Best of TTU – Crisis Alpha Explained

Kathryn Kaminski is one of my favorite people to discuss Trend Following with, because she has a great way of simplifying and explaining some of the key concepts of the strategy.  Today, we talk about the phrase Crisis Alpha, and how it may be better to think about these strategies as Divergent strategies, because in reality we don’t need a crisis in order for Trend Following to do well. Years like 2014 and 2017 are great examples of this.  Q1 of 2019 is perhaps a more recent example too. We also touch on Convergent strategies, which, in my mind, are 'short volatility' strategies- even if not all investors realize this. I think 2018 gave us a taste of what is to come when volatility starts to re-emerge in the markets.  So enjoy these unique takeaways from my conversation with Kathryn, and if you would like to listen to the conversation in full, just go to Top Traders Unplugged Episode 41 & Episode 42.

Is Trend Following just a hedge for bad Equity markets?

Niels:  Absolutely. Now, I want to stick with the cover of your book and especially the last part of the title: The Search for Crisis Alpha. Now, I know you are responsible for coining this term ‘Crisis Alpha’ and I want to talk to you about this. Before I do so, I also want to offer a slight concern that I have about the perception of the role of Trend Following in a crisis and it goes something like this. The way I see Trend Following being positioned, and this is not new. This is something that has happened for many, many years. It's kind of a hedge against equity markets if and when they run into trouble, and that always gets labeled as we're in some kind of crisis and that's obviously where the crisis alpha is linked to, but there are far more bonds than equities in the portfolios of investors and I never really hear any debate about trend following as "a hedge, or a protection" against periods where bonds might run into trouble. Especially in a time where bond prices are, to say the least, very high, how do you think about that and is there a concern that when we hear the word 'Crisis Alpha' and trend following, that people automatically think that this is relating to equities?

Katy:  So now going back to your point about bonds and commodities. That's something that really bothered me as well, because I kept getting that question all the time. So in the book we talked about crisis alpha for commodity indices. We talked about bond crisis alpha. We talk about commodity crisis alpha, but over the course of writing this book I actually had moved more towards a new idea, and this is the idea of divergence. What we do in the book is we explain that trend following strategies are long divergence. What that means is that the most divergent moment in history is always crisis, wherever it comes from. Yeah, so crisis alpha is part of that. That's extreme divergence. The story is a little bit more clear to me now that it's really about being long divergence in markets, and divergence can be driven by many things. The reason that equity is the central point is that most of us have a home biased equity markets. Our focal point from an emotional standpoint, are equity markets, so they have a little bit more impact on the psychology of the general marketplace, and that's why they can be more extreme, but they're in no way the only thing that drives divergence.

"Convergent risk-taking strategies are used when we believe that the world is somewhat stable, knowable, understandable, and quantifiable.  Divergent on the other hand.."

Niels:  Sure. I want to talk about the convergent and divergent strategies, and I'd love for you to explain this, but I have to say, I think certainly that many investors are perhaps not... and maybe we don't have enough data, but it will be interesting to see how trend following may actually also be very, very useful in a period where we get a massive crisis in the bond markets, which,