19 Top Traders Round Table with Andrew Lo and Sol Waksman - 2of2

Niels

Welcome back to Top Traders Round Table, a podcast series on managed futures brought to you by CME group where I continue my conversation with Andrew Lo, who is a professor at MIT Sloan School of Management and Director of MIT’s laboratory for financial engineering, as well as the founder, and, since 2018, the Chairman Emeritus at AlphaSymplex Group, and of course, the most recent winner of the Managed Futures Pinnacle Award. I’m also joined by another industry veteran, namely Sol Waksman, who is the founder and President of Barclayhedge.

So let me set up this question, the same question (more or less) to you Sol. My questions would be, as far as I’m aware, and you probably know this even better than I do, but, as far as I am aware of, there has never been a white paper written that does not conclude that adding managed futures or trend following to a portfolio of stocks and bonds does not improve the risk and return profile.

So, with that in mind, why do you think that still so relatively few investors, on a global scale, have added these strategies to their portfolio?

Sol

I think that when you look at stocks and bonds, you have a very strong argument for why stocks should go up over time and for the safety of bonds. These arguments, they are almost taken as a matter of faith. I don’t say that to denigrate the arguments. The arguments are excellent. They’re absolutely excellent.

When an investor is involved in managed futures, and they now go through those periods of inevitable underperformance, the foundation on which that investment is made is not nearly as strong as the foundation on which stock and bond investments are made. You’ve had the stock market, when it crashed, ten years ago. If someone had that type of loss in managed futures, they would never go back to investing in that area again. But, yet people had no problem with investing in equities again. They are judged by different parameters. That’s what I see as the difference, and that’s why you need constant education. You said a very interesting thing before, Niels, about that a more volatile investment can yield a more robust return, but that’s only true if you don’t bail.

Niels

Sure.

Sol

And Andrew, when you were talking about the charts that you showed to your students, the T-Bill return, that chart was the least desirable, if I understood correctly. Well, that’s the return you get without taking risk. If someone wants a better return, they have no choice but to take additional risk no matter how they feel about risk, or how risk-averse they may be.

Andrew

Right.

Niels

Absolutely. Speaking about risks, it has only been a few months since we celebrated or marked (maybe is the right word to use) the ten years since Leman Brothers went under, which obviously really fueled the financial crisis. I’m interested to ask you, Andrew, first; from where you site what have we learned, if anything, from the financial crisis and how has that changed the way you think about your teaching and how you think about, also, the way that the investment firm, AlphaSymplex, that you founded, adapts to this  world?

Andrew

I think there are a lot of lessons that were offered by the financial crisis, but the real question is who actually took those lessons to heart? So, what have we learned? Well, I guess the question that I would ask first is who are we talking about? Because I think different stakeholders learn different things.

If you ask me what I think the regulators have learned? The regulators, I think, have spent a lot of time now trying to understand the failure of the regulations that had really let us down over the course of the lead up to the financial crisis.

Clearly, we were not able to adapt quickly enough to the growth of derivatives and all of the various financial innovations that created the housing problems that we ultimately experienced. So, I think that one lesson that the regulators have been working on is how to change those regulations in order to make sure that this doesn’t happen again, or if it does, that we’re better prepared for it.

I think that the politicians, I’m not sure that they’ve learned anything, which is really the frustrating part of this. If you look at the Dodd-Frank Act, which was a very important piece of legislation that we’re still dealing with, even now, in terms of all of the changes. The Dodd-Frank Act actually did nothing to change the operations of Fannie Mae and Freddie Mac. There’s nothing about the housing market interventions that the government has been involved in, in that legislation.

It’s unfortunate because, ultimately, the difficult part of dealing with these financial crises is to say no to certain kinds of government programs, and politicians just don’t want to do that because it’s not popular. So, I think that’s one frustration: it’s that we really need to think about how to change the kind of political regime that we are in. I’m not quite sure how to do that. I’m not an expert in political theory, and I’m not even sure the political scientists have really spent enough time thinking about how to change these kinds of dynamics.

In terms of financial market participants, I think we’ve learned a tremendous series of lessons about how to manage risk and how risk actually has various different forms, one of which has to do with human behavior. When markets are going up everybody is a hero and brilliant. I think it was Warren Buffet that said, a rising tide may float boats, but it’s only when the tide goes out that you see who is swimming naked.

I think 2008 showed us a lot of people swimming naked and that we really need to have a very different investment approach to deal with these kinds of financial crises. That’s really where managed futures came into its own and the whole notion of crisis alpha.

So, at AlphaSymplex we’ve obviously understood that the diversification argument is really critical for any investor, but diversification takes on many forms. It’s not just about looking at correlations across these very different investments. You also have to look at the impact of major episodes like 2008 and see whether or not you are diversified from that perspective.

In those periods of the fall of 2008 through much of 2009, investments that were previously uncorrelated all became very highly correlated during that period. The correlations structures have actually changed. So, that’s another area where I think managed futures can play a really important role in being able to hedge against some of these kinds of crises and allowed you to diversify in ways that traditional methods of diversification really don’t get at.

Niels

I think that’s a great point, Andrew, and I want to stay with this point just a little bit longer. I want to bring in you, Sol. I want to bring you, Andrew, again, because 2018, for many investors, was a year where they came back and said, “Well, where was that negative correlation you talked about?” when looking at managed futures returns during the event of January, February of 2018, and then we had another kind of event in October of 2018. So,

I know Katy Kaminski just recently wrote a paper about correction versus crisis, so, since I have both of you here today, I would love to hear you explain the subtle difference between these two things that actually makes performance in 2018 a little bit more understandable for investors who were seeking or allocating to managed futures and trend followers in order to get some benefit through the year of 2018, but of course, they didn’t get it for the most part. So, can you explain a little bit about… and maybe start with you again Andrew, just a little bit about how you see the difference between the crisis, where maybe crisis alpha can play a role, but also the times where it just turns out to be “a correction,” and it doesn’t really help out?

Andrew

Sure, well, the idea behind managed futures is that they adapt to these changing trends and, in order for you to be able to identify a trend you obviously need a period of time where markets are going in a particular direction. When markets are going left and right, and left and right, when they become very choppy, that’s an environment where trend following is going to underperform. That’s, I think, a very different environment than the kind of crisis alpha that Katy and others have written about.

So, this past year, I would argue, has been much more a set of choppy markets where traditional managed futures is going to have difficulty. But, there are other investments that ultimately would need to come to bear to provide that kind of return for investors in these markets. But, this is part of the problem of political instability. In a period of great political uncertainty, investors are going to have a hard time generating returns because the way that we generate returns, the way that all investors are able to generate returns is to put money to work in a productive way. So, whether it’s investing in technology or biomedicine, or infrastructure, the way that any of us will earn a return for our investors is to be able to allocate capital to productive goods and services.

In an environment where there’s general political uncertainty, people are going to want to keep their powder dry. It’s like going into a Las Vegas casino. If you’re a card counter, and they don’t catch you, because we know that card counting is not permitted in these casinos, but if you go into a casino and you’re a card counter, and you have expertise, you have an edge, you will definitely be able to earn a better rate of return than a typical gambler who is just going there for fun.

So, these professional poker players are clearly going to earn a higher rate of return. But, imagine going into a casino where you sit at a table, and the dealer says, “Well, we’re going to play a game, but I’m not going to really tell you what the game is. Moreover, whatever you think the rules are? Along the way, I get to change the rules without telling you when I’m going to do that, and why I’m going to do that. How many professional poker players do you think will want to play in that kind of a setting? My guess is very few.

That’s what’s happening right now. Because of the political uncertainty, a lot of investors are saying, “You know, I don’t really want to play. I’m going to keep my capital to the side until we see a much clearer direction for the economy.” That process of capital withdrawing from markets and trying to find a home where they understand what the rules are, that is an environment that is very difficult for any investor to be able to generate returns.

Niels

What are your thoughts, Sol? Do you want to add something to this?

Sol

Well, Andrew, thank you. I think you did an excellent job explaining that. I see it in a very simplistic way. The managed futures industry, the overwhelming majority of assets under management, are traded using trend following methodologies. As you said, you need to be able to get on that trend and be there. It’s like if you’re rafting down a river and the water starts moving faster and faster and then you hit a waterfall. That’s what happened in 2008.

All the CTAs, not all but for the most part, were short and then it went over the edge. But, when you have these political events, or these announcements or just Tweets that impact the market, it is not possible to profit in that situation. If you’d been trading the S&P futures, for example, one day it’s up by two percent. The next day it’s down by two percent. Those are not tradable markets. Those are not tradable markets.

Just getting back to the question that you had a few moments ago, Niels, about what have we learned from this last stock market crash, I think we keep learning the same lesson. That lesson is that when liquidity dries up all correlations go to one.

We saw it in 1987 with the stock market crash. We saw it in 1997, 1998 with the collapse of long term capital and the Russia default. We saw it again in 2008, and now I don’t know whether investors are still taking the possibility of a drying up of liquidity into their analysis when they’re making their investments. I don’t know. Andrew, do you have any insight on that?

Andrew

Yeah, I think this is an example of fear and greed overwhelming rational deliberation. I think investors are spooked and it’s going to be a very difficult market in which I’d be able to identify these kinds of trends until such time as investors start thinking a little bit more rationally. Not to say that emotional reaction is not a reasonable thing to experience but it is something that is going to be very difficult to model unless we actually have really deep data about how sentiment is propagating throughout the market place.

There may be some hedge funds out there that are monitoring social media and are able to make those kinds of predictions. But, it is something that is going to make market dynamics much more complex over the course of the next few months and perhaps even years.

Niels

Sol, you mentioned the word liquidity a few times, and that was one of the things we saw, not just during the financial crisis but also, to some extent, what happened just a year ago in January, February, could certainly be described as more of a liquidity situation than just a volatility situation. Since we are here, and being sponsored by CME group, the largest futures exchange in the world, maybe I can just ask you a little bit about what you think investors really expect in terms of liquidity. Meaning so much money seemed to be pouring into very illiquid types of assets. That’s, of course, another thing that is not often talked about, necessarily, as the highlight of managed futures, but just the amount of liquidity we offer as an industry, which was very well used by investors during the 2008 crisis. Do investors really fully understand the value of that liquidity and maybe the risks of liquidity going forward, do you think?

Sol

Well, I remember back in 2008 the phrase that a lot of people were tossing around that investors were more concerned about return of capital than return on capital. I think we’re seeing, from what I’m reading out in the press… In fact, was a survey I was reading it this morning about how institutional investors are moving into more illiquid investments in order to try to earn a certain rate of return. Time will tell whether this lesson is going to have to be relearned or not. I don’t know. I don’t know the answer.

Niels

I want to change gears a little bit just to cover a couple of other topics before we draw to a close today. It relates to another thing that I think has been talked a lot about in the last few years and that is artificial intelligence or AI. I wanted to come to you, Andrew, first and hear your view on AI and the revolution we’ve seen and how that may affect the financial industry and investors as a whole.

Andrew

Well we’ve been having a technological arms race, in the financial industry, for the last several decades. We’ve seen the impact in many different markets as more and more powerful technologies like algorithmic trading, automated execution, all the connectivity among all the different exchanges, common protocols for communicating financial information, all of these kinds of technologies are now creating new sub-industries.

Who would have thought that cryptocurrencies would be a separate asset class, but it seems like it’s emerging as such. So, I think that technology has always played an important role in financial markets. But, I think what it has done, at the same time, is that it has created some unintended consequences. So, the idea of flash crashes really didn’t exist until prior to 2010, when, in May we had this big flash crash. I think that that is something that we now see as a common feature of these technological innovations. It’s kind of like two steps forward and one step back. There’s no doubt that artificial intelligence is an incredibly powerful set of tools that has transformed many different industries, and it is transforming the financial industry.

The issue, though, is exactly what kind of AI is going to be of most use to investors? Robo advisors is one area that I think is really changing the way that people think about investing. We’re not there yet, though, in terms of being able to automate investment decisions entirely. But, we are at a point where machine learning and tools are using massive amounts of data and try to measure sentiment in a way that is able to invest much more quickly. That is changing the nature of market dynamics. So, I think investors need to be wary of these kinds of technological innovations.

On the one hand, we can’t live without them. We can’t be Luddites and just simply ignore the fact that these technological advances are providing tremendous value to investors. At the same time, we have to recognize that they create problems of their own and that we need to be wary of the kinds of backlash that we’re going to see from investors.

For example, when markets declined of the last couple of years, Robo advisors were inundated with calls from investors who want to talk to a human in the face of losses. So, interestingly, a lot of the Robo advisor firms, over the last couple of years, have been hiring more and more human investment advisors to be able to talk to people when they need to hear a human voice. So, I think that we need to think about technology as a two-edged sword and we need to be wary of both the upside and the downside.

Niels

Before I come to you, Sol, because I do want to hear your views on this. I just want to ask you one more question on this, Andrew, and that is when I interviewed the founders of AHL a little while ago, I asked them about AI, and none of them seemed that excited about it. When I think about, and listen to other people on this topic, I wonder specifically on trend following. Do you actually think that AI can add any value to a strategy where you may only get three or four trades per market per year? Or is it more something that can, maybe, add value if you have a short term or high-frequency type strategy where you have so many more trade samples in a given period?

Andrew

Well, I think that that obviously depends on the user of the strategies. For example, I believe that even though you’re doing three or four trades a year, if you can develop a much better signal for those three or four trades, in other words, if you can increase the chances of those three or four trades being correct, you’ve added value. So, there are many different tools that people in the AI community have developed that could be useful for exactly those kinds of settings.

However, if investors that are using these kinds of tools don’t understand them, then I think they would actually be tremendously unhelpful. A good case in point is Warren Buffet. Warren Buffet makes probably three or four decisions a year. While I expect that some of these tools could be useful, I don’t think he needs any help. I think he’s doing just fine using the tools that he has developed over many, many decades of successful investing.

So, that may very well be the case with AHL and other traditional managed futures managers that have developed their own kinds of human algorithms to be able to make these kinds of decisions. Having said that, what we’re seeing today is a new generation of portfolio managers and investors that have grown up with these kinds of tools: the video game generation where they are very facile with machine learning, data mining and managing massive amounts of data to be able to extract information.

One example, in the area of energy investing: it used to be the case that the energy information administration would put together these weekly reports of inventory bills. Well, it turns out that now you can get satellite imaging to tell you where the oil tankers are… at what part of the ocean they are actually sitting at this very moment, and where they’re heading, and you can track them, literally, in real time. So, rather than waiting for the EIA to provide these weekly builds you can actually calculate inventories on a minute to minute basis.

That’s an example where, even though you’re doing two or three trades a year, you might actually benefit from the information that can be culled from massive amounts of data. So, technology is definitely going to have an impact, even for fundamental investors that are not used to using algorithms the way that some of these AI experts tell us they should. Never the less you have to be willing to use that information and be comfortable with it.

Niels

Sure. Do you have any thoughts on AI, Sol? Otherwise, I have another topic I wanted to come round to before we start to round up our conversation.

Sol

Well, when I think about AI… Andrew, earlier you were talking about card counting in the casino at a blackjack table, let’s say, and how that does increase your odds. I always looked at futures trading and signal generation as something very much akin to card counting. It’s not like you would get a signal to buy and the price would go up. It was more like you were trying to put the odds, ever so slightly, in your favor. You looked at the factors that you felt impacted the price of any particular commodity.

I think [that with] artificial intelligence, people realize that the deck is a lot bigger than it used to be and that the way to weight all these inputs requires automation, requires technology. It’s trying to do what the card counter does but with much more cards, trying to tilt the odds slightly in their favor.

Niels

Well, one last topic I just wanted to hear your views on, and that is something that we had a discussion on, on this podcast recently, and that is cryptocurrencies. It has attracted a lot of attention, a lot of interest, and, of course, initially, a lot of investors on the long side and certainly, in 2018 equally, a round of investors on the short side. Any views, thoughts, Andrew what do you make of this asset, so to speak?

Andrew

Well, first of all, I’m not sure that it’s an asset yet. It certainly seems like it’s taking on some of the elements, but part of the challenge of this market is that the technology is very new and it’s changing quite rapidly even as we speak. So, I think it’s a fascinating area, and there’s no doubt that digital currencies are here to stay. The question, though, is which one of these currencies will ultimately become the currency of choice for the majority of market participants?

In order to address that issue, I like to look back at history, to the 1800s where the development of the West, in the United States, really came with it the emergence of lots of local banks that started issuing their own paper currencies. These banks would print paper that looked pretty official. For some of the banks, many people traded these pieces of paper and actually used them as a kind of fiat currency.

What happened, of course, during the 1890s and the early 1900s, in the United States, is that a number of these banks failed and their currencies became worthless overnight. It became such a problem that, ultimately, the United States had to step in.

Ultimately, the Federal Reserve System, which Alexander Hamilton tried to create during his era and was ultimately reversed, it became, then, a much greater priority in the early 1900s. So we established the Federal Reserve system that we know today in the aftermath of these bank failures. Then what happened, of course, is that the U.S. dollar became the currency of choice and a lot of these private currencies just disappeared overnight once we established that system.

I think that that trend is very informative. We may very well see something like that happening in the crypto area. There are lots of currencies that have emerged as being useful in certain respects. But, at the same time, they’ve had their own challenges. BitCoin, for example, has declined dramatically. By the way, part of the reason for the decline was the introduction of the CME BitCoin futures contract. A couple of researchers out of the San Francisco Fed actually analyzed various aspects of the market before, during, and after the introduction of those futures markets and it certainly seems like that has lead to the price correction in that market.

So, the kinds of dynamics in the currency markets and how they interact with futures is a really interesting development. Ultimately, I think, what we’re going to see is eventually some large financial institution or sovereign entity will pick one of these particular algorithms for cryptocurrency and then offer to issue that particular currency. In which case, at that point, that particular cryptocurrency will be the defacto fiat currency for the digital world. Until then it’s going to be a wild, wild west and I think “Investors beware.” There are going to be some very big fortunes made and lost in these markets. There is lots of volatility.

Niels

Yeah, absolutely. Any thoughts, Sol, from you?

Sol

Well, I don’t really understand the need for cryptocurrencies. I don’t understand how to value one. All I know is, as the prices go up people become more bullish and as the prices go down, they become more bearish. I just don’t really understand it.

Niels

Then I have a question that you will understand, and that is, I mentioned in my introduction that Andrew is the latest winner of the Managed Futures Pinnacle Award which is given out by CME group and Barclayhedge, of course, so I would very much like to ask you, Sol, why did you decide on Andrew as the most recent winner?

Sol

It’s a group decision, and in that process, I think… and Andrew it’s not my intention to make you blush, but your résumé, all of your accomplishments, both in the academic world and in the real world, have been a tremendous credit to you, a tremendous credit to you and it was an obvious choice.

Andrew

Thank you.

Sol

You’re very welcome and thank you for accepting the award.

Niels

That’s the good thing about audio only, and that is we can’t see Andrew, whether he is blushing right now or not. But, we can, as we start wrapping up this conversation… I have one final question for you, Andrew, and that is based on all of your research, all of your knowledge, what’s the best way for investors around the world to deal with our shortcomings as humans when it comes to investing?

Andrew

Before I answer that question I just wanted to respond and thank Sol for a very nice comment, and it has been a tremendous honor to be part of this amazing group of previous winners of the Pinnacle Award. So, it’s certainly something that I never expected, and I am tremendously humbled by it, and hopefully, I will be able to continue working on my research and practice so that I can actually live up to the expectations that come with such an accolade.

In terms of what investors can do to arm themselves for the future, I think three things:

One is that they can understand the framework in which they’re interacting; this notion of adaptive markets. I really think that understanding that markets are more like biological systems than physical systems is really an important starting point.

The second is that they can start trying to understand what the competitive landscape is of that ecosystem, trying to understand the predators and prey and all of the various different species that are interacting. That actually provides a much better sense of what market dynamics are likely to be.

But, the third, and probably most important thing that investors can do is to “know thyself.” That is to understand what their own particular behavioral aspects are when it comes to investing. How much money can they afford to lose before they start to freak out? What kinds of investment objectives do they have? How comfortable are they with different kinds of investments and different kinds of risks? Do they really understand what it is that they are getting into, and if not, can they find experts, financial advisors, friends, family to help them and to support them through these kinds of market roller coaster rides?

Over the course of the next few years, I do expect that financial markets will be a roller coaster ride. I think we’re going to see much more instability in geopolitical events before we reach a new normal. During that process, there are going to be lots of ups and downs. Are investors prepared for it? That’s a really personal question that requires some introspection and some effort to learn about oneself, like any other aspect of life.

For example, today, we’re much more responsible for dealing with our own personal health than ever before. We have to watch what we eat. We have to measure our cholesterol, blood pressure. We are now in a period of medical insight that didn’t exist before. But, to use that insight investors and patients alike, they have to learn more about the world that they live in. So, I’m hoping that ultimately we will all learn how to use all the various different tools that we’re given by developing a deeper understanding of ourselves and how we relate to financial markets more broadly.

Niels

Yeah, that’s great.

Now, before we finish our conversation today, I also wanted to ask you if you had any question that you wanted to ask each other or if there is anything that you felt that I left out that you want to bring up before we finish today?

Andrew

Well, for me, I would be curious to hear from Sol as to what he sees in terms of the dynamics of the managed futures industry, over the course of the next few years, particularly as it relates to the traditional approaches versus some newer investment strategies that are being developed now.

Obviously, the last year has been quite challenging for managed futures. In my view these kinds of periods of challenges have occurred in the past and investors have done well to continue investing in this kind of a strategy simply because we know, from period to period you’re going to have these difficult periods of any kind of investment; whether you’re a value investor, a growth investor, small cap, large cap, emerging markets, all these investment strategies have their periods of underperformance. But, do you see any changes that are going on, at the grassroots level, in how managed futures managers are going through this period and how they’ll come out of it?

Sol

Well, I think it’s a very stressful time for managers. It’s not just been this last year, the last three or four years have been challenging, to say the least. In addition to performance being not as robust as many managers and investors would like, we’re also seeing a tremendous amount of fee pressure: management fees, incentive fees, these passive approaches, the smart beta strategies, all of these, I think, to a certain extent, we’re going to see consolidation, more consolidation. Everyone can’t be above average. I think we’re still in for a period of consolidation and we’ll see how that sorts out, but right now it’s a difficult time.

Long term, I am very optimistic. I think the diversification benefits are real. I think we’re seeing, and I do not know how many CTAs have gotten into the risk premia space where, if you look at the area that Bridgewater has made so popular with their all-weather strategy, risk premia approaches can be implemented entirely in the futures markets.

I think there are certain… If you look at diversification: the idea of weighting by volatility rather than by dollar weighting, I think, at least when you’re addressing the equity markets that there is a built-in return that comes from improving the Sharpe ratio of equity portfolios that are vol weighted rather than dollar-weighted, I think that’s enough of a wind behind the sails. I think it’s a door that more CTAs should walk through.

Andrew

Especially when volatility is shifting so quickly.

Sol

Yes, yes.

Niels

I think the other thing I just wanted to add, maybe as a comment to that: we talk about the difficulty of maybe managed futures for a while, but if you look at the correlation between bonds and equities, the last ten years, if you just do it on a rolling monthly basis, more or less, you’ll find that about eighty-five percent of the time, bonds and equities have been negatively correlated. So, they are the perfect hedge for each other. But, if you go back fifty years or a hundred years, they’re actually mostly positively correlated.

So, if I think if we go back to more normal times, there is a real risk that investors might see the traditional asset classes go down at the same time and not like we’ve seen in the last ten years kind of helping each other out. I think that’s also, of course, where people will start to appreciate more the diversification that an uncorrelated return stream like managed futures will provide in an overall portfolio.

Sol

Well, right now you’re seeing a perfect [negative] correlation between stocks and bonds, and it’s because of the Fed. The stock market goes down, people think that the Fed is going to back off from raising interest rates, so bond prices go up, and the other way around. But, again, that’s very, very short term. So, yes, and there is a lot of time periods when stocks and bonds are quite correlated.

Niels

Absolutely. Well, Andrew and Sol, thank you very much for sharing your thoughts and opinions on today’s topics. I really appreciate your openness during our conversation it’s so important to have practitioners like you share these ideas, because when ideas become conversations that lead to action, that’s when real change happens.

To all our listeners around the world, let me finish by saying that I hope you were able to take something away  from today’s conversation onto your own investment journey. If you did, please share these episodes with our friends and colleagues and send us a comment and let us know what topics you would like for us to bring up in the upcoming conversations with industry leaders in managed futures.

From me, Niels Kaastrup-Larsen and our exclusive sponsors, CME group, thanks for listening and I look forward to being back with you on the next episode of Top Traders Round Table.

In the meantime go check out all the amazing free resources you can find on CMEgroup.com as well as TopTradersRoundTable.com.