, despite it being the perhaps most widely used measure of riskiness of an investment.

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However, I think the sharp ratio has some real flaws, as you mentioned, and that many investors, frankly, may not be fully aware of.

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So with a question like that, Stik, I may have to give you a long and maybe a little bit nerdy answer, but I actually think that this could be one of the most important part of our conversation today. So I hope your listeners will take a few notes.

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So one of the problems that I see with the shop ratio is that it measures both upside, i.e. the good volatility and the downside, the bad volatility, and it treats them equal. So if you're trying to find out how risky an investment is, why would you even penalize it for being you know, it's upside volatility. Now, of course, some investors and analysts have noticed this and started using a variation of the sharp ratio where you only look at the downside volatility.

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And this is what's known as the Certina ratio. And you can certainly say that that's a better way of trying to determine the riskiness of an investment. But you still face some problems with this, I think, because these ratios don't really take into account the order of the returns. So let me try and explain that. And this is, of course, hard, because it's quite a visual thing to think about. And we're only doing this in an audio format.

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But if, for example, you take an equity index and you just show the equity curve of, say, a long, lonely buy and hold approach, you will get a certain level of return and volatility and hence you can calculate the sharp ratio. Now, if you instead ordered the daily returns in a different way, like, say, all the negative returns first, and then as time goes by, you had all the positive returns in order of magnitude, you can get to the same end result.

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But the path to that end result is very different and would have meant that your drawdowns along that path would have been much bigger. Yet your overall return and volatility is the same. So you shot ratio might be the same and you could also organize the same data to be much closer to a kind of a nice steady line where drawdowns are minimized. So again, you end up at the same place with the same volatility and therefore you have the same Sharpe ratio.

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But if you saw these three scenarios on the chart, there's no way you would say that they show the same level of riskiness. And this is mainly because the shop and all the measures they don't take into account the actual drawdown people would have to stomach in order to get that return. So the question is, are there any measures that will give you a better sense of how how can I put it gut wrenching in lack of a better word? The investment really is, because I think that tells you more about the real riskiness of the investment.

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And in my opinion, there are few that can help you with this, but they need to be calculated in a particular order. The first one I came across in a book, and it's called The Ulcer Index, and it's a great name, I think, for a measure of risk, because it really tells you how uncomfortable you would have been during the investment. So the also index measures both the depth and the duration of drawdown and is one of those rare risk indicators that is path dependent.

[00:38:13]

And if you adjust it for safe return, then in my opinion, it's a better indicator than the sharp ratio for investors who are more concerned about drawdowns versus volatility. And the name of the index comes from the notion that drawdowns caused the stress, of course, and therefore even also to investors.

[00:38:33]

Now, once you have the ulcer index calculated, you can actually easily calculate something that's called the also performance index, or UPI, which is the return divided by the also index. And so UPI is the also counterpart really to the shop ratio. And by the way, I mean, this will give you a completely different picture of the example I mentioned to you before. So once you have done this step, you're obviously going in the right direction, I think.

[00:39:04]

But the also index represents an average risk. So it does not take into account, you know, the tail risk, which is really what we should be worried about, because investments that look safe based on some of these measures may turn out to contain a lot of hidden risk like we saw with long term capital. Bernie Madoff, if you can call it the real track record. I mean, they look great until they blew up, so. In order to get a better idea of the hidden risk or negative surprises, you need to look at something called conditional drawdown at risk, which is like the VA value at risk, but it only looks at drawdowns.

[00:39:44]

And what it measures is the average of the drawdown that falls below, say, 95 percent confidence level. So really here you're looking at the worst negative surprises found in the data of a particular strategy.

[00:39:59]

So now that we know how bad it can get in the extreme, you really need to compare this to the volatility of the strategy. And this is called the pitfall indicator, which is really just the conditional drawdown at risk over the annualized volatility. And so what you're looking to discover here is any extreme drawdown that is not expected from the volatility of the strategy. So, for example, if you have two strategies that both have a conditional drawdown risk of, say, 10 percent, but one strategy has an annual volatility of the one percent and the other one had 10 percent volatility, you would think the strategy of a one percent annual volatility is less risky.

[00:40:43]

But if they have the same pitfall indicator, you would find out that this is not the case. And in fact, you could argue that it is more risky, more surprising. So to summarize, you could say the pitfall represents the average loss of the biggest drawdown expressed in units of volatility of the strategy. And therefore, the bigger the number, the riskier the strategy. And so if we want to take it to the final step in getting to what I think is a really good measure of riskiness of any strategy, we need to find out how, quote unquote, Sareen, the strategy is and here you have something called the serenity ratio.

[00:41:26]

What it's trying to do is to be kind of a sharp ratio equivalent, but it uses what's called a penalized risk measure instead of volatility. And the penalized risk is defined as the average risk, which we got from the also index. And then you times hit with the extreme risk which we got from the pitfall indicator. And once you've calculated the penalised risk, you simply say the return of the strategy divided by the penalized risk. And so the name is derived from the fact that the higher the value of the serenity ratio, the more serene an investor will feel in regards to his or her investment decision.

[00:42:05]

The serenity is comparable to the sharp ratio. The higher its value, the better it is for the strategy. And to me, if you do all of this work and you look at all of these combinations of indicators, you get a much better picture of true riskiness, if I can call it that. And you can't ignore all the risk of drawdowns of pain in your analysis, which is really what the Sharpe ratio does.

[00:42:34]

And maybe as a final comment to this, what you find is that when you look at strategies like global macro and trend following, they have much better serenity ratio. They're more serene than a long only S&P investment, for example, because these strategies are more transparent about the real risk they're running. So you don't have any of these surprises like we saw in March of two thousand and twenty. So a little bit of a long winded answer, but I think it takes a little bit of footwork to look at true riskiness of a strategy.

[00:43:12]

Well, Nils, thank you for the insights on that.

[00:43:15]

And, you know, this is just one of those great evergreen topics of what is risk. How do we define risk? How do we experience risk as investors?

[00:43:23]

So I really appreciate you really going into the weeds on that one. And I also think it's important to stress that because we are a stock investing podcast at heart, that a trend following strategy can follow the stock market. But as you also said before, you are trading in 55 different markets. So this is also why Trentham strategy does not tend to correlate much with the stock. My portfolio, even though that you, of course, might argue that something like the interest rate that has an impact on all markets and and therefore also have an impact on an even fifty five with that type of correlation that you might see.

[00:44:01]

But some of the things that you mentioned before, you talked about like the euro or talked about live cattle, you know, so many different markets to trade. Could you talk a bit more about which models to trade and why you selected those modest trade end? I mean, you touched on a really important point, because I think a lot of people, unfortunately, are led to believe that trend following works in isolation on all assets, but that's really not the case.

[00:44:27]

So, for example, if you use a trend following approach, say, on Tesla in the last few years or dare I say Bitcoin, you probably would have made a lot of money because the strategy does not care about the fundamentals or the news flow around Elon Musk or Michael Saylor. It does not get emotional attached to any trade. Instead, it would just register that, say, Tesla or Bitcoin were starting to make new highs and and it would have gotten you long.

[00:44:56]

And at the same times, once the sell off started in twenty seventeen for Bitcoin, at some point you would have told you to exit and therefore not sell for the eight percent drawdown like those who were just long Bitcoin had to stomach at the time. But the truth is that not all markets trend as well as these two have done in the past couple of years. So in order to make trend following work for you, you need to apply across a lot of different markets, ideally across a lot of different types of assets, like stocks, as you said, like bonds, currencies and commodities, and perhaps especially the commodities as they have the lowest long term correlation within a diversified portfolio.

[00:45:40]

And so when you look at performance of a trend following strategy, it often is just a few markets that makes all the money in a given year. Also, when you look at the returns on a trait by trait basis, a typical trend following strategy only makes money on about 40 percent of the traits that we do. In other words, we are going to be wrong most of the time, which is one of the reasons that people find it to be a really hard strategy to follow, because as humans, we want to be right all the time.

[00:46:15]

But I mean, the good news is that it's a strategy that has a lot of evidence to support it. I mean, in our case on Capitol Capital, we have, you know, more than 46 years of a continuous track record. And you don't find many strategies, I would say, that have lasted this long. And by the way, the returns over nearly 47 years are completely uncorrelated to stocks, which is why it makes it such an important part of any equity portfolio.

[00:46:45]

Let's continue talking about that, because I've noticed from some public databases that your phone strategy was close to flat in 2020, but that, interestingly enough, it made strong returns both in March whenever we had the big crisis and then in December when we had no crisis and everything felt very optimistic. And if I might add to that, your volatility strategy was up very strongly in March during the crisis, but managed to hold onto these gains and even add to them during the rest of the year.

[00:47:15]

And that is unlike the long volatility strategies, which is intriguing itself.

[00:47:19]

There's a lot to unpack there. Could you tell me a bit more about that? First of all, volatility is a strategy, it's true to say that it has grown a lot in terms of popularity in recent years, but when it comes to the VIX, interestingly enough, you can't really trade it using trend following techniques because of the way it moves. And this is because it doesn't really trend that well for long periods of time. So you need to use a different methodology to trade volatility.

[00:47:52]

And now many managers have become popular by either being short vol managers or long middle managers. But you face two challenges with choosing one of the other approaches. If you a short while manager, you tend to make consistent returns as long as there is no crisis in the world. And then when they show up like we saw in Q1 2020, you tend to lose a lot of money and maybe even blow up entirely. On the flip side of that, you have the long vol managers where you tend to do really well when there is a crisis.

[00:48:25]

But because, you know, they're somewhat rare, really, the crises, they tend to slowly lose money in between the crisis. So when we look at volatility and I would just add that we've been trading volatility for about six years and we have a small allocation inside our trend following strategy to volatility, but very small. And this is also why we now offer the volatility strategy as a standalone fund, because we find it interesting that we don't have a bias to being either long or short vol in the way we traded.

[00:48:59]

So in other words, we want to still offer an absolute return approach or return strategy that is able to generate returns in a crisis situation, as you mentioned, but also when the markets are more calm and without giving too much of the secret sauce away. What we look for really is changes in the forward curve of the VIX complex because there are certain patterns that repeat during calm periods and during crisis periods. And a good way of seeing that is that the strategy had its two best years in 2017 and in 2020.

[00:49:38]

So you had one year with the lowest level of volatility in history, actually, which was twenty seventeen.

[00:49:44]

And you had a year with the highest level of volatility, which was last year, 20 20. Now, of course, it doesn't mean that it performs well all the time in all environments, and it's certainly going to have its drawdown like any strategy. But it is basically no correlation to stocks, bonds, trend following even and hedge funds or short volatility strategies. So, again, it's an important component in any portfolio, which I know some of your previous guests have also argued volatility is an asset.

[00:50:14]

Class is a very interesting component. And in our case, because we're able to flip, say, from long to short volatility or vice versa in only a day, it has a higher probability of offering protection in the early part of any crisis. Really important, by the way, to add to this is the fact that unlike most volatility strategies, we do this via a fully systematic process like anything else we do. So we don't use any discretion in how we treat volatility.

[00:50:50]

I guess, but a lot of the listeners are thinking is you're looking for some sort of signal from the market that could be something as simple as headlines and the newspaper like something where you can really extract that something funky is going on. And then we can expect whenever the market close or whenever it opens this and that would happen. Is that any kind of way how you're doing it whenever you do trade something like the WX? No, I think that's exactly the opposite, right?

[00:51:19]

So when you decide to be a fully systematic manager, there's one luxury that you lose. Not that I think it's a great luxury and that is anticipation. Right. So as you say, if you see something in the news, you anticipate what is going to happen. We just don't want to go down that route because there's no guarantee that it will happen. Right. So we only look at price data. So we need the prices to move in a certain way in order to trigger a signal.

[00:51:48]

The same goes for all VIX or volatility strategy. We need to see certain patterns in the VIX curve in order to initiate all positions. Now, of course, all of these markets can change a lot in a day. And therefore, as I said in our VIX strategy of volatility strategy, we can actually change direction from being long to short vol in a day. So it is pretty fast reacting. And I think in particular with the volatility space, it is something that has a completely different pattern in terms of how it moves compared to many other markets.

[00:52:25]

But I think it's really important. I think this is where maybe a lot of investors underestimate the value of diversification in terms of investment approach, meaning if you have, say, for example, you were a fan of a particular stock picker or fund that uses fundamental analysis, value investing, for example, to make its decisions, I think that can be perfectly fine to be having a portfolio. But the added benefit you get from including, say, a systematic vol strategy or a systematic trend following strategy is you also diversify across investment decision process, because when there is a crisis and in the heat of the moment, even the most seasoned discretionary managers might actually get influenced by the headlines and by what's going on in the excitement.

[00:53:18]

And that's something that systematic strategies don't because they don't see the headlines, they just see the market data. And I think this is a really important but often overlooked point, actually. Now, rounding off here with twenty 20, I think it's safe to say that it's been a very divisive year in the financial markets.

[00:53:40]

One example, like you also mentioned before, that was all the buzz about Tesla and it seems like, if possible, that bulls and bears of Tesla been sitting even more in their echo chamber, telling each other why the other cab is just utterly wrong. Using Tesla as an example, how to trend followers capitalize on the emotions of investors. Again, you touched on a really important lesson that we can all take away from 20, 20, and that is how we as investors should not get too opinionated maybe about a market, since none of us know really what the future will hold.

[00:54:19]

So you mention Tesla, and as we both know, you can find people who think it's and still think despite the high price, I thought it was going to go to the moon and that Elon Musk is a genius. And then on the other side, you will find people who think it's a fraud. And this is just one example of how getting too emotionally involved in a particular market or stock can be dangerous. And maybe you could even say the same about Bitcoin, right.

[00:54:47]

So to me, the lesson really is that we should just focus at these markets as any other market, really. And of course, we have to make a decision whether we want to trade them or not. But if we want to treat them or not, we shouldn't get too emotionally attached to it. And of course, keeping emotions out of any investment decision, I think it has been proven to be the best strategy. So for those of us who are one hundred percent rules based investors, of course, this is quite simple because we're not interested in why a market is moving up or down.

[00:55:23]

Only that we can identify the beginning and the end of the move based on the only you could say, maybe one hundred percent objective input, which is the daily price of a market. And when you asked me this, it kind of reminds me of one of the legends in our industry, Richard Dennis. And I think we spoke about Richard Dennis in my first appearance on Tippee.

[00:55:47]

And when I interviewed him a few years ago on my podcast, he said something like, although the trend is your friend, the rules are your guardian angel. And I think this is actually quite an important quote. And I think often people only hear, oh, the trend is your friend. They actually forget the other part. It's the rules that are your guardian angel. So, yeah, I think that is why it's so important. And I think, as you said, 20, 20, good example of how emotions got into the bait of certain investments.

[00:56:22]

Well, something else wow. I mean, this has been once again, that's been fantastic to learn more about trend following and it's been great looking back in 2020 with everything that's been going on where the audience learn more about you. I also know you have two podcasts and you represent on campus also a lot of hands off there. But what can the audience learn more? I appreciate that, Steve. The best way to learn about Don Capital, that would be just to go to Don Capital Dotcom.

[00:56:52]

And there we have some educational content that is out in the open, so to speak. There's also a blue box in the top right corner where it says the latest performance, and that is where you can accredit yourself. And once you've done that and this, of course, is for regulatory reasons, you can then see a lot more details and all of my podcast series you can find then on top traders on dot com. And that's really a combination of, say, weekly conversations where we talk about current market events as well as we answer questions from the community.

[00:57:27]

And then in addition to this, you can find some one on one conversations with some of the very best hedge fund managers or investment managers in the world, and also some group conversations with really amazing thought leaders in the financial world. So I think that's really the best way to do that, Steve. And I really appreciate our conversation today, and I hope it was valuable for your amazing community. I'm sure it definitely was I learned a ton, like I mentioned before, I am sure that the listeners feel the same way now.

[00:58:00]

Thanks so much for coming on our show. Any time soon. Thank you so much. Take care. All right, guys. Israel letting deals go. I just have one ask of you if you do not subscribe to a fee. Please make sure to do so on unable Spotify or whatever. You listen to a podcast. But that's all that I have for you guys for this week's episode. Prestonsburg and Wednesday and Traini are back next weekend with another episode of the Masters podcast.

[00:58:24]

Thank you for listening to Te IP to access our schnitz courses or forums. Go to the investor's podcast Dotcom. This show is for entertainment purposes only before making any decisions. Consult a professional. The show is copyrighted by the Investors Podcast Network written permission must be granted before syndication or forecasting.