Niels Kaastrup-Larsen (03:43):
And this, along with all the 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 follower, 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. So when the market made a U-turn in late March, 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 off and to keep you out of too much trouble.

Niels Kaastrup-Larsen (04:28):
But maybe I can just finish off by saying that although 2020 was a year full of new data for our models, and 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 when something like this happens. And frankly, what has kept us going for more than four decades is really consistent but incremental improvements to our trading models.

Stig Brodersen (04:59):
I don’t know if you could elaborate a bit more than that, because whenever you include those new data for something like this happening, how is that being reflected in the model? Is it weighted like… I think last time we talked about it, you had a 47-year track record. Does that mean that it’s just another year? Is there some kind of triggerset next time there’s a pandemic, this will happen? How is another year that’s so different included in a long series of years so the system and the algorithm can learn from that?

Niels Kaastrup-Larsen (05:28):
First of all, we don’t do any AI stuff, so it’s not necessarily that the algorithm changes or learn something from that. But when you design your models, at some point, you need to decide on your lookback 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 se of data, you restrict it to a smaller set of data. And therefore, 2020 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 timeframes 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.

Stig Brodersen (06:20):
Continuing talking about 2020, 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.” But, I also think that many have been surprised by the magnitude that central banks pump money back into the system. And I can’t help wonder, how would the main asset classes have performed if the central banks hadn’t showed up? And what would the implication be for a trend-following strategy?

Niels Kaastrup-Larsen (06:51):
I think you’re absolutely right. I think that many investors have already forgotten what it feels like being in the markets just before March 23rd when equity markets were moving up and down by 10% in a day. But now, 10 months later in the cool light of hindsight, people might say, “Oh, but why did these so-called crisis alpha strategies not do better in a year with so much volatility?” And I get that, but I think 2020 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?”

Niels Kaastrup-Larsen (07:47):
And when you look at a typical trend-following strategy, I would say that most of us would have had a perfect set of positions had the central banks not shown up or failed because in late March we were short or 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 failed to provide any protection. And so if you look at the benchmark like the Stock Gen Multi Alternative Risk Premia Index, for example, it’s down a lot in 2020, just like some of the really large risk parity strategies.

Niels Kaastrup-Larsen (08:36):
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 fantastic track records, 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. 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.

Niels Kaastrup-Larsen (09:14):
And you may know that most trend followers, 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. Now, I do know of some shorter term managers that experienced concerns about the liquidity, but of course, this is the downside of being super short term in your approach, especially if you grow your assets too big,

Stig Brodersen (09:46):
You could also argue that it’s not fair to categorize trends following too narrowly. Just like some stock investors in 2020 have crossed the stock markets and others have lost the shirt, trend followers have shown very different results too. And if I could just use the example again of stock investors, just like the don’t just buy one stock, trends followers also don’t use just one strategy. So how should we as investors think about a portfolio of trend-following strategies?

Niels Kaastrup-Larsen (10:16):
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 trend to follow up because they’re all highly correlated.” And 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 0.6 to 0.8. But even relatively high correlation, it does not mean that they generate the same returns. You have some managers that are better, generating really strong returns during good trending environments.

Niels Kaastrup-Larsen (10:51):
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. There are a few things that really makes a huge difference between managers in our space, and I think 2020 was a good example of this. In some ways, you could divide it into two groups. One is what you trade, and the other one is how you trade. So if you’re comparing two 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 market you include in the portfolio.

Niels Kaastrup-Larsen (11:40):
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 “alternative markets,” which are smaller, less liquid markets. Like some commodities let’s talk about, say power, or it could be emerging market bonds, it could be interest rates 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 brings me to the other area of differentiation, namely how you trade, meaning, how do you design your trend following system?

Niels Kaastrup-Larsen (12:25):
And you can break that into maybe four broad areas. So one is how your entries are designed. A type of entry could be a breakout methodology or a moving average, it could be time series 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 trades, 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. And then maybe a last point would be how your systems and markets are mixed. Do you trade all markets using the same systems or do you vary that?

Niels Kaastrup-Larsen (13:12):
So when it comes to system design, this is often where trend-following managers are categorized in the speed of their systems. Are you a short-term manager? Which, in my view, might be, say, a holding period of up to two weeks. And then you have 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. So to me, it looks like speed of systems played a big role in determining your returns in 2020. 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 see that the longer term managers were, by design, slow to react.

Niels Kaastrup-Larsen (14:10):
But then later in the, yeah, the longer-term trend followers actually caught up and surpassed the short-term managers to deliver an overall better return for 2020. 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. 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.

Niels Kaastrup-Larsen (14:59):
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 trends strengths looks like. But many years ago, during the financial crisis back in 2008, the CTA firm that I founded and ran back at that time, we developed something called The Trend Barometer. And on my a podcast page, TheTopTradersUnplugged.com website, each day, I publish the percentage of markets in a, you could say classical diversified trend-following portfolio that are in some kind of a trend.

Niels Kaastrup-Larsen (15:38):
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 25% of the 44 markets in this portfolio that are trending. And maybe you have a breakeven zone terms of performance, which is around 45%, but you could even make it a bit wider, say 40 to 50%. Meaning you need about half the markets to be in some 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 followers is usually negative for that year. And then you can flip it and say, “Well, the greater the number of months with more than say, 60% of markets trending, the stronger the annual performance.”

Niels Kaastrup-Larsen (16:30):
But unfortunately, we have not seen that many strong month in the recent years, however, December of 2020 gave a very strong reading, which also confirmed that 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 followers last year.

Stig Brodersen (16:58):
Neils, 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 that we’ve covered several times here on the show. Basically, that you have an asset where 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. Perhaps you could elaborate more and give specific examples on rule-based trend following, including timeframes and the number of trades executed.

Niels Kaastrup-Larsen (17:33):
I think you certainly can drive parallels to momentum investing, because what helps us as trend followers identify trends is usually some strong momentum or burst of directional volatility that often takes the markets outside its current trading range. 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. 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.

Niels Kaastrup-Larsen (18:25):
It could also be a breakout of a volatility band. This could be like a Bollinger Bands that the market pushes through. It could also be a little bit less sudden, if I can call it that, like two or three moving averages cross over. And also, we have something that’s very popular called 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 two trend followers with the same investment horizon apart.

Niels Kaastrup-Larsen (19:13):
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 2020, 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. You also asked about trade frequency, and this can be quite different from manager to manager. I would say at DUNN Capital, we would be classified as a longterm trend follower.

Niels Kaastrup-Larsen (20:01):
One of the reasons we have ended up using the longer term timeframe, say 12 to 18 months, is simply because they are better and they are more robust than say shorter-term timeframes. And one of the really interesting analysis, I think, that we do is to compare what timeframes have worked best for each calendar year, and we do that going back about 30 years. By the way, we look at anything from say 20 days to about 300 days in this study. And over those 30 years, you’ll see that the majority of the years would have performed best if you used a timeframe of around, say 180 days to 240 days. 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.

Niels Kaastrup-Larsen (20:58):
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, 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

Niels Kaastrup-Larsen (21:39):
And of course, sure, we trade 24 hours a day because we have a portfolio of global markets, but we only need to do one adjustment trade per day per market. I mean, we trade about 55, 54 markets in our portfolio, and not all of them would even give a new signal to be adjusted. So on average, I think we do say, 25 trades per day, so it’s really not a lot. And then in terms of the markets we’ve decided to trade, 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. And this we’ve seen a few times.

Niels Kaastrup-Larsen (22:27):
And we’ve also seen stocks and bonds and currencies become somewhat illiquid during these periods. 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 a bank since your counterpart is each of the futures exchanges you trade on.

Stig Brodersen (22:49):
I’m trying to envision this, Niels, going back to what you said there before, say 25 trades a day. Does that mean that you always have 25 active bets? Does it mean that, well, that’s per day and your timeframe might be up to 180 days? How many active bets do you have?

Niels Kaastrup-Larsen (23:08):
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. At the moment, for example, we could be generally quite short, the dollar, meaning where long the Yen and the Pound and the Euro and so on and so forth, 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 100 lots today, well, tomorrow, we actually may only want to be short 99 lots. So we do a small adjustment of the position size.

Niels Kaastrup-Larsen (23:57):
That’s also impacted by our overall risk management system that sits the total portfolio risk. So if we see say volatility increases or correlation increase, we may do an overall reduction of all positions, 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% exposure in any one market, it’s just not possible.

Niels Kaastrup-Larsen (24:41):
So in theory, you could say that if we were fully invested in all of the markets, we would have about one-50th or 55th exposure in each of the markets, meaning we can have the same exposure in live cattle as we can in the Euro. But again, they’re limited to how much that exposure can be. And I think this is one of the strengths 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.

Stig Brodersen (25:24):
Interesting. 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 decade to come, but stable on a close to zero level, can we expect trend following to regress to the same low yield levels?

Niels Kaastrup-Larsen (25:48):
I mean, it’s a really hot 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 our users’ fund, which many European investors do, for each $100 they invest, we only need about $15 or so to be put up as margin on the exchanges that we trade. The remaining 85% is held in a safe cash management strategy. And of course, the returns of this 85% will be zero, essentially, if short-term rates are zero.

Niels Kaastrup-Larsen (26:44):
And this has in fact been the case for more or less since 2008. 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. So we actually only show “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.

Niels Kaastrup-Larsen (27:34):
But I’m not so sure we can pinpoint that course to just low interest rates, probably more likely 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 races, and that is, what are investors going to do with the fixed income and bond holdings as so many investors still have large portions of their portfolios in bonds? This is where I think trend following can be a really important component in any portfolio going forward. 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 non-correlation between stocks and trend falling makes these two asset classes really a perfect match.

Niels Kaastrup-Larsen (28:32):
And if you look at a simple portfolio of say, 50% SNP or 50% MSEI, and then you take 50% trend following, not only do you get a much better return, you get it with much lower volatility, you get it with much lower drawdown. And that’s really the magic of combining non-correlated assets. And I truly hope that this will be embraced even more by investors going forward before it’s too late.

Stig Brodersen (29:03):
Niels, let’s talk a bit more about evidence and simulations because I think to a lot of listeners, they know the concept about trend followings, you’ve been here on the show and educated all of us more about that, but fewer listeners have trend following as the core of the portfolio, they may 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. Now, how would a global equity portfolio, say the MSEI, have performed if we included trend-following strategies as 20 % of the oil portfolio?

Niels Kaastrup-Larsen (29:44):
If we look at the MSEI index as a standalone investment, and we’re obviously including more than 10 years of a massive bull market, you will have achieved an annualized rate of return of about say 10% since 1985, so the last 35 years, which is pretty decent. 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% better than the MSEI, but because the two investments have had pretty much zero correlation, when you add trend following to the MSEI, and you mentioned a 20% allocation, you actually still achieve a higher return than just the MSEI, somewhere between the MSEI and our own program.

Niels Kaastrup-Larsen (30:39):
But it comes with better reduction in terms of risk, meaning it comes with a 27%, I think it was thereabouts in terms of your worst drawdown. It goes down from, I think the MSEI was at some point down about 55%. And by including, say, a 20% allocation, you can probably reduce that to say, 40% or so. That’s meaningful still, I think, in a combined portfolio. And if we talk about the Sharpe ratio despite all of its flaws, you do get a healthy increase of about 25% in the shop. In other words, you get a high return with lower risk, and that’s a big reduction for many people.

Niels Kaastrup-Larsen (31:18):
Often what draw-downs in itself is important because it’s often the draw-downs that causes investors to make really bad decisions because they end up not being able to stomach these losses. So reduction in drawdown is important. And of course, these benefits would even get bigger if you go for a simple 50/50 allocation split bit to mainly, again, driven by the zero correlation between stocks and what we do for example.

Stig Brodersen (31:48):
You said it yourself there, Niels, talking about the job ratio.

Niels Kaastrup-Larsen (31:54):
Oh, oh, what am I gotten myself into?

Stig Brodersen (31:57):
If you look across industry, the Sharpe 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. If anything, value investors welcome volatility because it allows them to exploit Mr. Market. So what are your thoughts on the Sharpe ratio and some of the shortcomings?

Niels Kaastrup-Larsen (32:27):
I completely agree with you on this point, Sharpe ratio, despite it being the perhaps most widely used measure of riskiness of an investment. However, I think the Sharpe ratio has some real flows as you mentioned, and that many investors frankly, may not be fully aware of. So with a question like that Stig, 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. One of the problems that I see with the Sharpe ratio is that it measures both upside, either good volatility and the downside, the bad volatility, and it treats them equal.

Niels Kaastrup-Larsen (33:11):
So if you’re trying to find out how risky and investment is, why would you even penalize it for being its upside volatility? Now, of course, some investors and analysts have noticed this and started using a variation of the Sharpe ratio where you only look at the downside volatility, and this is what’s known as the Sortino 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.

Niels Kaastrup-Larsen (33:51):
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, but if for example, you take an equity index and you just show the equity curve of say, long only buy-and-hold approach, you will get a certain level return and volatility, and hence, you can calculate the Sharpe ratio.

Niels Kaastrup-Larsen (34:16):
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, 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 your Sharpe ratio might be the same. And you could also organize the same data, it could be much closer to 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.

Niels Kaastrup-Larsen (35:00):
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 Sharpe and other 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 can I put it, gut wrenching, in lack of a better word, the investment really is because I think that tells you more about real riskiness of the investment. And in my opinion, there are a few that can help you with this, but they need to be calculated in a particular order.

Niels Kaastrup-Larsen (35:44):
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 Ulcer Index measures both the depth and the duration of drawdown and is one of those rare risk indicators that is path dependent. And if you adjust it for say, return, then in my opinion, it’s a better indicator than the Sharpe ratio for investors who are more concerned about drawdowns versus volatility. And the name of the index comes from the notion that drawdowns causes stress, of course, and therefore, even also as to investors.

Niels Kaastrup-Larsen (36:29):
Now, once you have the Ulcer Index calculated, you can actually easily calculate something that’s called the Ulcer Performance Index or UPI, which is the return divided by the Ulcer Index. And so UPI is the Ulcer counterpart really to the Sharpe ratio. And by the way, 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, but the Ulcer Index represents an average risk. So it doesn’t take into account 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.

Niels Kaastrup-Larsen (37:23):
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 VAR, Value At Risk, but it only looks at drawdowns. And what it measures is the average of the drawdowns that falls below, say 95% confidence level. So really here, you’re looking at the worst negative surprises found in the data of a particular strategy. 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.

Niels Kaastrup-Larsen (38:12):
And so what you’re looking to discover here is any extreme drawdown that is not expected from the volatility of the strategy. For example, if you have two strategies that both have a conditional drawdown risk of, say 10%, but one strategy has an annual volatility of the 1%, and the other one had 10% volatility, you would think the strategy of a 1% annual volatility is less risky, 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.

Niels Kaastrup-Larsen (38:49):
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 “serene” the strategy is. And here you have something called the Serenity Ratio. What is trying to do is to be a Sharpe ratio equivalent, but it uses what’s called eight penalized risk measure instead of volatility.

Niels Kaastrup-Larsen (39:32):
And the penalized risk is defined as the average risk, which we got from the Ulcer Index, and then you timed it with the extreme risk which we got from the pitfall indicator. And once you’ve calculated the penalized 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 and investor will feel in regards to his or her investment decision. The serenity is comparable to the Sharpe ratio, the higher its value, the better it is for the strategy.

Niels Kaastrup-Larsen (40:08):
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 we can call it that. And you can’t ignore the risk of drawdowns of pain in your analysis, which is really what the Sharpe ratio does. 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 SNP investment, for example, because these strategies are more transparent about the real risks they’re running so you don’t have any of these surprises like we saw in March of 2020.

Niels Kaastrup-Larsen (40:58):
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.

Stig Brodersen (41:08):
Well, Niels, thank you for the insights on that. This is just one of those great evergreen topics of what is risk. How do we define risk? How do we experience risk as an investor? 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 trend following strategy does not tend to correlate much with the stock market portfolio, even though that you, of course, might argue that something like the interest rate, that has impact on all markets and therefore, also have impact on… And even 55 with that type of correlation that you might see.

Stig Brodersen (41:57):
But some of the things that you mentioned before, you talked about the Euro or you talked about live cattle, so many different markets to trade. Could you talk a bit more about which markets to trade and why you selected those markets to trade?

Niels Kaastrup-Larsen (42:12):
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. For example, if you used 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, let’s say Tesla or Bitcoin, or starting to make new highs, and it would have gotten new long.

Niels Kaastrup-Larsen (42:52):
And at the same times, once the selloff started in 2017 for Bitcoin, at some point, you would have told you to exit and therefore not sell for the 80% 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 it 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.

Niels Kaastrup-Larsen (43:36):
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 trade by trade basis, a typical trend following strategy only makes money on about 40% 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. The good news is that it’s a strategy that has a lot of evidence to support it

Niels Kaastrup-Larsen (44:17):
In our case at DUNN Capital, we have 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.

Stig Brodersen (44:41):
Let’s continue talking about that because I’ve noticed from some public databases that your trend following 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. And that is unlike the long volatility strategies, which is intriguing itself. There’s a lot to unpack there, could you tell me a bit more about that?

Niels Kaastrup-Larsen (45:19):
First of all, volatility as the 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, and now many managers have become popular by either being short-vol managers or long-vol managers, but you face two challenges with choosing one of the other approaches.

Niels Kaastrup-Larsen (46:00):
If you’re a short-vol 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, but because there’s somewhat rare, really the crisis, 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.

Niels Kaastrup-Larsen (46:43):
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 trade it. In other words, we want to still offer an absolute return approach, 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.

Niels Kaastrup-Larsen (47:24):
And a good way of seeing that is that the strategy had its two best years in 2017 and in 2020. So you had one year with the lowest level of volatility in history actually, which was 2017, and you had a year with the highest level of volatility, which was last year 2020. 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 roll down like any strategy, but it is basically no correlation to stocks, bonds, trend following even, and hedge funds or short volatility strategies. Again, it’s an important component in any portfolio, which I know some of your previous guests have also argued, volatility as an asset class is a very interesting component.

Niels Kaastrup-Larsen (48:13):
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 trade volatility.

Stig Brodersen (48:46):
I guess what a lot of the listeners are thinking is, you’re looking for some signal from the market, that could be something as simple as headlines in the newspaper, 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 way how you’re doing it whenever you do trade something like the VIX?

Niels Kaastrup-Larsen (49:13):
No, I think that’s exactly the opposite. 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. 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. So we only look at price data, so we need the prices to move in a certain way in order to trigger a signal. The same goes for all VIX or volatility strategy, we need to see certain patterns in the VIX curve in order to initiate our positions.

Niels Kaastrup-Larsen (49:55):
Now, of course, all of these markets can change a lot in a day, and therefore, as I said, in our VIX strategy or 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. 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.

Niels Kaastrup-Larsen (50:32):
Meaning, if you have, say for example, you were 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 and the excitement.

Niels Kaastrup-Larsen (51:14):
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.

Stig Brodersen (51:27):
Niels, rounding off here with 2020, I think it’s safe to say that it’s been a very divisive year in the financial markets. One example, like you also mentioned before, there 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 do trend-followers capitalize on the emotions of investors?

Niels Kaastrup-Larsen (52:00):
Again, you touch on a really important lesson that we can all take away from 2020, 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. You mentioned Tesla, and as we both know, you can find people who think, and still think despite the high price, 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.

Niels Kaastrup-Larsen (52:39):
And maybe you could even say the same about Bitcoin. 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 trade 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 100% rules-based investors, of course, this is quite simple because we’re not interested in why a market is moving up or down, only that we can identify the beginning and the end of the move based on the only, you could say, maybe 100% objective input, which is the daily price of a market.

Niels Kaastrup-Larsen (53:32):
And when you asked me this, it 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 TIP. 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, 2020, good example of how emotions got into the bait of certain investments.

Stig Brodersen (54:18):
Well said, Niels. Once again, this has 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 could the audience learn more about you? I also know you have two podcasts and you represent DUNN Capital. So a lot of hands up there, but where can the audience learn more?

Niels Kaastrup-Larsen (54:40):
I appreciate that, Stig. The best way to learn about DUNN Capital, that would be just to go to Dunncapital.com, 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, see 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 their note on toptradersunplugged.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.

Niels Kaastrup-Larsen (55:22):
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, Stig. And I really appreciate our conversation today, and hope it was valuable for your amazing community.

Stig Brodersen (55:48):
I’m sure, it definitely was. I learned a ton, like I mentioned before, I am sure that the listeners feel the same way. Niels, thank you so much for coming on our show.

Niels Kaastrup-Larsen (55:59):
Anytime, Stig. Thank you so much. Take care.

Stig Brodersen (56:01):
All right, guys. As we’re letting Niels go, I just have one ask of you. If you do not subscribe to our feed, please make sure to do so on Apple, Spotify, or wherever you listen to a podcast. But that’s all that I have for you guys for this week’s episode. Preston’s back on Wednesday, Trey and I are back next weekend with another episode of The Investors Podcast.

Outro (56:20):
Thank you for listening to TIP. To access our show notes, courses or forums, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decisions, consult a professional. This show is copyrighted by The Investors Podcast Network. Written permissions must be granted before syndication or re-forecasting.