Dylan Grice — Allocator Series — January 4th, 2023

 [00:00:00] Dylan

What we’re doing is not rocket science. It’s actually quite basic arithmetic. It’s doing some solid due diligence and understanding the risks we’re taking and working hard to understand the extent to which the risks relate to one another. And therefore, the risk premiums are genuinely orthogonal and independent. Once you get there, then you let the risk premia harvesting do its work.

[00:00:36] Intro  

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level. 

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we will have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their product before you make investment decisions. 

Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:30] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary investors from all around the world. In this series, I have invited one of them, namely Alan Dunne, to host a series of in-depth conversations on the topic of what it takes to be a world-class allocator. In today’s world, portfolio construction is fast moving to the top of the agenda of many investors as they try to analyze and understand the riskiness of their portfolios. And with ever-increasing uncertainty around the globe, being well diversified across many different strategies and themes in your portfolio can mean the difference between ruin and survival when the next crises emerge. The aim of these conversations is to try and understand the experiences that have influenced these highly specialized allocators and the processes they follow to harness the best returns for their clients so that we can all become better-informed investors. And with that, please welcome Alan Dunne.

[00:02:33] Alan

Thanks very much for that introduction, Niels. Today, I’m delighted to be joined by Dylan Grice. Dylan is the Co-Founder of Calderwood Capital. Calderwood Capital is a hedge fund boutique specializing in orthogonal, niche, and capacity-constrained hedge fund investing. Dylan has a very interesting background. He has been in the markets for a number of decades. He is possibly best known as the author of the Popular Delusions investment newsletter, but his career has spanned being a strategist, a family office allocator, and obviously now as the Co-Founder of Calderwood Capital. Dylan, great to have you on today. How are you? 

[00:03:13] Dylan 

I’m great, thanks. Thanks for having me on. 

[00:03:15] Alan  

Not at all. Well, I’m sure we’ve got a lot to get through. But we typically start off by getting a sense of the guest’s background. So if you wouldn’t mind, for the few people who maybe don’t know you and your background, could you give us a sense on how you got into markets and the trajectory of your career that brought you to setting up Calderwood Capital?

[00:03:38] Dylan  

Well, I guess the starting point for me was economics. That was my first passion, really – undergrad, and then of course, grad. All I really wanted to do when I was in my early 20s was be an economist (sad as that sounds). And I kind of stumbled into it. 

I was a student at the LSE, and everyone at the LSE was applying to all these investment banks. I didn’t know what an investment bank was. I thought a bank was just where I went to cash a check or something like that. But I then realized that they seemed to be talking about getting paid quite well. I discovered that a lot of these banks employed economists. I figured that if I could actually get paid well for studying the economy and doing economic research, then that was better than doing the PhD, which I had originally planned. So, it was a bit of an upgrade on my plans. Fortuitously enough, I was given a couple of offers. I took one of them. And so that was it.  

I started out as an economist, soon realized that predicting markets was more interesting than predicting the economy. I soon also realized that predicting markets was very hard. I went on to the prop desk. I was on the prop desk for about four or five years trading equities. I then did a couple of stints, one back in research, this time as a strategist at SocGen with Albert Edwards. 

Albert hired me when James Montier [was there], who had been there before me. James went to head up the asset allocation at GMO. And so Albert hired me, and the reason he hired me was because I had this 4-5 year prop trading experience, and I think that he felt that a lot of sales side strategists would talk a lot but they would never really put money to work; they’ve never actually managed risk; they’ve never managed capital; they’ve never felt that pain that you feel when your P&L just blows up in your face and your best-laid plans just fall apart. And I did that. 

One of the things that I got very interested in on the prop desk was really the psychology of trading. I got very interested in the psychology of risk-taking, because I observed very quickly that it seems to do something to you. When you’ve got money backing a view, it seems to affect that view. It affects your thinking. 

I discovered very early on that risk-taking can really make an idiot of you. It can really play with your rationality. And so obviously, to be a successful investor, you have to stay rational. So there was a very interesting challenge, an internal challenge: how do you stay rational when you’ve got capital on the line, when you’re actually allocating capital, when you’re making trades, and the world is going crazy? So this is a very interesting kind of psychological problem to solve. 

I guess that was my second passion. If economics was my first passion, then I guess investor psychology is my second. And I’ve never really left those two.  So, I went to SocGen. I kind of wrote a bit about that type of thing. James Montier was a well-known behavioral finance guy so I was kind of following his footsteps. 

After a few years, I did get a little bit bored of just writing all the time and not actually managing risk again. So, I was lucky enough to end up at a family office in Switzerland, one of the largest in Europe, actually, a multi-billion family office – single family office, where I ended up running about half the assets – helping run half the assets, building the team there and really just having a great time. I really, really enjoyed it.

I think a few years ago (so this is October 2017-2018), I was ready to do it for myself. I felt that the world was changing. I’d always had this kind of inkling to set up my own shop and run my own portfolio and try and build my own hedge fund. So, 2017, 2018, that was probably the right time to start doing that.

[00:08:37] Alan  

Very good. So, maybe tell us a little bit about the kind of portfolio you run at Calderwood. Obviously, you mentioned that, I guess, interest, desire for risk-taking. But I’m guessing it’s quite different to equity prop trading when you move into hedge fund investing. It’s a slightly different pay (I would think), but obviously some similarities, and some differences, I guess.

[00:09:02] Dylan  

Yeah. I think that the similarities are that you’re putting capital to work, you are taking risk. You don’t really know what is going to happen tomorrow. You don’t know what the future holds. Ultimately, it’s a kind of calibration exercise. You’re trying to calibrate that uncertainty, and you’re trying to size things appropriately. In that sense, running a fund of funds, which is what Calderwood is, is no different from managing an equity book. 

Another thing (which, I guess, kind of relatedly), something that all investors do is you’re kind of looking at something that’s happened in the past and trying to gauge whether or not that’s likely to happen in the future. So obviously, if something has performed very well (whether it was a stock or a bond or a manager), you’re asking yourself, well, is that going to continue? By the same token, maybe the stock or the bond or the manager hasn’t performed well. And you’re going to ask, well, is it going to change? Is that going to improve? 

So you’re always asking that kind of fundamental question. You’re trying to answer that question in a world of imperfect knowledge, of very, very imperfect knowledge. And so to that extent, they’re very, very similar. 

I guess the difference is one will be the cadence. So I don’t sit staring at Bloomberg screens all day. That’s by design. I don’t really enjoy doing that. I’m quite happy to let other people do that for me. 

The second is that there’s a kind of unusual return profile with hedge fund investing. That return profile is that your upside is typically quite capped to the extent that if everything goes well, you’ll get what the manager promises they’ll deliver. So maybe that’s 8% or 10%, or whatever it is. That’s your kind of upside. The downside is that it blows up, and you can be on the hook for multiples of that on the downside – potentially locked capital (or as backers of FTX, I’m now discovering, actually far worse). 

So, there is this kind of negative skew, which is maybe a little bit like a bond portfolio. When you’re managing a bond portfolio, a credit portfolio, you have limited upside, you’ve got all the downside, and actual allocating to hedge funds is kind of similar. So I guess that would be another difference. 

[00:11:29] Alan  

And I guess when people think of a fund of hedge funds or hedge fund investing, I guess long-short equity is probably the biggest sub-strategy within the hedge fund world. But I’m assuming you’re investing in quite different strategies. You say orthogonal, niche and capacity-constrained. So it’s very much outside the plain vanilla (by the sounds of it). Presumably, that’s by design that you think there are greater opportunities once you get away from the main strategies, I guess. 

[00:12:01] Dylan  

Well, that was why we did it. That’s why we’re here. That was the opportunity that we saw. When I was sitting in the family office, we saw lots of hedge funds, trust me. Everyone was pitching to us. And by and large, they kind of all did the same thing. And it seems to me that what you are getting, generally speaking – generally speaking what you were seeing in the hedge fund space was equity in disguise. 

So long-short equity was equity; event-driven was equity; risk arbitrage was equity. Structured credit – vanilla structured credit was equity. What you found, even a lot of quant stuff was kind of trend following until there was a market downturn and then it would get battered when the market was down. 

Quant is, actually, slightly different for reasons that you know very well, but too much of the hedge fund space was actually just repackaging equity risk with a few bells and whistles and some extra fees.That was never very interesting to me. 

One of the things that I also saw, when I was at the family office, was that there was actually some really, really interesting stuff. There were some really, really interesting firms; some really, really interesting investors doing stuff that seemed to be quite funky superficially, but once you dug into it, actually, it wasn’t so funky. So, life settlements, for example. You’d kind of dig into life settlements and firstly, you don’t even know what life settlements are. How does that work? How do you price it? How do you value it? 

Once you would dig into it and actually speak to a few managers, speak to a few traders, you would discover that there are people in that market who have made their careers in that market. That market has its own culture. It has its own narrative, it has its own kind of folklore. 

Stock investors would talk about 1987 or 2008 as the Great Crash, and they’ll be scarred by those experiences. Bond investors used to talk about 1994, they’re probably now talking about 2022. You would find the same thing in life settlements – catastrophe or (more recently), cryptocurrencies. That was just very, very interesting to me. 

I think that the opportunity, as I saw it, as we kind of saw (speaking to my partner about it), was that actually, you could really, really – you could build a very, very robust portfolio; a very, very solid, sound, low volatility, low correlation, high returning portfolio if you harnessed the full richness and diversity of the hedge fund space. 

So that was the motivation for what we were doing. Nobody needs another portfolio which is kind of dressed up as a hedge fund but is really just an equity book in disguise. So, that’s really what we set about to do. That’s what we’re trying to do at Calderwood. 

[00:15:21] Alan  

Good stuff. I’m guessing the macro environment that we’ve been in, the low-rate kind of environment, and people have been saying for a while, 60/40 is dead or will be dead going forward. And obviously, people might reassess that after this year, you can debate that. But was that part of your thinking that we were at an interesting inflection point? 

[00:15:41] Dylan  

Absolutely. I think that it was and it still is. The thing about fund of funds, it allows you to be very, very precise about the risks that you’re taking. Now, if you’re going to restrict yourself as an allocator to long-short equity and to some kind of vanilla-structured credit, maybe a bit of event-driven, then you’re really not harnessing the full potential of the hedge fund space. All you’re actually doing is you’re playing it safe, for sure. You might throw in a little bit of macro and a little bit of quant for a little bit of diversification purposes, but basically, what you’re going to have is an equity portfolio. It’s just not that interesting. 

Now, if you’ve got equity risk, you’ve got all sorts of things going on. You’ve obviously got a huge amount of duration risk. You’ve got your standard kind of equity risk – equity volatility.  You’ve got your liquidity risk. You’re kind of bundling a whole bunch of things together in that one package which 99% of investors have already. 

Whereas, if you actually say, “What we’re left with, suppose we don’t go down that traditional path – if we don’t tread that very well-worn path. Suppose we actually go a little bit off-piste and see what we can find?” You can be incredibly precise about the risks that you’re taking. 

So, for example, maybe we do want to take catastrophe risk through a reinsurance manager or through cat bonds or something like that. So we’re underwriting the risk of a hurricane hitting Florida. Maybe we’d want to do that because we’re getting paid well for it. Maybe we would want to take longevity risk in the life settlements market (and by the way, I should say that we haven’t actually done that yet, in the fund, for several reasons); maybe longevity risk is an interesting risk premia that we can take; maybe some of the risk can be taken in private credit markets – these are quite interesting; maybe a little bit of credit risk is also interesting; maybe a little bit of equity risk, but maybe duration is something that we really don’t want to take. We don’t want to take any duration risk. We can do that in our own set-up because we can be so precise about what we want to do. 

Whereas if you are stuck with a 60/40, you’re just bundling together all sorts of things that you just cannot get out of. That was something that we really, really, were very clear from the outset that we just weren’t interested in doing. And obviously, the way things have gone in 2022, that’s been very, very – that’s been good. It’s been very, very good for our portfolio. We’ve had no duration. We’ve been able to build a decent portfolio without duration. So that’s just one example, I think, of the kind of advantage you get with a fund of funds. 

[00:18:34] Alan  

And obviously, I mentioned at the outset, you’re probably best known or you’re at least well known for the Popular Delusions newsletter. I know your business for a long time was kind of research and investing. But I understand that that may be changing, is that right? 

[00:18:52] Dylan  

Yeah. Well, I mean, when we set up Calderwood a few years ago, the first thing we did was set up the research business. So, we relaunched Popular Delusions. Popular Delusions was the research I wrote at SocGen. We relaunched that and that went down well. We also launched the hedge fund business. 

When we started it, it was just me and my partner, and that was it. What has happened over the last few years is that both businesses have grown. We were really pleased about where we were, but we were kind of at a crossroads. We had to really choose one or the other. 

Obviously, the bigger a business gets, the more attention it demands and the more bandwidth it demands. We were getting to the stage really, we had to make a decision. We had the bandwidth for one or the other. We told our subscribers (we were very, very clear from the very beginning) that they were paying for the research, and the research was really about leveraging what we were doing in the fund, but the priority was always the fund. 

You’re managing other people’s money, you’ve got a fiduciary responsibility to those people, to those owners of capital. And so we were always very clear that if push comes to shove, we will drop everything to manage the fund. It’s not the other way around. It just got to the stage that we had to kill one of the businesses. So, the business that we wound down was the research, sadly, because it was a lot of fun. We were really pleased with where we’d managed to take it. We had some excellent subscribers, and made some very, very good relationships. But you know, you can’t do everything. Our focus has always been the fund and that’s, now, just going to be our full focus from here.

[00:20:47] Alan  

Obviously, you have had that kind of… Obviously, you started off with economics, and you’ve always had that macro view. At the same time, you’re getting into micro quite a bit too, in terms of manager selection and individual strategies. Would you say, is it more top down, or bottom up, or a mix of both? How would you describe that?

[00:21:08] Dylan  

Well, I mean, probably a mix of both. I think that one of the foundational experiences for me on the prop desk was this realization that actually I couldn’t predict anything very well. A lot of people might listen to that and say, well, obviously, I mean, everyone knows that. But I don’t think they do. I think people typically think that maybe they’ve got (obviously it’s difficult), maybe I probably would get 51% or 52% of things right and that’s all you need. 

I think no, you don’t get 51%, you get 50%, and you probably size your positions wrong so that you’re actually, on average, you are just going to lose money by taking these punts. And I kind of realized that and saw that, frankly, on the prop desk. So, this kind of idea that the future is fundamentally unpredictable was something that, as I said, this was a kind of foundational experience.

I should say, I’ve definitely met investors who do work hard on predicting. And they are effectively in the business of predicting, and they would read the macro funds and some of the quant funds. But when you speak to the people who are very successful at that and you see how hard they work at it. It’s just not as simple as pulling up a couple of charts that you can get for free off the internet, drawing on a few squiggly lines around it, and then thinking that your view has any actual value. It’s just much, much harder than that. 

I think Richard Feynman used to talk about the advantage he had over most other pundits – most pundits and most social scientists he was particularly talking about. The advantage he had, he said, was that he knew how difficult it was to know something. This is the guy who actually worked at Los Alamos and did the first experiment on some kind of nuclear reaction. If you got those wrong, they would know about it. So, he knew how hard it was to know something. 

I think a lot of people don’t fully realize how hard it is to really, really know something. You get into the prediction business and it’s really, really hard to accurately and reliably make accurate predictions.So, that’s not really something that we do. What we do is kind of the opposite. Our starting point is that we can’t really predict. We can stress test, though. 

So, we can say, well, what if inflation is running at 10% in 10 years’ time, where would interest rates go, and how would our portfolio handle that kind of scenario? Can we build a portfolio that actually can accommodate those different stress scenarios and accommodate it well and robustly? So, from that perspective, the macro comes in, in terms of trying to understand the range of outcomes and build in that portfolio robustness through those different outcomes. That’s where the macro comes more from stress testing, not from predicting. 

In terms of the micro, ironically, I think you get much better macro information from the micro. If you want to have a view on defaults, for example, you want to have a view on the cycle, a great place to start is to speak to the CLO manager. Go and speak to a guy who has managed CLO equity. They still won’t really know, but they will have far more insight into where we are on the default cycle, and more importantly, where the market thinks we are in a default cycle than any kind of high-level strategist that’s sitting looking at the S&P data or something like that. 

We got great insight, I think, into some of what was going on in the crypto markets because we were invested in cryptocurrency arbitrage managers. So we were talking to them regularly. We were having regular dialogue, regular conversations. Obviously, we were doing our own research at the time and following the market in our own way. We started to see things that we didn’t quite understand, that didn’t quite add up, that certainly smelt bad. Speaking to our crypto managers, it just kind of felt that this was actually a market that was not very healthy. 

We didn’t predict FTX, by the way. We didn’t predict these things, but we could see that this was actually a market where there were a number of red flags. So, here you could get a macro view, arguably, but it all comes from much higher quality micro information. I think that the information quality at a micro level is just far higher. 

[00:25:53] Alan  

Okay, interesting. Putting that in the current context, we’re obviously in the midst of a tightening cycle. It’s the most aggressive we’ve seen going back for a number of decades, and we’ve had this big rate shock (zero to it’ll be about 4% or so, over 4% probably this week and possibly going to 5%), and everybody’s worried what’s going to be the impact of that. Will we see stresses or strains somewhere in the system? Are you picking up any evidence of that from a micro perspective amid all of the different types of strategies and managers you talk to? 

[00:26:31] Dylan  

Actually, not really, which is interesting. In terms of the big shorts, if you like, we still haven’t seen it. We can’t really find it. I think that in isolated markets, there were absolutely some big shorts. So I think in Canada, the housing market is an absolute disaster. I think that is going to be very, very painful for that economy and probably for its financial system. I think you probably have something similar, although not quite as egregious, in the UK, maybe in some of the Scandi countries, probably in Australia as well. 

I think the housing pain is something which is going to be potentially quite brutal in pockets of the global economy. But I think it’s not like in 2008 where it was the US housing market and therefore the entire global financial system. So I don’t think that it’s necessarily globally systemic, those types of things. 

Some of the guys we speak to are very, very bearish on the default cycle and where it goes, but some of them aren’t so bearish, and it doesn’t feel that there’s any great… I should say some of them aren’t so bearish relative to where default risk is trading. A few weeks ago, you could get double-B CLOs giving you 15%. So, that can absorb quite a meaningful default cycle. You’re unlikely to lose money even in a default cycle kind of like 2008. So that’s telling you that the market is kind of already there. 

As I said, things have changed over the last few weeks, but yeah, beyond that, it’s difficult to see. As I said, we’ve seen pockets of stress. We’ve seen stress in the US mortgage market. We saw the agency spread really blow out. We saw pockets of stress in the UK pension market when gilts completely nosedived, yields ballooned. We’ve seen stress in the crypto markets, but it just hasn’t really been systemic. We haven’t seen that systemic thing, and always, you’re kind of wary of saying this, but I think our best guess, at the moment, is that there isn’t really a systemic issue. 

[00:29:13] Alan  

Interesting. Yeah. I can sense why you’d be wary as soon as you say that, you might regret it. But no, I hear what you’re saying. I guess that’s what we’ve seen in equity markets as well, this year, with the VIX not really ever having that big spike that people had expected. 

[00:29:29] Dylan  

I mean, just because you can’t see something doesn’t mean it’s not there. There’s always that hesitancy to be overly forceful about a conclusion like that. But when you get a big spike in VIX, the VIX hasn’t changed above 40 this year. If somebody told you at the beginning of this year that the market was going to be at its low point, 25% down, but the VIX wouldn’t gain above 40, you’d probably be quite surprised by that.

You don’t have the VIX market, you don’t have the VIX index going back to over the last 100 years, but you do have realized volatility. Realized volatility, during market drawdowns, doesn’t always spike to 80 or 100 or 120. In fact, it’s actually very, very rare. The kinds of environments… Obviously, it spiked and, I think, realized vol hit something like 120 in 1987. I think you were close to the 80/90 level in 2008. We saw something similar again in 2020, during COVID. In 1929, I think in 1929 you got through 100 on realized volatility. 

Generally, those kinds of spikes are very, very rare. They’re very unusual. The reason is those spikes happen when correlation spikes. I know you’re a quant and probably some of your listeners are quants. But that’s the equation. It’s not just the actual volatility of the constituents, it’s the correlation of those constituents. 

So, you get the real vol spikes when you get a correlation event. ’87 was a correlation event, 2008 was a correlation event, 2020 was a correlation event. The NASDAQ bust of 2020 wasn’t a correlation event. Yes, you had lots of tech stuff that was going under, but you had all the kind of old economy stuff that was recovering. You had all the value stuff that was recovering. So you didn’t have the high correlation. Some stuff was going up while other stuff was going down. 

In the 1970s, it was the same. During inflation, the resource stocks, the gold stocks, the miners, those guys were doing brilliantly. So, it was almost like the 1970s inflation was a kind of redistribution. You didn’t quite get the correlations and you didn’t get the volatility spikes. I feel that this has been something similar. We’ve actually had some people doing really, really well out of the problems of 2022. You haven’t had that correlation and you haven’t had the spike in volatility. 

I think that people are almost so positioned for it, because 2008 is so fresh in their memory, and 2020 is so fresh in their memory, but I don’t think it’s going to happen partly for that reason. That’s one of the reasons why tail funds have generally done so badly even though markets are down. Most tail funds have been dreadful. 

[00:32:36] Alan 

Yeah, it’s one of those questions. Is there something going on that we’re not aware of or is it going to happen with a lag? If you had gone back to when the rates cycle started, I think everybody kind of said, oh well, rates might go up to 2.25% or 2.5%. That was the previous kind of 2018 cycle. And you’d see these charts showing the Fed funds with a downward sloping line, showing every progressive Fed fund’s peak has been lower. It seems surprising that if you told people, no, we’ll get to 5% and nothing will break and the equity market will go down and bounce back up, that would have been a surprise, I’m guessing, to people. Has that surprised you?

[00:33:20] Dylan  

Yeah, it has been a surprise. I’ve certainly been surprised by how aggressive the Fed has been. By the way, if you look at this tightening compared to, for example, what Volcker did in the early ’80s, it’s not that aggressive. Interest rates are below inflation. We’re still with negative real interest rates in that perspective. So, I think that’s an important qualification. Although, as I said, I have been surprised at his kind of aggressiveness. I like to think that I don’t really care.

 We look at some of the opportunities that sat in front of us and it doesn’t really matter what happens over the next few years. Personally, for what it’s worth, I actually think that we’re probably through the hump cyclically. There is structural inflation, cyclical inflation. I think cyclical repeats and I think that the markets will probably do okay, and that risk assets will probably do okay, but that’s not a bet that we’re interested in making. I don’t think that’s high-quality investment decision-making for the reasons I already talked about. 

When we look at some of the things that are coming across our desk, you’re looking at, certainly, 15% to 20% returns in some areas. For example, reinsurance. We already talked about reinsurance. Reinsurance, those markets are very hard at the moment. There’s a real shortage of capital in those markets. They’ve had a tough few years. They had a very tough 2022 because Hurricane Ian was the biggest event, the biggest insurable loss, it looks like, in Florida’s history. So there’s a shortage of capital at a time when interest rates have gone up. 

Reinsurance is priced off LIBOR or whatever they call the benchmark now. So you would have been looking at double-digit returns there anyway. But now, given the hardness of the market, given this kind of peculiarity (well, not peculiarity), this idiosyncrasy and the idiosyncratic shock of that market, it’s kind of been a perfect storm. So I think that you can be looking at 15% to 20% returns in that space, which I haven’t seen for a long time. That’s really interesting. It kind of doesn’t matter what happens to inflation. If we’re right about inflation or if we’re wrong about inflation, we’re still looking at it, call it a 15% return on that space. 

As I said earlier, I think it’s very interesting to talk about where the economy is going and what might happen to inflation, what the Fed will do, but it doesn’t really matter to us. We’re just seeing some really, really interesting opportunities that are just more interesting.

[00:36:20] Alan  

So, moving into that then, in terms of how you can construct a portfolio, I guess you’re trying to access a range of different uncorrelated sources of return. What’s the overall objective? Is it, I guess, return with capital preservation, or are you trying to maximize a sharpe ratio? Tell us a little bit about how you think about building a portfolio and the risk-return profile.

[00:36:49] Dylan  

Well, you know, I’m very, very much a product of the kind of family office mentality. A family office typically is about capital preservation. Family offices, they’re typically very, very wealthy individuals with very wealthy principles. They’re not necessarily interested in becoming more rich, they just don’t want to be poor. So there’s a different kind of focal point on the risks that you’re taking. 

Within portfolio construction, you don’t necessarily build a low-risk portfolio by only making low-risk investments. You can build a very low-risk portfolio by taking very high-risk individual investments, as long as those risks don’t correlate. And that’s what we do. And so the objective is really to have something which is genuinely all-weather, it’s not correlated to mainstream assets. It’s not correlated to equities, it’s not correlated to bonds. It should be robust to potential regime change. It should be robust to uncertainty, robust to our own ignorance. That’s what we try to do. 

What kind of return are we expecting to make? Probably, let’s say, between 4% and 6% in excess of whatever risk-free returns are. So, right now that puts you close to double-digit returns that we can make. By the way, historically, that’s an equity return. Historically, equities have returned something like (depending on which equity market and which currency), over the last 100, 150 years have returned about 4% to 6% in excess of the risk-free rate. What we’re effectively doing is we’re making equity returns with very, very low volatility and very low correlation, which, of course, is the holy grail. 

[00:38:41] Alan  

Yes. Exactly.

[00:38:42] Dylan  

I think the difference is that we’re actually doing it by harnessing, what Swensen called, the “only free lunch in finance”, which is diversification. What we’re doing is not rocket science. It’s really not rocket science, it’s actually quite basic arithmetic. It’s doing some solid due diligence and understanding the risks we’re taking, working hard to understand the extent to which the risks relate to one another. Therefore, the risk premiums are genuinely orthogonal and independent. And once you get to that, once you get there, then you let the risk premia harvesting do its work.

[00:39:27] Alan  

When you get into these more niche, funky (as you call it) strategies, is it more difficult to think about return expectations and the range of outcomes and are these risk premia more fleeting? Does it require more of a tactical kind of mindset? Like, for example, is that return in catastrophe bonds or reinsurance, does that vary quite dramatically depending on whether we’ve just come out of a hurricane or not?

[00:40:00] Dylan  

Yes. The opportunity set is always moving. So what might be very, very attractive right now may not have been attractive a couple of years ago and vice versa. To give you a kind of indication of what kinds of things we look at, I mean, well, we look at anything. But in terms of our portfolio right now, we do have a lot of quants. We have some arbitrage strategies, whether it’s capital structure arbitrage, convertible bond arbitrage. 

As I said, we had been very active in cryptocurrency arbitrage for a time but we pulled out of that earlier this year, which I think is a good example of what you’re saying. Sometimes the opportunity set does just shrink. That can be due to one of two ways. It can be because the expected return was declining or because the expected risk is increasing. (What happened in crypto was both.) We also look at stuff like litigation finance, trade finance, mortgage derivatives, correlation trading, volatility, volatility relative value. All of these kinds of things are non-trivial. All of these things require a certain amount of understanding. 

I should say, my background as a family office manager was also as a prop trader. My kind of prop trading was equity and equity products. This is, I suppose, my natural kind of home. I also did some commodity stuff, but I have this macro background. I should say that in our team, my partner, Rob, who you know well, spent his whole career in quant. He’s got a PhD in econometrics – a very technical guy. Most recently, he was actually running RenTech’s European office for Jim Simons. So, he’s very well connected, very, very well versed in quantitative strategy. So, we feel that we understand that stuff pretty well.

 Another partner, Tim Bergin, he’d spent the bulk of his career actually running credit prop books, so he was doing IG high yield and convertibles, including convertible bond arbitrage. I think that between us we’ve got the building blocks to really understand. If you understand equities, understand credit, understand converts, understand quants, I think you understand pretty much everything. You can apply it even if you haven’t seen it before, you scratch away the toughness and then you realize you have it, actually. 

So, credit correlation is not so different from equity volatility, for example, in many ways. As I said, it’s non-trivial, but we’re confident that we can understand what we’re doing. And I should also be very clear, if we don’t understand it, we don’t do it. It’s not like we do everything that’s funky. We say no to most things. Quite often, things that come across just don’t make any sense or the risk profile is just far too high. 

The risks of allocating to a manager are a legion and it’s not just about the strategy. It can be about the operational stress, set-up, the manager’s mentality, how you mark the book, all these kinds of things which are unusual. 

[00:43:31] Alan  

Interesting. Yeah. I mean, you touch on an important point there of understanding the risks in the strategies and the investments and how they link. I guess, obviously, we’re all familiar with correlations going to one in a crisis, and familiar with unforeseen consequences. How do you navigate that risk? 

I guess that’s part of the skill of running a portfolio thinking about, if we have a problem in X, how do you know that it’s not going to impact this particular investment that you have? You can kind of probably seduce yourself and think, well, correlation is low, but as I say, that can change quickly. How do you, I suppose, deal with that risk of something that might be driven by a micro consideration being overwhelmed by a contagion from a macro factor?

[00:44:30] Dylan  

I mean, yeah. I guess that’s where it starts to become very, very specific to managing a hedge fund portfolio. As I said, we can be very, very precise with the kind of risks that we’re taking. Therefore, we can be very, very precise about how to diversify away from some of those risks. If you’re just allocating financially, if you’re managing an equity portfolio, for example, you might have some bank stocks, because you think they’re very, very cheap, and you maybe have a hedge against some kind of systemic problem, some gold mining stocks or something like that. If there’s a huge liquidity event, and everything kind of correlates to one, as you said, then the gold mining stocks are going to go down with the bank stocks. So, your diversification is not really going to be there. 

The problem here is that that type of manager is just in one asset, in one asset class and one type of instrument, i.e. publicly traded equities. We don’t have any of those constraints so we can actually diversify. So, suppose we find credit risk to be attractive, and we were talking about CLOs, double-Bs, a moment ago, suppose that’s an interesting way to take credit risk. You’re getting paid much more on CLO double-Bs than you’re getting in say high yield or investment or something like that. Let’s just suppose for example, that that’s an interesting risk that we want to take. Of course, we’re kind of on the hook for a much bigger default cycle than we think or a much bigger correlation event, but we can actually allocate to traders and investors who benefit from that correlation. 

Implied correlation is a tradable thing in the CDS tranche markets. Like anything else, sometimes it makes sense to own correlation and sometimes it doesn’t. Sometimes it’s cheap and sometimes it’s expensive. Typically, not always, but typically what you find is that correlation is cheap when spreads are tight. We know of managers who trade that correlation and effectively know how to get very, very cheap when the market is offering it. They know how to get very, very cheap convexity to correlation events because they are long-correlation. 

If we’ve got in our portfolio a manager who’s actually going to get hit by a correlation event, but another manager who’s going to benefit from a correlation event, then now we’re offsetting those risks. And of course, if each of those managers actually has some kind of alpha underlying it, then all the time, what we find is that both managers should be performing, but at any particular time, if one is not performing, the other one should be. So, that’s one way that we can manage that risk. 

You might then say, yeah, but if there’s a really, really big correlation event, caused by a financial system meltdown, and prime brokers are pulling leverage and the banks go down, even your correlation manager is going to be in trouble because he’s got counterparty risk with the financial system. And so how do you diversify? Now you’re getting into the realms of things that are very difficult to diversify away from but this is where things like private credit can be useful. 

Private credit is very risky in all sorts of ways. But one of the ways is, well, if you’re structuring transactions where you actually have the bank account, and it’s a segregated bank account, and you’re just permissioning people to put money in and disperse it to borrowers, and you’re always in control of it, then you’re kind of more in control of your counterparty risk, and you’re more in control of the liquidity profile that you’re facing. You’re not going to get gated. So, in terms of the portfolio construction, to some degree, you can hedge some of those more hidden risks because you’ve got a wider range of instruments that you can deploy. 

[00:48:54] Alan  

Okay. And I mean, in terms of building that all-weather kind of return profile, do you have some kind of buckets in mind? Are you thinking, this strategy falls more into growth, and this is more inflation prediction, and this is kind of correlation prediction? Or is it more taking a more holistic view and making sure you have some protection to all of the scenarios? How do you think about all-weather in that sense? 

[00:49:24] Dylan  

That’s a great question. I should say that, in simple terms, we’re value investors. Suppose for example, you say, well, you know, so you’re not going to predict that the market is going to decline, but you stress test well, what would happen if the market just suddenly fell by 30% in a month or a week and volatility spikes? Obviously, that might happen. There’s no way to predict it, but it might happen. So, how do we build a robust portfolio against the market falling by 30% in a month? And the answer is you can buy some put options. 

The problem is, that’s not a very good value. That’s not a very intelligent way to protect yourself from that tail, we would argue. Sometimes it is, but usually it isn’t. Buying puts, we’ve given you a vanilla example, you’re not really getting good value. It doesn’t really make a lot of sense. 

You actually want to hedge yourself from a very sudden market decline. But we’re not just going to go out and spend lots of money on insurance premiums because that’s how you lose money. I think what we think much more closely about is how can we get good value for that tail? How can we get good value? How can we get a very, very cheap or even a negative cost protection against that type of scenario – very cheap exposure to that scenario? That’s kind of what we do. As I said, that’s not easy. 

You’re talking about cheap or even free insurance and people don’t like to give away cheap or free insurance. People normally charge quite a healthy premium for that. So, we spend a lot of time doing that. One good example right now is the SPAC market. SPAC is a really hated area of finance, I think, for a very, very good reason. There are lots of crooks, lots of phonies, lots of bad actors, some terrible companies, and just frankly, some all-round kind of bad behavior. Obviously, the SPAC market has been kind of found out. It peaked, probably would have been about, I think, it would have been about February last year. It has had a very, very tough time since then. Activity has ground to a halt. 

What you’re left with now, you’re left with a market that pretty much everyone has exited. And you’ve got all these distressed, probably defunct SPACs lying around trading for zero. The interesting thing about SPACs is that when a SPAC is issued (I don’t know much you know about SPACs) it comes with a warrant. And that warrant, which is just an option (typically a five-year option) on the future value of the stock. Now, when a SPAC IPOs, it’s a pool of cash. So an option on cash isn’t worth anything. But if you do a deal, and suddenly that cash now becomes a stake in the business, and the business goes well, then obviously that option, that warrant is worth something. 

So, what you have with these warrants… Suppose you’ve got a bull market and suddenly, these SPACs are finding lots of deals to do and these deals, actually some of them are worth something and they actually go up in value, then these warrants are worth something. What you have right now is that these warrants are trading basically for zero. There are very good reasons for that, specific to the SPAC market. 

If you get a return to the bull market or even if you actually just get some kind of life coming back into the market, and the market starts moving higher again, those warrants are going to be worth something. Right now we’re getting them for zero. So this is interesting. This is very interesting, because now we’ve got that right tail. Suppose there is a runaway bull market in stocks, we can get exposure to that for free, with no downside. That’s a kind of interesting risk profile for us. 

Of course, you can then even take it more macro and say, well, why would that happen? Well, it might happen if there was a big inflation blow up. Suppose inflation hasn’t been brought under control. Suppose, actually, the Fed is talking tough because it’s easy to talk tough with unemployment at 3.5%, but how tough are they going to be if unemployment hits 8% or 9%? Suppose that happens sooner than we think and suppose the default cycle is worse than we think. Actually, suppose they pull out and they stop raising interest rates without really killing inflation and inflation rips during the next cycle. That could be very, very bullish for equities as a kind of inflation hedge. 

If we can get exposure to that for free, or very, very cheaply, that’s very, very interesting. So, hedging outcomes, it’s not just about necessarily hedging market downturns. It’s pretty much all of the angles that we can think of – can we find a cheap way to get access to that?

[00:54:26] Alan 

Interesting. The other, I suppose, skill that’s involved in all of this is assessing the manager as well. Obviously, you’re a fund of funds investor so you’re handing over the cash to another manager. You talked about how you’ve worked with people and have been fascinated with the behavioral side of things. Is that a different skill manager selection? Is it subject to the same kind of behavioral biases when you select a manager as when you invest in an equity or they’re different biases?

[00:54:59] Dylan 

 I think it’s the same. I think, honestly, I run an equity book. I run an equity book at the family office. This isn’t just my prop trading stuff. So prop trading, it was quite short-term. It was a trading desk. Whereas, in the family office, when I first went there, I went there with the job of building an equity team and this was a family office approach to invest in equities, which is radically different. That firm was very, very fundamental, very, very long-term, and the opposite end of the spectrum from the prop desk, really. 

One of the things that always struck me about the equity market was the power of the narrative. People would always go after the narrative. People love the sexy story, and we just saw it kind of turbocharged in 2021. The SPAC market we’ve just been talking about. That kind of narrative, it can seduce you and it can blind you and distract you from the things that you should be paying attention to and the things that you should be looking at. And that’s absolutely no different with managers. 

Managers will try to seduce you with a narrative. They will have their story, as everyone does. I think that maybe the best heuristic that I came across and deployed and continue to deploy was that you watch the actions, you pay attention to the actions, not the words. What are they doing? What do they say they’re doing? And that’s fine. That’s interesting. But it’s not the same as what they’re doing. Do you actually understand what they’re doing? I mean, it’s so straightforward. It’s such an easy thing. Nobody would disagree with that. It’s so uncontroversial. You play with the ball, not the man. But it really is, I think, one of the most common mistakes. 

[00:57:13] Alan  

Okay. And I mean, from your own perspective selecting managers, are there criteria you would say, okay, this makes them a great investor or a great manager. Is that just a qualitative assessment or do you think you can kind of quantify that? 

[00:57:31] Dylan 

I am very skeptical that that’s quantifiable. Again, I have a kind of macro background. I have known a lot of macro investors. I do think that a lot of it is hot air. We actually don’t really invest in macro because it’s very, very difficult to determine the extent to which people actually know anything. Are they just guessing? Are they just on a hot run? There’s a couple of exceptions, but macro is very, very much about the narrative, lots of people spinning a narrative and buying a narrative in a way that it’s very difficult to invest in. 

Our preference really, is to invest in managers. I think it’s much easier. Invest in managers who just have found this niche that they absolutely are on top of, and they know how it works and they know how to do it and they’ve been doing it for bloody donkeys and their team have been doing it for donkeys, and that’s all we do. Ideally, those types of managers are just harnessing something from the market, whether it’s some kind of risk premium that just has to exist or just some little kind of niche that’s too small for the big guys to be interested in. 

Those types of managers are more interesting, I think. I think that people spend so much time fussing about alpha and finding the best in the peer group. Of course, you want to find the best in the peer group. You don’t want to knowingly associate with the dummies. You don’t knowingly want to allocate to the idiots. But to reliably be the best in the group is just very, very, very, very hard. I think it’s much easier to pay for access. 

If you find someone who knows how to source litigation claims in the North of England, that doesn’t mean that they’re the best litigation source. It doesn’t mean that. But you’re still going to pay them fees because they’re going to make a very high return because it’s such an inefficient market and you don’t know how to source those deals. You don’t know the ecosystem, you don’t know the landscape, you don’t know the background, you just don’t know how to source. So effectively, what you’re paying the manager for is access. And of course, the manager has to have high integrity. Ideally, they’re quite smart, but you’re not really paying because this manager is the best in class. You’re paying just because this manager has access to a return stream that most people don’t have access to. That’s the type of activity that we like. 

The type of manager that we like, typically, is probably not the type of manager that you would necessarily want to have dinner with. Maybe the kind of manager who’s so down his rabbit hole and so obsessed with his or her space that they don’t really have much else to say and they don’t have much else to talk about. That’s the ideal kind of manager. And even better, if those types of managers don’t have a good sales department and they’re not very good at selling themselves because they’re not great dinner companions and they’re frankly a little bit geeky about their own area, that’s a great kind of manager to invest in. I should say that a lot of our managers are very, very fun. They are very good over dinner. So, it’s not the case that we only go for people who are not great dinner companions, but that would be the sweet spot for us.

[01:01:30] Alan  

Briefly (we’re getting close to the hour), when things go wrong, and the types of scenarios that prompt you to exit from a manager, is that typically be driven by maybe that risk premia isn’t there or the expected return isn’t as strong or can it be something more manager specific? What are typical triggers around that side? 

[01:01:51] Dylan  

Yeah, I mean, all of the above. I think it can be that the overall market is not looking as attractive. That can be because expected returns are lower, or it could be expected risk is higher. It could be manager specific. The manager has lost their focus for some reason. The manager’s AUM has grown very, very rapidly, very, very quickly. And again, sometimes, rapid AUM growth is kind of okay. It depends on what the space is and it depends on what they set out to do. 

If they set out to say we’re doing capital structure arbitrage, we think we can deploy a billion dollars in this space and they’re a $150 manager, well, if they suddenly go up to  600 or 700 or 800, that’s okay, because that’s what they said they were going to do. When you get a private credit manager who’s managing $50 and says they think there’s maybe $150 of space or capacity, and next thing you know, they’ve gone through 300 and they’re looking to get to 500, then I think you kind of ask questions. I would say it’s a combination of those things.

[01:03:13] Alan  

Yeah, fair enough. Great. Well, we typically ask people before we wrap up, you’ve obviously been in the markets a number of decades, done a bunch of different things. For people who want to develop a career along similar lines, either as a strategist or researcher or hedge fund allocator, what would be the tips that you would tell people, things to focus on or things to read, etc.?

[01:03:38] Dylan  

Firstly, read a lot. You have to read a lot. I think Charlie Munger said he didn’t know any successful person who didn’t read a lot. And I think that’s true. Read a lot and read actively. So don’t just read a book and then read another one and then read another one. Take notes on it. Absorb it, digest it, find people to talk to about it. And it’s not just about books. It’s investor letters, it’s newspapers, it’s whatever you can kind of get your hands on. 

The second thing is, you can read as much as you like, you won’t actually know how to do something until you do it. So go and do it. If you’ve got an idea or you’ve got something, most people will tell you it’s a bad idea, most people will tell you that it’s stupid, most people tell you not to do it. If lots of people tell you that, it may just be that they’re right. But if you really, really feel it, and you really, really believe it, listen to yourself. Don’t let other people dissuade you if you really, really want to do something. You have to go out there and do it. You will ultimately be better off for the experience. 

The last thing is that you’ve got to love it. You’ve got to really love what you’re doing. It’s got to be what animates you. You have to be very honest with yourself about what animates you and what you love to do. Because you’re competing, and this is true for anything. It doesn’t matter if it’s finance or soccer or anything, you will be competing with people who really do love what they’re doing. The people who really love what they’re doing, they will put the extra hours in, they will be the ones who are kind of thinking about it when they should be watching a film with the kids. They will be the ones who will kind of be waking up in the middle of the night jotting down investment ideas or whatever. That’s who you’re competing with. So, make sure you love it. If you don’t love it, don’t do it. Find something that you do love.

[01:05:35] Alan 

Great. That is great advice. Appreciate you coming on. It’s been fascinating talking to you. So thanks very much, Dylan.

[01:05:44] Dylan 

Thanks a lot for having me. I really enjoyed it. 

[01:05:46] Alan  

Absolutely, with that, thanks and back to Niels, I should say. 

[01:05:51] Niels

Thank you so much, Alan and Dylan, for some great insights into the thinking of a hedge fund allocator. Dylan made some really great points, one of which, of course, is how difficult it is to know something and why it’s better to build portfolios that are really not sensitive to the latest CPI or nonfarm payroll figures, or whether or not you can make accurate predictions about the future. Stress-testing ideas and building portfolios accordingly seemed to have served them well. 

I also found his observations and experience about how so many of the hedge fund strategies, in reality, are just different shades of equity risk, something I very much agree with. Of course, his research into how historical realized volatility does not have to always spike during a crisis, due to the correlation factor, was also very useful to hear for many investors who are looking to protect their portfolios, and how he believes that you can build a low-risk portfolio using higher risk strategies as long as they don’t correlate, something that we, of course, are very much in agreement with on this podcast. But of course, there are so many more gems in this conversation. 

That’s it for this episode. Make sure you go and follow Dylan’s and Alan’s work, because as you can tell from the conversation today, it is so important that you understand what’s going on from a global macro point of view in order to allocate capital well, and we really look forward to sharing many more of these insights as our series continue. From Alan and me, thanks so much for listening, and we look forward to being back with you on the next episode. And in the meantime, take care of yourself and take care of each other.

[01:07:33] Ending  

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