229 Systematic Investor Series ft. Andrew Beer – February 5th, 2023

[00:00:00] Intro

You’re about to join Niels Kaastrup-Larsen on a raw and honest journey into the world of systematic investing and learn about the most dependable and consistent, yet often overlooked investment strategy. Welcome to the Systematic Investor Series.

[00:00:23] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor Series with Andrew Beer and I, Niels Kaastrup-Larsen, where each week, we take the pulse of the global markets through the lens of a rules-based investor. If you’re new to the show, I hope that today’s episode will trigger your curiosity enough to check out the back catalog and listen to the past episodes that you may have missed, like last week’s episode with Alan where we discussed if the markets are priced for perfection, how CTAs capitalize on people’s behavioral biases, and what we learned so far from speaking to the best managers in the world in our CTA series.

Also, I would like to really encourage you to listen to the midweek episode where Kevin was joined by Professor Perry Mehrling, where they discussed the fascinating history of the US dollar and how it came about becoming the world’s reserve currency. Fascinating stuff, really. Of course, not to forget, you really should listen to the extra episodes Alan and I are putting out in the last few weeks where we talk to the largest CTA firms in the world and I think it’s probably the first time it’s ever been done, where we’re trying to capture all of their opinions and views, more or less at the same time. So I hope you all enjoy that series as well.

Andrew, it is so great to have you back on the podcast. How are you doing? How are things in sunny Florida?

[00:01:45] Andrew

Things are terrific. I’m down here for a big ETF conference. Now they’re having record cold in New York this weekend so I’m very happy to be here. It’s great to be back.

[00:01:56] Niels

Yeah. Absolutely. It’s funny because this week, of course, is also the week where CTAs and managed futures funds and hedge funds are meeting in Florida, so it is definitely a busy time to be in the Sunshine State. Now, before we dive into all of the topics we’ve planned, and it will be a little bit different because you and I always talk about different things than I do with the other guys, but I do want to try and summarize what happened in the first month of the year. January really turned out to be a peculiar month in that the new year kicked off with a general feeling of malaise, in terms of the market sentiment, stemming from what proved to be a disappointing holiday selling season.

The stock market actually started the year trading at the December low as economic data continued to disappoint. The Fed, reacting to a string of weak Q4 economic reports and continued stop in inflation readings, communicated that they would reduce the magnitude of rate hikes again from 50 basis points to 25 basis points. In holding to their word, they did exactly that this week, at the February 1st meeting. Moreover, the committee members loosely suggested that the peak of the rates cycle will now reach 5% and not the 5.25% of 5.5% they communicated just three months ago. That change in messaging succeeded in boosting investor’s concerns witnessed in both stock prices and bond yields.

The 30-year yield kicked off 2023 yielding 3.96%, only to close the month of January at 3.63% as investors fretted that the economy was on the verge of recession and the Fed would be forced to cut rates later this year. Paradoxically, equity indices rallied for the same reason. The S&P 500 gained more than 6% for the month, and while it’s still 15% below the all-time high touched in December of 2021, the index has in fact rallied nearly 20% off the 2022 lows which it touched back in October. Now, the catch-22 to the mid 2023 recession story is the employment situation. Despite an alarming number of layoffs; announcements, the unemployment rate, unemployment insurance, and the available job openings, continued to signal a robust job market.

Observers have cited the retirement of baby boomers and the general lack of desire to work as a cause, but there’s clearly a worker shortage in play. A recession typically results in a spike in unemployment and if the worker shortage narrative holds true, then perhaps the Fed will be able to engineer their much-desired soft landing, but only time will tell.

I think it’s fair to say at this point, at least, there seems to be somewhat of a disconnect between what Powell is saying and what the markets are hearing. Andrew, we’ve been in this year for about five weeks, what’s been on your radar? What have you been interested in following the first few weeks of this year?

[00:05:05] Andrew

On the macro side, I think you hit it, which is that I feel, in a sense, that we’re, once again, in one of those months where everybody is completely certain it’s what the outcome is going to be, which is that the Fed is going to engineer this beautifully soft landing, they’re going to stick to the landing, they’re not going to fall off the balance beam. We have a track record over the past 24 months of the consensus view, when it’s optimistic, being consistently wrong. We were talking before, I was asked yesterday in a meeting about what my target was on the S&P 500, which is not something that I do. I said, “Honestly, it could be up 30%, it could be down 30%.”

There is this, as you mentioned, game of chicken that’s going on between the markets and the Fed, where the market is assuming that the Fed really isn’t as aggressive as they say that they’re trying to be. On the other hand, the more meme stocks go up, crypto goes up, equity markets overall go up, you have to think that’s probably not a great thing from an inflation perspective either, if there’s a big boost to wealth creation. At least looking at what seems to be going on in the managed futures space, I think the industry (and you would know better than me), it seems to be trying to figure out which direction we’re going. We’re in one of these transitional periods where they’re kind of hunting for signals but they’re not quite sure and they’re moving out of things and looking. Is that the sense that you’re seeing as well?

[00:06:36] Niels

Well, there’s no doubt, and it kind of ties in with what I was going to talk about anyways, which is the performance of trend following so far this year. There’s no doubt that trend followers had some headwind in terms of performance in January. Some more than others, for sure, because two of the strongest trends in 2022 (which was global bond yields going up as well as the dollar) have continued to reverse course in January. The question is, is this a bear market rally in price or are we seeing something more fundamental taking place?

The same with equities, as I mentioned before. They’re pretty strong so far this year and it was somewhat undetermined. But what’s interesting about the equity side, I think, within trend following is, I don’t know if you were able to pick that up in your replication, and that is I think positions, they’re not uniform across the globe.

There are going to be parts of the world where trend followers are going to be long, and there’s going to be parts of the world where they’re short. I think that’s interesting, but it’s also a sign of, as you say, a transition period.

Now, fixed income, of course, has been a big driver last year and it’s certainly also been a big driver this year in terms of where the losses have come. Again, it comes down to speed of models, for sure, in terms of how you navigated the first few weeks.

Currencies, not so sure. Of course, faster trend following models would have maybe done somewhat better in terms of picking up the weakness of the dollar a bit earlier.

In commodities, I think it’s probably very much dependent on the breadth of commodities you trade. I think some of the smaller commodities have had big moves, like lumber. I see this month, for example, I think things like orange juice, none of these that we trade on our side, but they’re going to have an impact on performance for some managers, for sure. But overall, commodities were not necessarily the place where you saw the biggest performance attributions in January, I would say.

It is an interesting start to the year. But I think the real question is, are we just getting a little bit ahead of ourselves and are we getting too excited? The wish for a soft landing is so strong. But the interesting part in all of this, when you look at it from an investor point of view (who will both hopefully have the traditional investments and some CTA exposure), is that, isn’t it just wonderful that what didn’t work last year is now working well and you’re probably making more money on your traditional investments because the allocation is bigger than you’re losing on your trend following or your CTA side. That’s exactly how it should be.

[00:09:30] Andrew

Back to your point about hope, I wrote a short paper in the beginning of 2021 about the return of inflation. Like a lot of things, I was standing on the shoulders of a giant and that is Stan Druckenmiller who made this incredible inflation call, and it was very completely contrarian. I talked to people for the next 18 months about it. I think when people talk about trend following, they often talk about taking advantage of behavioral biases. To me, the bigger component of it is actually people’s jobs. The asset management industry is designed to move slowly. We are not supposed to be nervous crack addled squirrels who buy and sell because we know one new piece of information. Advisors are supposed to be steady hands. Allocators come up with, consultants come up with 20-year asset allocation assumptions.

So the vast majority of the asset management industry is designed to move slowly and so when inflation started to happen, it started to happen fast. What you really saw was that the vast majority of the asset management industry fought it for 18 months. Every time there was a glimmer of hope, it was, “Okay, it’s a ports issue, it’s transitory; it’s this, it’s that.”

So, my observation was that the reason managed futures did so well in that 18-month period of time was because it was contrarian. It wasn’t just that they made money. It’s that other people weren’t reacting because they couldn’t. If you had a standard 60/40 portfolio at Vanguard at the end of 2020, you had a massive low rates bet everywhere.

If you were buying double A bonds at 1.5% yield and you had an S&P 500 where you had FANG stocks being supported by low interest rates and you were buying real estate with recaps, everything you were doing had a low rates bet. Everybody who was famous had made money and been leveraged into the low rates bet; whether it’s Cathie Wood or Chase Coleman or crypto people.

So, when I was in Boston, on November 10th, when it was the first inflation print that came in below expectations. I was with a lot of big long-only institutional consultant-type investors and at that point, you could see it in their eyes. We were seeing things in our portfolios; everything was going in the wrong direction. The yen is spiking, rates are coming back down, but I can see the same reaction on their side. And these are long-only guys, they had cut duration, they had gotten out of growth stocks, they had gone through this kind of wrenching, and they finally conceded that we’re in this period of perpetually high rates.

So, I think a lot of what happened in the last six months of the year was people panicking and basically saying because they had six weeks, if they didn’t readjust their portfolios and get back in, the fear of missing out, but it was also they would be killed on the benchmarking side. I think when people talk about how difficult this market has been, a lot of it has been that. On the managed futures side, I think what happened basically was that all of us were collectively in this contrarian position, and then now with everybody piling into a lot of the trades by last fall, it means that as the unwinds have happened, as the changes have happened, it’s been more violent than it otherwise might have been.

[00:12:48] Niels

Yeah. The other thing, as I hear you speak, I’m reminded of the fact that I think trend followers actually started going short bonds in the early part of 2021. Over the summer of 2021, we got stopped long because markets took one of those corrections that were just long enough and big enough for us to have to change position. So our models flipped to the long side, not by much, but still. And then of course, it all turned out to be a fake signal. So we just got short again in Q4 of 2021. There’s no emotion, there’s no drama, that’s just the way it is. Even though we, as humans, observe these changes in direction of our models, it sometimes can be a little bit of an upset that we just had to close our positions. But that’s the strength of what we do, that there are no opinions, there is no sentiment or feeling.

[00:13:49] Andrew

There are no research reports to retract, there are no clients to update and tell them that your great 10-year prediction of three months ago is now wrong. I think it’s, as we talk about, how do we take that incredible strength of the strategies, the dispassionate, cold, rational nature of it, and get people to buy into that; to want that as much as they want the illiquidity premium; as much as they want a particular factor that they think is going to do well over the next 70 years.

Once I hit the holiday season, I shut off a lot of social media and I said I need to actually learn how to write full sentences again and spend time thinking and processing the hundreds of conversations I’ve had with people and try to figure out where we go from here.

[00:14:38] Niels

Yeah. Great. I can’t wait to dig into some of those thoughts.

Just to finish off the month of January, my own trend barometer finished at 34. That also confirms that we should expect some negative returns. It’s certainly on the weaker side.

When I look at the early numbers for the industry, the BTOP 50 Index was only down 11 bips, so 0.11%. The SocGen CTA Index was down 0.77%, the Trend Index was down 1.34%, and the Short-Term Traders Index was down 0.17%. So this is, of course, incredibly irrelevant, so to speak, in terms of performance. There’s no drama in that department, but I will say that, of course, some managers will have seen much bigger swings than this. It very much depends on the timeframe because the longer term models certainly got hit harder in January, and I speak a little bit from experience in that area.

Andrew, we’re going to dig into some of your observations. When I started communicating with you a couple of weeks ago in terms of what we should talk about today, you had a great idea. I think the idea is trying to (and I don’t know exactly the word you used), but it goes to the point about how we can essentially get investors to be compelled to look and invest in what we do. We’re not trying to force anyone, not trying to convince anyone, but really compel them to look at this strategy.

You have a number of great points. I’m going to let you start off, and hopefully, I’ll keep up and comment a little bit and we can dig deeper and go in all directions that we find appropriate. But I think that’s what today is all about. It’s not about nitty gritty correlation or ATR, anything like that. This is big picture stuff, and hopefully, it’ll appeal to a very broad audience in terms of that.

I’ve heard you say it (and I think maybe you said it last time you were here). I’ve seen you put it in your writing that, ‘managed futures is the single most valuable diversifier you can add to a portfolio of stocks and bonds’. Now, of course, this is something that became clear to me after I read the 1983 Dr. John Lintner study which came out a few years before I started in this industry. I thought, wow, this is really great.

So, what’s funny about some of the points that we’re going to be talking about today is that they’re kind of the same as they have been for a while, but we’re going to maybe talk about them in a slightly different way. I know you have some great analogies that you use to explain things so I’m excited about our conversation. Let’s just start with point number one, so to speak.

[00:17:35] Andrew

Sure. As usual, I’m late to the game so I’m learning from people who’ve been doing this for a lot longer than I have. Just as a reminder, we got into the managed futures space in 2015 when we were building a portfolio. Our business is really not to build our own strategies. We did look at building simple trend strategies and we looked at the risk premia products, we looked at a bunch of different things. When I take a step back and look at just the basic strategy (forget about the headline of what it is), and you say that here’s a strategy that has four characteristics. By the way, when I say the strategy, I mean the SocGen CTA Index, because one of the incredibly annoying things about hedge funds is you don’t have 70 years of good data for obvious reasons.

But SocGen has done everybody a great service, from January 2020 to the present, saying what are the top 20 guys in the space; the 20 largest guys in the space, and how they have done So, we consider that to be the gold standard of data on the space. Barclay has good data as well, as do some other places now. But if you look at that data from 2000 to the present; through the dot-com crisis, through the GFC, through 2022, you have a strategy that has done 75% of the returns of equities, 120% of the returns of bonds. It has done that with zero correlation to either one of those, it has a max drawdown, over 22 years, of 14%, which is less than a third of equities which have had 250% drawdowns and now is less than bonds, and it’s done the best when stocks and bonds have done the worst.

Well, I shouldn’t say stocks and bonds, but when 60/40 portfolios have done the worst (like 2000 through to 2002, 2008 and 2022), it’s done the best. So, if you stop there and you’re building an asset allocation model, the debate is over. This strategy, defined broadly as the overall space, should be 5% to 20% of every portfolio. It has much more diversification benefits than private equity (which is even if they don’t mark to market and Cliff Asness’ head explodes when you get the smoothing of returns). It’s obviously highly correlated to the equity markets, whether people want to believe it or not. Private credit is obviously correlated to bonds.

Now we’re in a world where stocks and bonds are going to be moving together probably for the next 10 or 20 years. So to me, the really interesting question about managed futures is why don’t people own more? In our space, in the ETF space in the US, it grew a lot last year and we’re still somewhere between 2 and 3 basis points of the overall ETF world, not 1%, not 50 basis points.

In the mutual fund space, let’s say it’s $25 billion in assets, so that’s maybe 6% of the overall liquid alts world in the US mutual fund world, and has infinitely more diversification benefits than the other 94%. It’s 10 basis points of the overall mutual fund world. I’ve had the great opportunity of talking to tons of people on the US advisor side, at the wealth management platforms, less on the institutional side and the family office side (but I’m talking to those guys a little a little bit more now).

To me, the fascinating question is 9 out of 10 guys I talked to don’t have anything in this space. Why? What is it that stops them from owning it? What is it that makes it so easy for them to say I want to own private equity at the tail end of a bull market where the industry has been completely changed and capacity constrained and all sorts of other issues? So that’s been my obsessive focus and I’m trying to write about it and talk to people about it because I think we just need to find a way to bring more people into the tent. I think it’ll be good for them and good for their clients and good for their businesses if we can get it right.

[00:21:24] Niels

Yeah, I obviously completely agree with all of that. Before we then dive into some of the things that we hopefully can help with in terms of overcoming some of these challenges, I wanted just to pick up on one little sentence you said, and I’m curious whether there’s something you think about in terms of why you believe that. You mentioned that stocks and bonds are likely to move in tandem for the next 10 years. Is there a reason why you think that’s the case? I’m just curious.

[00:21:55] Andrew

People who study this, and I’m not somebody who studies it myself, but people who I think are very smart and spend their time thinking about these things; and PIMCO did a study on this as well, and from what I’ve heard, they’re quite good at the whole bond market thing. Basically, when rates get higher, when you look at stocks and bonds over very long periods of time and you divide that according to the absolute level of interest rates, as rates get above to about 4%, you tend to see positive correlations over time. What all the underlying drivers are, I don’t know. But all I know is that in 2022, they both went down together. In October, they all went up together, or November, they all went up together this month, they’re both going up together. So it doesn’t feel like they’re really offsetting each other.

Now, I think the reality is the inverse correlation of stocks and bonds, even in the 2010s, was a little bit of an absurd statement because it was obvious that Fed policy was driving both. What happens is, when statistical models get involved, people’s brains, human brains just sort of stop working and they want to see what the models say. So, even though you have this underlying factor driving both of them, the day to day or month to month correlation between the Bloomberg Ag and an equity market was low or negative, but you take over a longer period of time and you see they’re both going up. So, I think it’s been an issue for a while, but I think just statistically, anybody who’s building a model right now has a major problem because they’re turning the dials on what their assumptions are, their correlation and other assumptions over the next 10 years, and it’s not negative the way it was. Maybe it’s something.

[00:23:40] Niels

I completely agree. This is the data that I have been looking at as well. I also, about a couple of years ago, started talking about it on the podcast saying this is most likely going to happen. So, I completely agree with that. Also, it kind of touches on another thing that I think is important, maybe we’ll come to that later in the discussion, and this is this thing about, sometimes we just need to trust the evidence. We shouldn’t be too concerned about trying to explain every single little detail as to why this will happen. But you sometimes just have to say, well, as you say, if it’s happened most of the time, in the last 100-plus years, there’s probably a high probability that it’s going to continue to work like this.

Same with why trend following adds value to stocks and bonds. Well, it’s actually done that for however long we can go back so maybe there’s a good argument for continuing to do that. So, I like, sometimes, these more simple explanations where you don’t have to come out with your professor hat to understand why something might happen.

[00:24:50] Andrew

I think that was a really interesting implication for diversified portfolios, because you can, in a sense, divide the portfolio into things that are correlated to stocks and things that are correlated to bonds, and then truly other stuff. The other stuff is sometimes illiquid, where people do market to market. Sometimes it’s something like millennium where they have magically seemed to eliminate all market risk with 10x leverage and not blow up – hats off.

But there aren’t that many things you can point to, like real estate is going to be really correlated to stocks or bonds depending upon the market environment that we’re in. So there are very few things you can point to and say it’s not correlated; it truly marches to the beat of its own drum. That’s my little soapbox that I will be carrying around for this year. Basically, if you think 60/40 is dead, then managed futures should be your first due diligence exercise to try to figure this space out before you waste your time in other areas.

[00:25:46] Niels

Well, let’s help them out a little bit further. I think you go on to talk about predictable diversification benefits. Do you want to dive into that?

[00:25:55] Andrew

The world has been taken over by the idea of building diversified models. In the 1990s, people started to build models and a guy named Brinson and Beebower wrote a paper that basically said, the reality is if you get the asset allocation, that’s 90% of what you do. What that has done is first, through the institutional consulting world, it overtook the institutional space. So, let’s add more and more slices to the portfolio and we’ll add more and more complexity and our Sharpe ratio, over the next 10 years, will go from 0.4 to 0.42. But people like it, it’s complicated, the only things you can point to. That same thing has happened in the wealth management space.

Now, the difference on the wealth management space though, is that people build asset allocation models. So how do you decide what to put in it? You can look at the past and you can look at all the data in the past, but then you end up saying, “I really wish I’d owned the S&P 500 or the NASDAQ over the past 10 years, that’s not necessarily what I want to own over the next 10 years.”

So you start with the historical data and then you massage it to line it up and it’s 80% art, 20% science to try to figure out what you think the world is going to look like over the next 10 years. Are emerging markets going to come back? What sort of premia do they have? So you divide up the asset allocation pie into all these different buckets, then comes fun selection.

All fun selection is, the sole purpose of fun selection is to find something that matches or outperforms each of those pies in the bucket. One way to do it would be to say, “I’ve used the SocGen CTA Index to decide that this space is amazing, from an asset allocation perspective, and look at DUNN, they’ve done better.” So I not only get these great diversification benefits to the space which I can see, but even better, because DUNN is going to be my pick for that. That’s what I mean, the category, the strategy of diversification benefits, but individual funds within it will be quite different.

I think the challenge is on the institutional side of the fence, because in a sense, the managed futures space grew up as a single manager products being offered to family offices, institutional investors, wealth management platforms, etc. In the larger investors, they can build their own cars from these different parts. You can combine a short-term guy, a long-term guy, throw in a counter trend guy, or whatever, and you get some sort of diversification. But really, all the role of that is to construct something that looks like, or matches, or outperforms the benchmark you just used in deciding that you want this to be a 5% or 10% allocation in your portfolio.

The problem is, that doesn’t translate easily into the wealth management world because most guys in the wealth management world (it’s not just managed futures, it’s equity long-short), they generally say I want this strategy and they pick one fund. In the managed futures space in the US, AQR to me did an incredibly positive thing when they launched their fund back in 2010. Before that, a lot of the funds were kind of sub-advised products, and they came into the market with a true institutional quality fund with what I think people thought was a fair fee structure. But I think what a lot of the allocators thought was AQR and the index will always be the same because of who they were. That tension, I think, has been a real problem for a lot of allocators and I think we’re trying to figure out how to solve that.

[00:29:29] Niels

Absolutely. I obviously kind of understand why you were also taking that view, and of course, single managers will be different. I will say one thing, and of course, there are some managers that go out of business so obviously you have to be aware of that. That’s true. I guess some multi products also go out of business, whether it’s because they are true fund the funds or whether maybe there’s been some replicators that have gone out of business over years as well, I don’t know.

[00:30:01] Andrew

And there are a few more that should.

[00:30:05] Niels

But what I will say, to some extent, I wanted to hear maybe your thoughts on that, couldn’t you argue, from my side of the table, couldn’t you argue that if you pick someone that’s been around for a long time, so there are plenty of established names that I think are unlikely to go out of business; that actually, their performance, in the long run, will be pretty close to the SocGen CTA index, if that’s what people want. I do accept the variability in performance, year by year, or whatever. But on the other hand, when you look at these long-term curves, there’s a lot of correlation in the end, and therefore, actually once you volatility adjust the returns, performance is not super different.

[00:31:02] Andrew

To me, having a single manager managed futures fund, in your portfolio, is a lot better than having zero. Having two, to me, from a risk perspective, is better than having one. Three is probably better than two from a risk perspective; four, you get a marginal benefit.

You can go to Abbey. Abbey does this for a living, and they’ll give you more diversification and hopefully they can find a collection of guys who do it. There are a lot of different ways to approach it and there are advantages and disadvantages to each. My whole career has been getting into a new area and trying to figure it out, and what I’m trying to figure out now is what really goes on in the minds of advisors. So, one of the things I’ve realized is that managed futures as a strategy has three very different kinds of diversification benefits for them.

The first is those numbers on the SocGen CTA Index. It’s a little bit like when you read an AQR paper that says trend would have worked for 140 years. There’s an element of absurdity in that, that if only somebody had invented a computer in the 1880s, we could have made money in trend. But what it is the long-term numbers allow people, at the investment committee level, at the model level, it’s the piece of paper that allows them to justify doing what they want to do in the first place, which is add the strategy because they like it. People who know that private equity returns are smoothed don’t try to unsmooth them and then justify putting them into their models.

If they want to own private equities, they’ll put them in that way. So it’s very, very long term, and that’s where you can sit down with a client and say, “Hey, if you do Vanguard over there…” Again, the asset management business is really weird. One of the largest firms is a nonprofit. Imagine if Citadel, tomorrow, decided, “Yes, thank you. We made $10 billion or whatever we made last year. Now we’re doing it for free?” What that would do to Millennium and everybody else.

So, everybody who is out there, everybody has terror about Vanguard, because you’ve got somebody who’s basically saying not only philosophically do we think nobody adds value in a 60/40 portfolio and you should do everything for 5 basis points. So you’ve got to justify why you’re putting it in. You put this into a model portfolio and your Sharpe ratio goes up, your drawdowns improved, that’s step one of diversification.

The more near-term thing is what happened last year. We call this the beacon of green in the sea of red, that this happens to be a strategy where even if you had a 2% allocation in managed futures last year, and instead of going down 20% at the bottom, you went down 19.5% at the bottom or whatever the number is, the value of that punches way above its weight. Because there is a constant dynamic between advisors and clients or allocators and their ICs of shifting attention to the things that are working. So in a year like last year, you didn’t have a lot of things working. If you had a great big crude oil position, you were happy for most of the year. But now you have something that’s up, so that’s a much more tangible thing that people are looking for.

Now what happens right now in a period like this is they feel like, “Darn it, I missed it in 2022. I got to wait 10 years for it to happen again, so I’ll wait nine and hope that I can time it,” which I don’t think works. So you basically have these three different things. You have a long-term thing, a shorter term thing in terms of being able to show last year that we outperformed because we have this as a diversifier, and then you have the client management of being able to point to something up. So, all those can be accomplished then.

If I had a 5% allocation to you guys last year, all I would have done is talk about you guys, and most guys will do that. There is one large member of the SocGen CTA Index was down 35% last year, and who was outperforming almost everybody else in the preceding years because they were better equipped for that world.

Even in the mutual fund space and ETF space in the US, 20% of funds were down last year, and the spread between you guys and the bottom guy was 70 points. That’s a lot of variability for most advisors. Now, you, and AlphaSimplex, and AQR, you guys are generally going to be pointing in the same directions because there’s an underlying philosophy that I think is common in what you guys do. But some of the funds out there, like Millburn, was not a trend fund by the time 2020 rolled around.

A lot of those nuances have been lost because people say they’re in the same category, they have business cards with roughly the same names, and therefore, they must be doing the same things. And I think sophisticated guys like you, who’ve lived in this space, and sophisticated allocators know about these distinctions. I think that’s lost by the time you get to 99% of the population out there. So, it’s attention, and people have to figure out how to deal with it.

[00:36:13] Niels

Yeah. I completely agree. From an advisor’s point of view, there’s definitely some mileage in that. It’s funny, before we jump on to the next points that you wanted to talk about, I have to share a little story with you because you mentioned this thing about cost. What if some of these big firms were just saying we’re doing it for free? Well, I actually happened to be at a conference last week in Barcelona. It was not a trend following or futures conference, it was actually a volatility conference. But to my pleasant surprise, there was quite a bit of trend following that was being talked about.

There were even some presentations being done by big investment banks about trend following. It was kind of funny, because both of the ones I noticed had some, let’s put it, interesting ways of showing it or talking about it. I’m not going to name any names, but there was one very large investment bank that claims to have $3 to $4 billion in their trend strategies. When asked by one of the people in the audience, so how much do you cost, what does it cost, how do you charge for it? The guy basically said, well, it doesn’t really cost anything. And then he says, of course, there’s a little bit of structuring fee, and you want it as a swap, etc., etc.

We all know it really does cost something, but the fact that they’re prepared to say it doesn’t cost anything, I thought that was interesting, especially as a manager doing business with a firm like that. You kind of think well, okay, it’s one thing that you’re replicating your clients, but if you’re doing it for free and not even making money on it, it’s kind of even more irritating, I would say. But that’s just my personal opinion.

[00:38:01] Andrew

The alternative risk premia space, when it took off in the mid-2010s, was all in swaps. For the first couple of years, it was basically marketed as free. And then regulators and boards and stuff said you got to do a little better than that, and so they got bumped out of some of the portfolios that they’d been in because zero turned out to be 3. I know of one case where zero turned out to be 9 when you got through everything. I’m not an anti-fee guy. I’m a red-blooded capitalist like everybody else. I get up in the morning about 4:00 or 5:00 in the morning, and I do this stuff because I love it, but I also want to make money doing it. Figuring out what the right fee deal is. It’s not just a moral exercise, it’s also an economic and cost benefit exercise. I accept, a lot of strategies have tremendous value.

If somebody said you have to give money to one hedge fund for the next 20 years, I’d hand it all the Citadel or Millennium or something and let them figure it out and pay fees from my nose, but then they’d leverage $1 into $10, and hopefully, wouldn’t blow up and I’d have a 2 to 3 Sharpe ratio, and would be happy in 20 years. I think what happens, is in the asset management industry and in the hedge fund industry of old, people always would say I only care about net of fee returns. What they’re really saying is, I’m going to buy a fund who has gone up where nobody cares about fees. Last year, in the managed futures space, hundreds and hundreds of basis points later in fees and nobody cared because they were up 20% when everything was down.

I think what I’m just trying to do is try to understand it’s not just education, it’s trying to understand what people believe. Because I talk to people. I was in meeting yesterday and the guy’s frame of reference was a 10-point trailer on a John Henry product in the 1990s. I had to kind of shake him on how much the world has changed since then.

It’s just fascinating to see how people think about the space because there are so many ideas that are just flat out wrong. You tell somebody who’s had a max drawdown of 14% over 22 years, they’re just like, “No, no, this is a leveraged long-short derivative based blackbox strategy. Of course, you’ve had major blow ups.” And they haven’t. Anyway, I think it’s so complicated, all these different threads out there.

[00:40:38] Niels

Sure. I completely agree with that. I just wanted to mention my other story, because then I went to this other presentation of something that is pretty close to what you guys are doing because they will be replicating the SocGen Trend Index, let’s call it that, and they’re going to be using some fancy AI. It all looked very good when you added that and the equity curves got better and better. The final point was, you could also add some short-term trend following, and then the equity curve went even higher.

Then there was another guy raising his hands in the audience saying, “Well, I’ve heard that trading short-term can be very expensive. How much cost have you included in your chart?” It was very quiet in the room and then they said, “Well, we didn’t include the cost.” So anyways, people have to certainly read the small print before they get into any of these things.

Anyways, let’s move on. You also talk about a clear and simple reason why it should work. Is that where you want to go next?

[00:41:50] Andrew

I think a lot of people have talked about this space, and again, you have much greater history and knowledge about the space than I do. But I think a lot of people have talked about the space. It’s always a question of why it makes money. The best answer for that is a sentence in 12 words or less that nobody argues about. So even today, you walk into an institution and say, “Why do private equity firms make money?” They’ll say, “Oh, the illiquidity premium.” But people take these things as canonical.

In the managed futures space, particularly in the 2010s, I think it started with Asness’ paper. He wrote a paper called An Alternative Future back in the mid-2000s. What he really established was this idea that you could identify some more complicated strategy that was driving the performance of a particular hedge fund strategy that seemed even more complicated than that. So, this idea of trend following, I think it became very popular to say managed futures equals trend following. Now, in our world where we see the world divided between guys who, as you say, have high correlation, they’re trend followers, in general, they’re going to be different lengths, etc., but in general, their skis are going to be pointing in the same direction, and then you’ve got guys who are doing other things.

So the problem with calling something trend following is that we’ve not established that it’s something that people want, and why. Because people then come back with questions like, “When does trend following work better? When does it not?” People don’t generally say, “When is the illiquidity premium? When’s the right time to buy the illiquidity? How do I time the illiquidity premium?” But I think the way people have tried to explain it is around heuristic biases, and it’s lined up with behavioral finance, that we’re all these flawed calculation machines with all sorts of biases built into it. My sense is it’s always out there. I spoke to people who were asking if we were going to do 20% a year last year, and I said no. Let me just be very clear, no, we’re not going to. I hope we do, but it’s very, very unlikely.

I think the bigger issue, though, is constraints; that we have jobs. In the asset management world, in the allocation world, that’s even more pronounced. It’s back to the point that we were talking about. At the beginning of 2021, Stan Druckenmiller can change his views on the world and shift his portfolio in a week if he feels the world has changed. Not a single pension plan in the world can do that. Not a single model portfolio will do that. For them, a courageous move is going from 5% to 6% in emerging markets after having talked about it for a year, and that’s very much by design. The whole ethos of asset management, the whole wealth management industry, the institutional asset management industry is that the smart guys are patient. They are long-term thinkers. They are steady hands at the wheel, because if you flip fast and get it wrong, you’re done.

I actually think the real reason managed futures has this advantage, it’s most pronounced in a period like 2022 or the GFC, is because sometimes the world changes a lot faster. There’s a regime shift that occurs a lot faster than most investors can adapt. So, what do you do if you’re in that seat?

The first thing you have to do is hope. You have to hope it’s wrong. You see the data starting to come in and to preserve your job, to protect the decisions that you’ve made, to confirm the decisions that you’ve made and how you’ve built your business, you have to hope it’s not happening. What I think happened in 2021, back your point about flipping to short treasuries, is there are guys who are flexible, there are guys who do it, and it does move prices, but not all the way, just like in a contract. It moves them a little bit.

Managed futures guys, again, they don’t care that they had the opposite position. They don’t care that they were saved by being long bonds in March of 2020. They see those breadcrumbs and they just flip to it. So they do it fast. They can move in a matter of weeks or a couple of months, not over 18 months or two years. So I think that’s a better argument because it’s less condescending to people. You’re not supposed to be a day trader. But you know what? You can outsource a portion of your portfolio to guys who do this really well, who can do it. You give money to Millennium because Millennium is going to figure out how to manage and make money over time. You are outsourcing a portion of your decision making to them to find ways to make money. This is a way of outsourcing a portion of what you do.

Katy Kaminski has this incredible term, crisis alpha. I’ve been toying with tactical alpha. But the thing about tactical alpha as opposed to strategic alpha, you’re the asset allocation, you’re going to deliver strategic alpha by dialing up EM now and making money over the next 10 years versus the S&P or something. But tactical alpha, the problem with tactical is that it’s considered CNBC. It’s the guys who are day traders. Serious investors aren’t tactical. So I think we have to find a way to frame it that fits better into the language of the people on the allocation side. When you say it to them, they’re like, “Oh, yeah, that makes sense.” Because it lines up with their observations of the markets. This whole thing about people being locked into a position by virtue of their jobs, that resonates with people because they experienced it.

[00:47:47] Niels

It’s funny when you say that. I think you’re right that, actually, narrative really matters. Of course, there’s been books written about narratives. But the fact is that if we could come up with something that, as you said, I actually thought crisis alpha in the beginning when I heard it was fantastic, and luckily, we’re going to have Katy back in a few weeks on the podcast. But yeah, narrative is definitely important, so we need to find something to help with that.

Speaking of help with something, and that is another thing that we’ve been conditioned to as investors at least, and that’s trying to time things, trying to buy the dip or whatever we call it. How do you go about dealing with that in your day-to-day conversations and meetings? Because that’s, again, one of the things that I’m trying, on my side, to compel investors to understand when it comes to managed futures or trend following, you have to leave all of that aside. I mean, you really have to.

[00:48:52] Andrew

I’ve spoken to hundreds of people about it and one guy got it right last year. He invested in January, and sometime toward the end of October, he just got out entirely. He called me afterwards and he said, “Aha! Touché. I did it.” I think Asness, he’s like the allocator whisperer in terms of what he has done in that he is absolutely brilliant. If AQR went to people and said we have these black box leveraged long-short quantitative strategies, it’d be really hard to get that through an investment committee. But instead, he seemed to sort of reframe everything they did in terms of these 70-year, 100-year truisms of the market. They’ve done some of that work in trend where they say, basically, trend has always been around and it’s always going to be around.

My first job was working for this great value investor, and it was just after Fama had published his value paper and I was all ready to come go look for value stocks, and I’m telling you, what Fama wrote about in his paper did not exist in the early 1990s. It was over. He described a world of horse-and-buggies that no longer existed. But I think that there’s something incredibly compelling, on the allocator side, of being able to say this is a truism; this is something that’s out there, it’s been out for a long period of time. My go-to right now is the SocGen CTA data. In 2015, the suspicion was 2008, or the dot-com would never repeat. Then we go through the long winter, and what happened during the long winter is that a lot of guys, it was much easier to kill the space and to claim the space was dead.

So it became very, very cool during that period of time as an allocator to say, “Oh, I used to like managed futures”. I would hear stories where people were like, “Well, I invested with Man AHL in 2005 and then I got out in 2013.” Part of that was also because everything else was working. I think the first step is to talk about the benefits over a longer period of time as we do, [as opposed to] the month to month fluctuations. But then I think it’s a lot about understanding how people frame it with their clients and how they end up positioning your portfolio. Because the point that you made in the beginning was, of course, people were down last month. Of course, people who did the best last year are going to be down more this month.

The world is changing and it’s flipping. You cannot make $10 on a trade and get out with a 10-cent loss. It’s not the way the investment world works, but rather to always get people to frame or pack it into their other assets from a complementary perspective. I think I’m making progress on that but it’s hard because I think there is always this tension, when I talk about these long-term asset allocation models, and then the reality is if a client calls you on Thursday. How do you explain it?

The last thing that I would say on it is that I get asked questions a lot on the space that are hard to answer because they don’t apply to the space. Do you feel better about medium-term or short-term trend right now, is a question I get. I have absolutely no idea how to answer that. So my answer is yes, I like both. Because in a sense, what people have done, in the asset management side, is they always have a really good narrative of why not to sell off at the bottom. That has a lot to do with the psychology of allocators. I’ve worked and been friends with a lot of guys who invest in hedge funds and we joke about this.

When they go to make a decision to invest in a hedge fund, they’ve got these elaborate 20-page due diligence reports, and they’re, “In a high volatility environment, they’re going to thrive and in this environment, they’re going to whatever.” Then, invariably, a couple years later, one of those scenarios has happened and the fund has done nothing like they thought. So, what does a Stan Druckenmiller or George Soros do? They sell it, they’re out. But the moment somebody pulls a trigger on a fund, they’re wed to it. It’s their fund. In a lot of areas, if you invest with a value guy and he does terribly for five years during the value crisis, your argument is, “Don’t get out now,” because all of his stocks are trading at three times EBITDA. You don’t want to be the guy. It plays into this ethos of you don’t want to be the guy who gets out at the wrong time.

The problem in managed futures, there’s no argument for reversals, there are no strong arguments for short-term reversals, because then you’re getting into a discussion about the intrinsic value. “We were still short treasuries last month and we lost money on it, don’t get it now because yields are definitely going to go higher.” We don’t want to be having that discussion with people. We don’t want to become the macro strategist. So, I’m not sure how to handle that. But I think that’s a really important psychological piece that we’re missing. What I’m trying to do is basically say, forget about month to month. You’ve got to find a way to leave it alone. Look at 2022, look at these different periods, look at it over longer periods of time, that’s where the benefit is and you’ve got to be able to withstand it. I haven’t figured it out yet but I’m trying to keep working on it.

[00:54:34] Niels

I like your thoughts on this. I would say my own views on this are that this is where it gets really hard because we, unlike so many other types of investments, when it comes to this, we have to get people just to look at the data; just to look at the evidence. Because yeah, we see talking heads on CNBC and Bloomberg coming with all of their predictions, but usually, nobody knows the future. Even central banks never forecast a crisis in advance. It just never happens. Yet most people love to hear these views, and so on and so forth.

When it comes to managed futures and trend following, we have to just really look at the evidence, which you would think would be enormously appealing to people to say let’s just look at the evidence. You think, well, yeah, let’s look at the evidence, like you do in so many things. You don’t go into a court case saying, “Let me think what might have happened.” You look at the evidence, right?

[00:55:40] Andrew

My view is that’s not how allocations work; that people decide what they want to do, and they look for things to support it. So one data point that…

[00:55:50] Niels

But wouldn’t you say, Andrew, that the evidence should support it?

[00:55:54] Andrew

Of course, people will come up with the evidence they want. My experience with allocators is that there’s a reason they like something, there’s a reason they want something. They want diversification, they want to be able to point to it. The evidence on managed futures as a strategy is indisputable. But how do you get them to want it? I think getting them to want it is about… First of all, I’m dealing with advisors who are dealing with dentists and lawyers and others, so there’s a huge translation issue in all this stuff and I think that’s where metaphors come in. It has got to be a way that resonates.

I wrote this Barron’s article editorial and I basically talked about managed futures being hurricane insurance, but also, one where you can get paid while you’re waiting for the storm. An experiment metaphors is that I’ve seen people use ‘riding market waves’. So, I’ve been trying to expand that and say, so here are guys who basically spend their lives building models, trying to figure out how to ride market waves, and every now and then, you’ll have an earthquake that creates a series of tsunamis and that’s when they do the best. I think what I found on my site is that once you get into the weeds talking about things and talking about data, people are suspicious of it.

If you’re a typical allocator, you’re getting sold nonsense all day long. Somebody comes in with ARK in 2000, and they tell you that Cathie Wood is the greatest stock picker who’s ever lived, and look where things like that get you. People sell what they have and what’s gone up. They don’t tell you it was luck, they don’t tell you it was a convergence of things that happened to go in their favor. They tell you it’s a skill and it’s a repeatable skill.

So allocators are trained, whenever you present them with an argument, they’re trained to try to pick it apart. The way you can mitigate that, I believe, is that, psychologically, when somebody wants something because of the benefits that they can see (back to your point about the evidence), they don’t ask the questions because they don’t want to hear bad things.

At that point, they’re going to ask the questions that are not about trying to understand. I used to have conversations with people about what we do and they would want to understand the nitty gritty of how the models work, and how they work, and what’s the data source and everything. I realized over time, guys, we do this for a living; DUNN does this for a living. You’re not going to walk in and pick apart their models and say, “Are you sure that’s coded correctly?” These guys have been doing this for decades and they have every incentive in the world to keep getting it right and to make it better next year than it is this year. So, let’s first talk about the outcome, where it fits in your portfolio, what it does, what are the objectives, why you guys built it the way that you built it.

Let them understand that there are human beings who are doing this. Even though you’re building quant models, it’s human beings doing it, using your judgment every day to decide what to do and what not to do. Get them comfortable with that decision making as though you’re picking stocks. And then once you have that, once they’re comfortable and they want you because they trust you as an investor, then a lot of these ‘I need to understand in detail what’s underneath the hood’, a lot of these questions just sort of go away. I think with models, people are so afraid they’re going to miss something. They don’t go in and ask a stock picker, “How do you know it’s not a fraud?”

Always, there’s this deep-seated suspicion about models and that’s where I think we can apply it by focusing on the other side of the brain, the more story side of the brain. I think it’s a way to mitigate it, but we’ll see. In a year, I’ll know more.

[00:59:47] Niels

I agree with you on obviously getting the desire built before, but that’s actually what I meant. I think the desire could come from using the evidence to show people how great it is. All right.

Now, I’ve got one more topic, which is not one of your topics, but it concerns you. Is there anything else you wanted to share in terms of this plan we had in how we get people to…

[01:00:19] Andrew

First, I love talking to anybody about this stuff. I learn a lot from both people like you who’ve been dealing with a different kind of investor than I deal with for years. For people in the industry, I just hope we can keep comparing notes. Because I think collectively, in the industry, what we all do should be 10x what it is now. My first job on the private equity side was in 1993. A billion-dollar private equity fund was a huge deal back then. Now, if we can get the messaging, the education, the positioning right, the industry can be 5x or 10x what it is right now, and that requires having these kinds of conversations, I think, because the evidence is there. Then the question is, what’s stopping people from following the evidence?

[01:01:13] Niels

Yeah. Well, the good news is that it’s already 2x, Andrew, and I think you know where I’m going because there now is, apparently from a tweet or a few tweets that was shared, a filing for launching a DBMF 2x, and now you, as the replicator, is being replicated. They’re cutting your fees in half. What is going on Andrew? How are they doing it? Do you know?

[01:01:41] Andrew

From our perspective, we’re not involved in the launch of the fund. Actually, if he raises $1, in theory, $2 comes into the ETF, basically, the way it’s set up.

[01:01:53] Niels

So they borrow 50 cents every time.

[01:01:59] Andrew

The mechanics of it involve banks and swaps and things like that. But basically, I am fully supportive of what Matt is doing on it. One of the things I’ve learned, on the investor side, is to focus on the guys who I think…

[01:02:17] Niels

Sorry to interrupt you here because you said something that I just want to fully and clearly understand. So are they actually investing in your fund with twice the amount?

[01:02:25] Andrew

What I understand happens technically, in these leveraged vehicles, is that $1 comes into his ETF, there’s a swap with a bank, where the bank can either look at our positions and hedge themselves through futures contracts with basically 2x leverage, or they can go out and just and just buy DBMF as a hedge. My expectation is that it’s a lot easier for them to do that than the other. But if it goes in the other direction, I will feel a little bit stupid.

[01:02:59] Niels

No wonder you’re supportive of his job, is they’re going to buy two times your own?

[01:03:03] Andrew

We had a lot of people ask me last year, because there’s a whole movement around capital efficiency. In the managed futures world, institutions often think it’s silly that you put up $1 to get $1 of exposure. Why not just put up a margin? I can invest the fixed income myself, etc. But in the ETF world, in the model world, there’s this idea around capital efficiency, and then there’s a whole segment of investors, we call them gunslingers, these are the guys who want to be 2x Tesla because 1x isn’t enough. That’s Matt’s bailiwick.

He knows that world very well. I’m never going to spend my time on that world. I want to spend my time with Soberg ETF allocators who have 60/40 portfolios and are trying to figure out where to move 5% of it. That’s always going to be our audience. That’s why we built what we do. There’s been a huge proliferation of products in the ETF world. So I very much obviously wish Matt to have the best success with it, but we have no direct involvement in it.

[01:03:11] Niels

No, no. So maybe it’s a little bit of a let’s say (I don’t know what the word is, I have to be careful here), but maybe it’s not entirely true to say that it is at lower fees, because you actually don’t know exactly how much fees are packed into this either through a swap, either through paying you and then charging themselves, etc. This is kind of a bit of a jungle which I was hoping we were getting away from. I think transparency is incredibly important especially when it comes to fees and stuff like that. But if there are different avenues for them to get that 2x DBMF, then that could be interesting.

[01:05:00] Andrew

There are tons and tons of technical issues around leveraged ETFs. Do you do daily rebalancing? Jerry Parker, I think, was making a point. He read the prospectus and had some view on it. I try to remain as blissfully ignorant of those mechanics as I can. But I think what I do, I would say in the ETF world, it’s become a lot easier to launch ETFs, there’s been a lot more flexibility around derivatives after some rule changes a few years ago, and there was a big push to segment the market and to have specific funds for different segments of the market. That’s what Matt’s doing with this. But in terms of exactly the mechanics and how it ends up, I’ll probably know a lot more in a year than I do right now. Although I’ll see him next week, I should ask him. Email me your questions and I’ll ask him.

[01:05:58] Niels

Let me know how that turns out. Okay, good stuff.

All right. I think that’s going to be our contribution for this week. If you enjoyed it, why don’t you go and leave a rating and review. We’d love it if you could take five minutes and just go over to Apple or Spotify or Amazon, wherever you listen to the podcast, please go and leave a rating and review. Of course, as always keep your questions coming to info@toptradersunplugged.com.

Next week, I’m not sure yet who will be joining me. It shouldn’t stop you from sending in questions. I’m sure some of us will be able to answer them, but we’ll do our very best, and of course, go and follow Andrew and some of the other co-hosts here on Twitter. There’s lots of great information there.

With that said, from Andrew and me, thanks ever so much for listening. We look forward to being back with you next week. In the meantime, take care of yourself and take care of each other.

[01:06:51] Ending

Thanks for listening to the Systematic Investor podcast series. If you enjoyed this series, go on over to iTunes and leave an honest rating and review and be sure to listen to all the other episodes from Top Traders Unplugged. If you have questions about systematic investing, send us an email with the word “question” in the subject line to info@toptradersunplugged.com, and we’ll try to get it on the show.

Remember, all the discussion that we 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 products before you make investment decisions.

Thanks for spending some of your valuable time with us and we’ll see you on the next episode of the Systematic Investor.