We Study Billionaires - The Investor’s Podcast Network - TIP333: Trend Following w/ Niels Kaastrup-Larsen

Starting point is 00:00:00 You're listening to TIP. On today's show, we have a veteran of the finance industry, Mr. Niels Costa-Larsin, with us. Niels has been part of the head to the 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 with equity's portfolio and how models that are built on historical data perform in a year with a pandemic that we've never seen before. So without further ado, here's our interview with Niels.

Starting point is 00:00:30 You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to The Investors Podcast. I'm your host Dick Broderson. And today we bring back Niels Costa-Larsen to educate our audience about trend following and the financial markets. Niels, welcome back on the show. Thanks so much, Dee. it's great to be back with you. Let's jump right into the first question here.

Starting point is 00:01:14 2020 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 of recovery. Since financial models are based on historical data, what happens when you have a year when something you've never seen before happens? And how did you experience 2020 from a trend-falling perspective? I mean, you're absolutely right,

Starting point is 00:01:37 Steve, 2020 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. 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, Steeke. So at Don, 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 dataset. So you could argue that it would be unreasonable to expect us or any other systematic data-driven strategy

Starting point is 00:02:23 to make money in a year like that, 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 return, say between flat to up 10% or so for the larger trend followers is a sign of robustness of the strategy. Now, robustness of a strategy 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. So even if our models had not seen these type of market moves before,

Starting point is 00:03:05 because they only see the raw 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 these signals. And in our case, we had started the year very long, actually, in stocks because they were trending higher in 2019,

Starting point is 00:03:33 but during the last week of February, once the uptrend had been broken, our models reduced their long exposure by about 87% 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

Starting point is 00:03:53 when they most needed it. And as a medium to long-term trend follow, 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, 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.

Starting point is 00:04:28 But maybe I can just finish off by saying that although 2020 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 when something like this happens. And frankly, what has kept us going for more than four decades is really kind of consistent but incremental improvements to our trading models. I don't know if you could elaborate a bit more than that, because whatever you include those new data for something like this happening,

Starting point is 00:05:06 how has that been reflected in the model? Is it weighted like, oh, I think last time we talked about you had a 47-year track record. Does that mean that's just another year? Is there some kind of trigger set next time there's a pandemic? This will happen. Like, 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? First of all, we don't do any AI stuff.

Starting point is 00:05:30 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 kind of restrict it to a smaller set of data. and therefore 2020 becomes one of say maybe 10 years

Starting point is 00:05:58 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. Continue talking about 2020. I mean, one thing that really is,

Starting point is 00:06:23 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 but 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? 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 23rd when equity markets were moving up and down by 10% in a day. But now kind of 10 months later in the cool light of hindsight, people might say, oh, but why did the so-called crisis alpha strategies

Starting point is 00:07:12 not do better in a year with so much volatility? And I get that, I think that 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? 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

Starting point is 00:08:01 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 correlations broke down and therefore they really kind of failed to provide any protection. And so if you look at the benchmark like the SOGGEN multi-alternative risk premium index, for example, it's down a lot in 2020

Starting point is 00:08:31 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 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.

Starting point is 00:09:03 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 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.

Starting point is 00:09:31 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 too big. You could also argue that it's not fair to categorize trend following too narrowly. I mean, just like some stock investors in 2020 have crossed the stock markets and others have lost a shirt, trend followers have shown very different results too.

Starting point is 00:10:01 And if I could just use the example again of stock investors, just like they 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? I've certainly heard many people say that when they look at trend following as a strategy or as the space of trend followers, they would go, oh, so I only need one trend follower because they're all highly correlated. 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 0.6 to 0.8.

Starting point is 00:10:38 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.

Starting point is 00:11:04 So, you know, 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,

Starting point is 00:11:27 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 engage. include in the portfolio. So to put this into perspective that there's no pond 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, let's talk about, say, power or it could be emerging market bonds, it could be

Starting point is 00:11:59 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.

Starting point is 00:12:29 So one is how your entries are designed. You know, a type of entry could be a breakout methodology or a model, 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 trade, so position sizing.

Starting point is 00:12:55 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? So when it comes to system design, this is often where trend following managers

Starting point is 00:13:16 are categorized in kind of the speed of their systems. You know, 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 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.

Starting point is 00:13:41 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 say that the longer-term managers were, by design, slower to react.

Starting point is 00:14:10 But then later in the year, 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. 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.

Starting point is 00:14:45 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. Now, that's obviously easy to say that any trend-falling program returns depend on trend strength in the portfolio, what is not so easy is to quantify

Starting point is 00:15:08 and to visualize what trend strength 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 podcast page, the top traders on plug.com website, each day I publish the percentage of markets

Starting point is 00:15:30 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 25% of the 44 markets in this portfolio that are trending. And maybe you have a kind of a break-even zone in 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 kind of trend in order

Starting point is 00:16:06 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. But unfortunately, we have not seen that many strong months 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.

Starting point is 00:16:44 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. Let's take a quick break and hear from today's sponsors. All right, I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year, bringing together activists, technologists, journalists, investors, and builders from all over the world. many of them operating on the front lines of history.

Starting point is 00:17:33 This is where you hear firsthand stories from people using Bitcoin to survive currency collapse, using AI to expose human rights abuses, and building technology under censorship and authoritarian pressures. These aren't abstract ideas. These are tools real people are using right now. You'll be in the room with about 2,000 extraordinary individuals, dissidents, founders, philanthropists, policymakers, the kind of people you don't just listen to but end up having to. having dinner with. Over three days, you'll experience powerful mainstage talks, hands-on workshops on freedom tech, and financial sovereignty, immersive art installations, and conversations

Starting point is 00:18:11 that continue long after the sessions end. And it's all happening in Oslo in June. If this sounds like your kind of room, well, you're in luck because you can attend in person. Standard and patron passes are available at Oslof Freedomforum.com with patron passes offering deep access, private events, and small group time with the speakers. The Oslo Freedom Forum isn't just a conference. It's a place where ideas meet reality and where the future is being built by people living it. If you run a business, you've probably had the same thought lately. How do we make AI useful in the real world? Because the upside is huge, but guessing your way into it is a risky move. With NetSuite by Oracle, you can put AI to work today.

Starting point is 00:18:54 NETSuite is the number one AI cloud ERP, trusted by over 43,000 businesses. It pulls your financials, inventory, commerce, HR, and CRM into one unified system. And that connected data is what makes your AI smarter. It can automate routine work, surface actionable insights, and help you cut costs while making fast AI-powered decisions with confidence. And now with the Netsuite AI connector, you can use the AI of your choice to connect directly to your real business data. This isn't some add-on.

Starting point is 00:19:26 It's AI built into the system that runs your business. And whether your company does millions or even hundreds of millions, Netsuite helps you stay ahead. If your revenues are at least in the seven figures, get their free business guide demystifying AI at Netsweet.com slash study. The guide is free to you at Netsuite.com slash study. NetSuite.com slash study. When I started my own side business,

Starting point is 00:19:52 It suddenly felt like I had to become 10 different people overnight wearing many different hats. Starting something from scratch can feel exciting, but also incredibly overwhelming and lonely. That's why having the right tools matters. For millions of businesses, that tool is Shopify. Shopify is the commerce platform behind millions of businesses around the world and 10% of all ecommerce in the U.S. from brands just getting started to household names. It gives you everything you need in one place. inventory to payments to analytics. So you're not juggling a bunch of different platforms. You can build

Starting point is 00:20:28 a beautiful online store with hundreds of ready-to-use templates, and Shopify is packed with helpful AI tools that write product descriptions and even enhance your product photography. Plus, if you ever get stuck, they've got award-winning 24-7 customer support. Start your business today with the industry's best business partner, Shopify, and start hearing... Sign up for your $1 per month trial today at Shopify.com slash WSB. Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right.

Starting point is 00:21:07 Back to the show. Niels, let's be even more specific about trend following. Intuitively, I think a lot of all listeners might compare it to momentum investing, which is something that we've recovered 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.

Starting point is 00:21:31 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. I think you certainly can drive parallels to momentum investing because what helps us as trend followers identify trends is usually some kind of strong momentum or burst of directional volatility

Starting point is 00:21:56 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. So in terms of ways of identifying trends, this is probably the easiest part of what we do

Starting point is 00:22:18 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 it's 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.

Starting point is 00:22:43 It could also be a little bit less sudden, if I can call it that, like if 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

Starting point is 00:23:20 with the same investment horizon apart. 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

Starting point is 00:23:45 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. So you also ask about trade frequency and this can be quite different from manager to manager.

Starting point is 00:24:06 I would say at Don 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 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, you know, over those 30 years, you'll see that the majority of the years would have performed best

Starting point is 00:24:50 if you used a time frame 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. 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

Starting point is 00:25:33 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 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

Starting point is 00:25:59 and since, 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, 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.

Starting point is 00:26:27 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, 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.

Starting point is 00:26:47 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, Niels, going back to what you said there before, say 25 trades a day. Does that mean that you are trading, you always have 25 active bets? Does it mean that, well, that's per day and the time frame might be up to 180 days?

Starting point is 00:27:16 How many active bets 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 trend strength in each of the market. So, you know, at the moment, for example, we could be generally quite short the dollar, meaning we're along the yen and the pound and the euro and so on and so forth.

Starting point is 00:27:46 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. That's also impacted by

Starting point is 00:28:09 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 but that's based more on the risk management

Starting point is 00:28:25 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 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

Starting point is 00:29:10 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. 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 decade to come, but stable on a close to level. Can we expect trend following to regress to the same low yield levels?

Starting point is 00:29:58 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, our uses 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.

Starting point is 00:30:52 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.

Starting point is 00:31:18 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.

Starting point is 00:31:45 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 raises, and that is, what are investors going to do

Starting point is 00:32:11 with their fixed income and bond holdings? As so many investors still have large portions of their portfolios and 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.

Starting point is 00:32:36 The non-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% S&P or 50% MSCI, 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.

Starting point is 00:33:04 And I truly hope that this will be embraced even more by investors going forward before it's too late. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a SOC or running an enterprise GRC program, VANTA keeps you secure and keeps your deals moving.

Starting point is 00:33:42 Instead of chasing spreadsheets and screenshots, VANTA gives you continuous automation across more than 35 security and privacy frameworks. Companies like Ramp and Ryder spend 82% less time on audits with Vanta. That's not just faster compliance, it's more time for growth. If I were running a startup or scaling a team today, this is exactly the type of platform I'd want in place. Get started at vanta.com slash billionaires. That's vanta.com slash billionaires. Ever wanted to explore the world of online trading, but haven't dared try? The futures market is more active now than ever before, and Plus 500 futures is the perfect place to start. Plus 500 gives you access to a wide range of instruments, the S&P 500, NASDAQ, Bitcoin, gas, and much more.

Starting point is 00:34:35 Explore equity indices, energy, metals, 4X, crypto, and beyond. With a simple and intuitive platform, you can trade from anywhere, right from. your phone. Deposit with a minimum of $100 and experience the fast, accessible futures trading you've been waiting for. See a trading opportunity, you'll be able to trade it in just two clicks once your account is open. Not sure if you're ready, not a problem. Plus 500 gives you an unlimited, risk-free demo account with charts and analytic tools for you to practice on. With over 20 years of experience, Plus 500 is your gateway to the markets. Visit Plus 500, to learn more. Trading in futures involves risk of loss and is not suitable for everyone. Not all applicants

Starting point is 00:35:21 will qualify. Plus 500, it's trading with a plus. Billion dollar investors don't typically park their cash in high-yield savings accounts. Instead, they often use one of the premier passive income strategies for institutional investors, private credit. Now, the same passive income strategy is available to investors of all sizes, thanks to the fund-rise. income fund, which has more than $600 million invested and a 7.97% distribution rate. With traditional savings yields falling, it's no wonder private credit has grown to be a trillion dollar asset class in the last few years. Visit fundrise.com to invest in the fundrise income fund in just minutes. The fund's total return in 2025 was 8%, and the average annual total return

Starting point is 00:36:11 since inception is 7.8%. Past performance does not guarantee future results, current distribution rate as of 1231, 2025. Carefully consider the investment material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income fund fundrise.com slash income. This is a paid advertisement. All right, back to the show. 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 they've educated all of us more about that. But if you all listeners have trend following as the core of the portfolio, they might have

Starting point is 00:36:54 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 portfolio. Now, how would a global equity portfolio, say the MSEI, have performed if we included trend-following strategies as 20% of the overall portfolio? I mean, if we look at the MSCI index as a standalone investment, and 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% since 1985, so over 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,

Starting point is 00:37:46 it's been somewhat better, let's say about 25% better than the MSCI. But because the two investments have had pretty much zero correlation, when you add trend following to the MSCI, and you mentioned a 20% allocation, you actually still achieve a higher return than just the MSAI, somewhere between the MSCI and our own program. But it comes with better reduction in terms of risk, meaning it comes with the 27% I think it was thereabouts

Starting point is 00:38:19 in terms of your worst drawdown. It goes down from, I think the MSCI 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. I think in a combined portfolio. And if we talk about the sharp ratio despite all of its flaws,

Starting point is 00:38:39 you do get a healthy increase of about 25% in the shop. In other words, you get a higher return will lower risk. And, you know, that's a big reduction for many people. Often what drawdowns in itself is important because it's often the drawdowns that causes investors to make really bad decisions

Starting point is 00:39:00 because they end up, you know, 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 kind of a simple 50-50 allocation, split B2, mainly again driven by the zero correlation between stocks and what we do, for example. You sort of said it yourself there, Niels,

Starting point is 00:39:24 talking about the shops ratio. What am I gotten myself into? Right. If you look across the industry, the sharp ratio is 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.

Starting point is 00:39:54 market. So what are your thoughts on the sharp ratio and some of the shortcomings? I mean, I completely agree with you on this point, right? Sharp ratio, despite it being the perhaps most widely used measure of riskiness of an investment. However, I think the sharp ratio has, you know, some real flaws, as you mentioned, and that many investors, frankly, may not be fully aware of. So with a question like that, Steak, 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,

Starting point is 00:40:29 today so I hope your listeners will take a few notes. So one of the problems that I see with the sharp 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, its 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

Starting point is 00:41:04 and this is what's known as the Sotino 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

Starting point is 00:41:27 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, a long, only buy and whole approach, you will get a certain level of return and volatility, and hence you can calculate the shop ratio. Now, if you instead order the daily returns in a different way,

Starting point is 00:41:53 like, say, all the negative returns first, and then time goes by, you add 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 sharp ratio may be the same.

Starting point is 00:42:18 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 sharp ratio. 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.

Starting point is 00:42:41 And this is mainly because the sharp 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, 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. And in my opinion, there are a few that can help

Starting point is 00:43:13 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 ALSER index measures both the depth and the duration of drawdown and is one of those rare risk indicators that is path dependent.

Starting point is 00:43:42 And if you adjust it for, say, 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 cause stress, of course, and therefore even ulcers to investors. Now, once you have the Ulcer index calculated,

Starting point is 00:44:06 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 sharp 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,

Starting point is 00:44:31 you're obviously going in the right direction, I think, but the Ulcer Index represents an average risk. So it doesn't like 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,

Starting point is 00:44:53 Bernie Madoff, if you can call it a 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,

Starting point is 00:45:09 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.

Starting point is 00:45:28 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

Starting point is 00:45:56 that both have a conditional drawdown risk of, say, 10%, but one strategy has an annual volatility of, say, 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. So to summarize, you could say the pitfall represents the average loss of the biggest drawdown

Starting point is 00:46:29 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 serene the strategy is, and here you have something called the serenity ratio. 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 ALSA index,

Starting point is 00:47:11 and then you times 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 ALSER index, a 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. 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,

Starting point is 00:47:48 you get a much better picture of true riskiness, if I can call it that. And you can't ignore the risk of drawdowns of pain in your analysis, which is really what the sharp 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,

Starting point is 00:48:20 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 2020. 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. Well, Nels, thank you for the insights on that.

Starting point is 00:48:43 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? 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-fallen 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, you know, that has an impact on all markets and therefore also, you know, have an impact on even 55 with that type of correlation

Starting point is 00:49:29 that you might see. 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 markets you trade and why you selected those? those markets to trade end? I mean, you touch 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.

Starting point is 00:49:54 But that's really not the case. So, 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.

Starting point is 00:50:17 Instead, it would just register that, say, Tesla or Bitcoin were starting to make newer highs and it would have gotten you long. And at the same times, once the sell-off started in 2017 for Bitcoin, at some point it would have told you to exit and therefore not suffer 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.

Starting point is 00:50:46 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. 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.

Starting point is 00:51:19 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 trades 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. 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, at Don Capital,

Starting point is 00:51:52 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. Let's continue talking about that because I've noticed from some public databases that

Starting point is 00:52:19 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 on to 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? First of all, volatility as a strategy, it's true to say that it has grown a lot in terms

Starting point is 00:52:58 of popularity in recent years. But when it comes to the VIX, interestingly enough, you can't really traded 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-wall managers or long-wall managers. But you face two challenges with choosing one of the other approaches. if you're a short world manager,

Starting point is 00:53:35 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-vall managers where you tend to do really well

Starting point is 00:53:52 when there is a crisis, but because, you know, they're 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.

Starting point is 00:54:16 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. So in other words, we want to still offer an absolute risk. return approach or return a 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 source away, what we look for really is changes in the forward curve of the VIX complex because there are certain patterns that repeat

Starting point is 00:54:54 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. 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 the environments, and it's certainly going to have its drawdown like any strategy, but it is basically no correlation to stock, spons, trend following even,

Starting point is 00:55:32 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 as an asset 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

Starting point is 00:55:56 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. I guess what a lot of the listeners are thinking is you're looking for some sort of signal from the market

Starting point is 00:56:26 that could be something as simple as headlines in 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 Vex? No, I think that's exactly the opposite, right? So when you decide to be a fully systematic manager, there's one luxury that you lose,

Starting point is 00:56:54 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

Starting point is 00:57:15 in order to trigger a signal. The same goes for our VIX or volatility strategy. we need to see certain patterns in the VIX curve in order to initiate our positions. 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

Starting point is 00:57:47 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, meaning if you have, say, for example, you were a fan of a particular stock picker or fund that uses fundamental analysis,

Starting point is 00:58:14 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 twin-falling strategy is you also diversify

Starting point is 00:58:29 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. And that's something that systematic strategies don't,

Starting point is 00:58:50 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. 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, that was all the buzz about Tesla.

Starting point is 00:59:12 and it seems like if possible that bulls and bands of Tesla have been sitting even more in their echo chamber telling each other why the other camp is just utterly wrong. Using Tesla as an example, how do trend followers capitalize on the emotions of investors? 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. So you mention Tesla and as we both know, you can find people who think it's, and still think despite the high price,

Starting point is 00:59:57 that it was going to go to the moon and that Elon Musk is a genius. And then on the other side, you'll find people who think it's a fraud. And this is just one example of how getting to immembourg, emotionally involved in a particular market or stock can be dangerous. And maybe you could even say the same about Bitcoin, right? 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.

Starting point is 01:00:27 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 to be. 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,

Starting point is 01:01:03 which is the daily price of a market. And when you ask me, this, it kind of reminds me of one of the legends in our industry, Richard Dennis. I think we spoke about Richard Dennis in my first appearance on TIP. And when I interviewed him a few years ago

Starting point is 01:01:19 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

Starting point is 01:01:35 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. Well, as that, Nils. Wow. I mean, this has been, once again, it'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.

Starting point is 01:02:03 Where can the audience learn more about you? I also know you have two podcasts and you represent Duncapital. So a lot of hands up there, but where can the audience learn more? I appreciate that, Steve. The best way to learn about Don Capital, that would be just to go to Doncapital.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 C latest performance. And that is where you can accredit yourself.

Starting point is 01:02:34 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 plot.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. 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

Starting point is 01:03:10 world. So I think that's really the best way to do that, Steak, 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. Niels, thank you so much for coming on our show. Anytime, Sikh. Thank you so much. Take care. All right, guys. So as we are letting nails 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 whatever you listen to our podcast. But that was all that I had for you guys for this week's episode.

Starting point is 01:03:47 Preston is back on Wednesday, Trane and I are back next weekend with another episode of the Ammasters podcast. Thank you for listening to TIP. To access our show notes, courses or forums, go to the Investorspodcast.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 rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP333: Trend Following w/ Niels Kaastrup-Larsen

There aren't comments yet for this episode. Click on any sentence in the transcript to leave a comment.