SI422: Why Trend Following Rewards Patience ft. Katy Kaminski

Katy Kaminski · AlphaSimplex Group

Commodities work when inflation is spiking but not in deflationary environments, so they hedge only some inflation regimes.

Katy presents an AQR paper that tests strategies across rising, stable and falling inflation. Her takeaway is that commodities deliver in inflation spikes but not in deflationary or other environments. She uses this to argue that protecting against different inflation types needs different responders. In her view, trend following is more robust across inflationary and deflationary periods than the alternatives the paper tested, so commodities are a narrower hedge than trend.

“they show how commodities really work when inflation is spiking, but maybe not in a deflationary and other environments.”at 34:38

Katy Kaminski · AlphaSimplex Group

Passive commodity allocation gives poor risk-adjusted returns; active, episodic management works better.

Citing the AQR paper, commodities show the inflation-related correlation investors want, but a passive allocation over time has poor risk-adjusted returns. Commodity returns are very episodic: 2014, 2020 and 2022 were big years, and the big years, up or down, are the opportunity set. Index exposure is also energy-heavy, so an investor who wants wheat (a big mover that summer) gets little of it. Her conclusion is that commodities need active management, through trend or other strategies, rather than raw exposure, because they are volatile and can produce extreme outcomes.

“does have that correlation, but a passive allocation to commodities over time is not very good risk adjusted returns.”at 43:33

Niels Kaastrup-Larsen · Top Traders Unplugged

Commodity ETFs' construction, including roll yields, can badly hurt actual performance; investors should be careful.

He warns that many investors assume they can simply buy a commodity ETF, but some are built in challenging ways. The mechanics, roll yields in particular, can seriously hurt returns. He also notes that commodities have long periods where they drag on a portfolio, and recommends getting expert advice before buying them. Katy adds that index exposure is energy-heavy, so commodity ETFs may be undiversified.

“because a lot of people think, oh, commodities, I can just buy an ETF. But hold on. There are some really challenging ways some of these ETFs are put together. It has to do with roll yields”at 45:42

Katy Kaminski · AlphaSimplex Group

Bonds lose diversification benefits when inflation is the dominant risk, co-moving with stocks and losing safe-haven status.

Katy argues bonds are vulnerable to inflation, which she calls a natural predator of bonds. Her research ('Bonds Behaving Badly') finds three things: bonds tend to co-move with stocks when inflation is a key risk, as seen this year and over the last five years; bond volatility is elevated when inflation is higher, as in 2022 and again this year; and bonds lose their safe-haven status when inflation is high and stocks are down. She notes bonds are still a good investment in general, and that long-run data going back about 800 years (with Alex Grazerman) shows bonds are good but vulnerable to inflation. She also says bonds become attractive again once yields are high enough.

“bonds [co-move] sometimes with stocks when inflation is a key risk.”at 22:02

Katy Kaminski · AlphaSimplex Group

Bonds may stop being a reliable safe haven when inflation, not equity drawdowns, is the dominant risk.

Her framing is that the portfolio threat has shifted from equity drawdowns to inflation, and investors hold a lot of bonds. Bonds do give positive carry as a risk mitigator, but if they are not much of a safe haven, investors need other diversifiers. She says the old world of stocks and bonds is no longer simple, and that equities can be vulnerable too if the inflation shock is large enough. The argument rests on inflation becoming the main risk, which is why bonds lose their diversification role.

“Bonds, as a risk mitigator, at least they give you positive carry in return... If they're not as as, you know, much of a safe haven, then you just have to find other stuff too.”at 44:56

Katy Kaminski · AlphaSimplex Group

Geopolitical risk foreshadows inflation, creating a structural inflation risk premium that markets are now repricing.

Katy cites a recent paper using over 100 years of data across 44 countries, which finds geopolitical risk foreshadows inflation. Especially on the supply side, geopolitical risk produces an inflation risk premium or structural inflation premium. She says this is exactly what we are living in now, with inflation risk premia being repriced in markets. For bond investors this should be a concern. Her summary: geopolitical risk has risen, it affects equity premia and firm-level outcomes, and it causes inflation, so inflation is here to some degree.

“over a 100 years of data across 44 different countries that geopolitical risk foreshadows inflation.”at 16:49

Niels Kaastrup-Larsen · Top Traders Unplugged

AI's heavy energy demand ties it directly into the energy story, compounding the current geopolitical and rates pressure.

Niels describes a perfect storm. Geopolitical tension pushes oil prices up, which pushes rates up and raises the US government's financing bill, so Treasury supply rises. At the same time, companies are competing for capital, driven largely by AI. He adds that AI ties directly into the energy story because it is so energy-demanding. Combined, this could leave traditional portfolios vulnerable for a longer time.

“not only that, AI ties directly into the energy story because it's so energy demanding.”at 18:47

Katy Kaminski · AlphaSimplex Group

Private equity and equities were very vulnerable to inflationary shocks in the AQR inflation-regime research.

Katy summarises the AQR paper, which examines multiple strategies and assets across rising, stable and falling inflation. She says trend was the most robust strategy across inflationary and deflationary periods, more than any other investment studied. Many more classic investments, including private equity and equities, were very vulnerable to an inflationary shock and to changes in inflation. She presents this as support for why investors need different responders for different inflation types.

“many of the more classic investments, like private equity, equity, they were very vulnerable to an inflationary shock and changes in inflation.”at 34:59

Katy Kaminski · AlphaSimplex Group

Trend investors' dollar-weighted returns trail the strategy because they chase performance and exit too early.

Citing the Quantica paper, she says trend averages about 5.6% over a long horizon, but removing the 20 largest months takes it to roughly -0.5%, so a few episodic months drive the result. The typical dollar-invested return was lower, around four percent (she was unsure whether it was 1.7% or about four), so investors get out after underperformance and buy after strong run-ups. The gap is smaller in private funds than in public funds. Institutions with risk-mitigation buckets tend to rebalance rather than chase returns, and return-chasing reduces the overall benefit of a trend allocation.

“But they said if you took out the 20 largest months... you basically go to negative half a percent.”at 48:53