FM: What is it about your systems that have persisted so long and what adjustments, if any, have you made over the years?
BE: Aristotle’s Ship of Theseus gradually had every one of its parts replaced. Was it still the Ship of Theseus? Over the decades every part of our systems has been modified. It’s our scientific approach that persists and supports the whole structure.
FM: There seems to be a growing understanding of tail risk and the value of strategies that can take advantage of it instead of simply hedging it. As a result, managed futures are becoming more popular. Do you agree and, more importantly, do you see this as a permanent shift or a temporary reaction to the recent financial crisis?
BE: I’d like to distinguish diversifying from hedging. Futures trading diversifies risk and can improve returns, but it falls short of a hedge. Hedging requires anti-correlation to the risk that is hedged. Futures returns mostly are uncorrelated to those of other assets. This makes them an excellent vehicle for diversification. The large-tail phenomenon means that most statistical tests overestimate reliability and underestimate risk. I don’t know if it’s possible to take advantage of this, but it’s important to protect yourself from it.
FM: You make an important distinction between diversifying and hedging, but many equity-based managers are looking at tail risk insurance strategies. Wouldn’t an allocation to managed futures provide better insurance as it has been shown to be negatively correlated in bear equity markets?
BE: If you select unique periods such as when stocks are extremely weak, it creates a powerful selection bias. The anti-correlation found in these studies may have been a selection artifact. Futures trading has its own heavy tail to add to the mix. The key is independence, which makes efficient diversification possible.
FM: It has been shown that normal distribution curves under-estimate tail risk in equities. Does your approach give you a better picture of the tail risk in your trend-following approach?
BE: Tail risk is hard to estimate but we spent over 25 years on this project. We have worked on it really hard and we do have various techniques to deal with the fact that the tails are so heavy. It is absolutely crucial because the tail risk changes everything that we do. Every single part of designing and implementing the system is affected by the fact that you have more extreme values than you expect under any kind of normal model.
FM: Are you better prepared because trend-following as a model attempts to take advantage of this tail phenomenon in the general market?
BE: Yes, but it has its own tail risk. I have a little bit of trouble with the idea that the tail risk in futures trading is what is helping because I see it strictly as a hindrance, strictly as a problem to be overcome. You may have a point because I guess it helps to have these really big outsized moves. It is only going to help you if you treat it like a wild tiger. …Trend-following doesn’t work only because of the tail risk but tail risk turns up the volume.
FM: We spoke to Richard Dennis a couple of years ago and he said that trend-following is getting more difficult and systems don’t hold their edge as long. Do you agree?
BE: In general I agree that it is getting harder and you have to improve, though I don’t know that you have to improve faster. Hastiness can be costly in this game. When you are doing your research and you are improving, it should be with the confidence that the system you are currently trading is good. The value of the current system you are trading gives you the time to make a deliberate and cautious improvement.