239 Systematic Investor Series ft. Andrew Beer – April 16th, 2023

0:00:00 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.

0:23 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 conversation with Rob where we explored topics like how to forecast future market volatility, and the pros and cons of using Value at Risk methodology. Before the conversation took a surprising twist where we found ourselves discussing reasons why you should not be a trend follower.

As you can imagine, this was a difficult segment we had to go through. Also, let me warmly recommend our latest midweek episode with Rick Rule, where he shares his personal investment philosophy and some of the wildest speculations he’s done in his career in a quite personal and fun conversation. There’s lots to learn from his expertise in navigating the complexities of the natural resource space. I think you might also have a smile on your face as you go along.

Lastly, I’m excited to invite you to enjoy the mini CTA series, where Alan and I have had the privilege of speaking with some of the decision makers of most of the largest CTAs in the world. We dive deep into the most pressing topics and have gained some unprecedented access to these industry leaders who share some exceptional insights into the CTA world. So head over and check them out once you’re done listening to Andrew and me today.

Anyways, Andrew, it is great to be back with you this week. How are you doing? Where in the world are you? I’m guessing you’re in New York, and I hear that it’s super warm already? What’s that all about?

2:13 Andrew

Yeah, so I am back in New York. First of all, thank you so much for having me back on. Yeah, I think we forgot Spring this year. When I got on a plane for a business trip it was below freezing here. I got back and it was in the high 80s or low 90s. It’s hot and unpleasant a lot sooner than I expected it to be. Hopefully it will moderate.

1:02:34 Niels

Yeah, right. Well, apparently it’s not just the markets that surprise us from time to time. Mother Nature seems to be able to do that as well. We’ve got some good topics, as usual, that we are going to discuss. Before we do that let me try and summarize what’s been going on in the markets this week.

Now, following the Fed induced banking crisis that captivated the markets last month, much debate has focused on the next course of action. Clearly the Fed’s sharp and relentless rise in interest rates and negligence on its regulatory responsibility contributed to the demise of Silicon Valley Bank and Signature Bank. From that an argument can be made that they should pause from any additional rate hikes to evaluate their action to date, if not, for no other reason then to let the banks that extended the duration to soon generate some net interest income.

However, an equally persuasive argument is that the inflation mentality is starting to become entrenched. Perhaps there are three big hurdles to overcome to justify raising rates at the next meeting, and all of them have flashed a green light for the Fed to continue. The unemployment report, the consumer price index, and the producer price index all portrayed an economy that is slowing down but by no means is falling off a cliff. That should be enough to give them the room for at least another 25 basis points hike.

In addition to Friday’s PPI number, the first of the money center banks released quarterly earnings results. JP Morgan, Citibank, and Wells Fargo all reported better than expected earnings for the first quarter. Investors were fearful that these three would miss expectations or report balance sheet deterioration. But contrary to that concern, all three reported better than expected results. Now that’s not to say that we’re out of the woods completely in that sector. We have Bank of America, Morgan Stanley, Goldman Sachs, TD Bank, and US Bancorp all reporting next week with smaller regional banks coming later in the month.

Also released yesterday, Friday, was the University of Michigan survey. These surveys represent an unbiased portrayal of consumer sentiment in real time, as opposed to the BLS reports that are massaged and seasonally adjusted to smooth changes. In reviewing the results many were surprised that the current conditions index currently rose to 68.6 from 66 last month. While that’s well off the high reached in 2020, given the noticeable deceleration in the economic activity, it is surprising that it didn’t fall.

Now the other U of M surprise, and this one is certainly going to be noticed by the Fed, is the one year forward expectation of inflation, which rose to 4.6 from 3.7 last month. While that’s well off the 5.4 expectation that it touched last year, that consumers expect inflation to rise further despite the rate hikes to date suggests inflation concerns are starting to become ingrained; exactly what the Fed had hoped to avoid.

Anyways, I think I managed to get through that introduction in my little intimate set-up here, in a hotel room, in Singapore. But I think we did okay. Andrew, what have you been looking at the last few weeks since we last spoke? Is there anything other than SVB that caught your eye?

6:00:00 Andrew

Well, I think to me, SVB was absolutely fascinating, and also sort of terrifying at the same time. I think one of the things that’s been so remarkable about this tightening cycle is we didn’t have to worry about the banking system. I mean, the standard view was, but banks have become utilities, Dodd Frank worked in the US, we could worry about everything else but the banking system; the plumbing was fine. So we worried about crypto. We worried about the nickel markets and the LME. We worried about the Ukraine war, and oil, and China, and lockdowns, and all these other things which, if the banking system isn’t functioning, those are sideshows with it.

So watching, there was a period in March where it looked like, oh my god, there was this exogenous factor that nobody thought about. Which is, it took a decade to kill Credit Suisse. The question with Credit Suisse is how was it still breathing after this series of hits that it had taken across its business? What it also showed was that with an organization like that, it takes a long time. You’ve got people who have relationships with the organization, bankers they’ve worked with. There’s a human element to it that kind of slows everything down.

Silicon Valley Bank showed a completely different side of it. As soon as Silicon Valley Bank hit, we were moving our money from First Republic. Not that we had it at any of the funds or anywhere else, but it was just one of these things. Well, wait a second if $42 billion can leave SVB in a matter of hours. The whole idea of the banking crisis changed overnight. Then, even more bizarrely, three weeks later it was in the past and it was gone. The Fed and the treasuries almost sort of flippantly implicitly guaranteeing all unsecured deposits in the US. It was just the weirdest, most jarring, exhausting month. So right now I’m happy it’s April, I guess.

0:08:01Niels

Yeah, I completely agree with that. You make some very good points. I’m not sure it’s really sunk in for me, and I’m sure for many other people, that it is quite extraordinary what’s happened on all these things like, okay, we can just guarantee everything. That even that, when you think about it, it’s just very extraordinary.

What does it really tell you? I mean, I think it tells you that we have some huge problems somewhere if that’s the kind of guarantees that are necessary in order to bring back confidence in the markets. I’ve always (not always), but I’ve said in the last couple of years that my biggest worry is actually confidence. It’s not something we’ve had to worry about too much, as you’ve pointed out. But now we’ve seen how quickly things can change. Of course, if that confidence, or lack of confidence were to hit the policies of the central banks and the central banks themselves, which could happen, then, yeah.

0:09:02 Andrew

I think if we lined up macro economists and said show me your macro predictions over the past five years, we wouldn’t invest with any one of them. It’s everybody’s macro predictions. I mean, maybe one guy gets it right once or twice in a row, and he’s completely wrong. I mean, look at March, some of the huge winners of last year, you’ve seen articles in Bloomberg, in the FT talking about guys who were up 100%, 200% last year who are down 40% this year.

What I find just fascinating watching it is just the certainty with which people have. So we went overnight, we had this debate in the first several months as to whether we were in a Goldilocks situation or a Cassandra situation. Goldilocks being the economy slows down, inflation pulls back, and the Fed refills the punchbowl in the second half of the year, and woohoo, let’s go buy tech stocks again. That was sort of one view.

The other view was: Well, actually, the economy is so strong and so vibrant that the Fed’s going to have to tap it down a little bit harder. In neither one of those scenarios, which was the debate that was wrenching the two year treasury back and forth over the course of months, nowhere in that debate was what if the Banking system fails, and what if we go into a deep recession?

You get to the end of March, bonds and equities are up 3% at the end of the month, after having just stumbled out of a multi car wreck that happened. It does feel (to your point about it) like it sort of hasn’t sunk in yet. It’s almost like there’s disbelief about what happened. So we’ll see.

I think the irony is that, you know, I asked people today (and we’ll talk about managed futures performance, when they say they’re frustrated with managers performance), I said, “Imagine if the space was flat in March, you’d be loading up on it.” You’d be looking at it and saying, “Hey, sure, given how wrong people’s predictions have been by such a wide margin, where do you think equities are going to be in the next six months? They could be up 30%, they could be down 40%.”

We have those kinds of really, really wide ranges of outcomes that are possible on both sides of it. Yet, people are just utterly confident that we’re going to hit down the middle of the road. I just think that’s been the fascinating part of this market that has been fueling volatility.

0:11:17 Niels

Yeah, I agree with that. Just one more comment about this banking situation. What I also find surprising is that I thought we were doing stress tests on a regular basis with the banks. If the banks are now failing based on what the Fed is doing, I mean, that shouldn’t come as a surprise to the Fed because they’re doing it. So I’m kind of thinking why? What’s the purpose of all these things? How can you come up with so many bad policies and not really notice that there are parts in the system that are breaking?

Anyways, we’ll leave the banking system as it is and we’ll talk about something we probably know a little bit more about anyways, which happens to be managed futures trend following.

Just as a quick update for people, as I normally do. I mean, I think this week was generally pretty good for trend followers, we have high yields, we have higher stock prices, I think that has probably suited most trend followers. In particular, there were some pretty nice contributions from the Japanese stock market, like Nikkei and TOPIX. CAC 40, I think also did pretty well in the Euro stocks. Of course, we have one more financial sector, which is the currencies. I don’t think that necessarily contributed a lot this week. Some currencies did okay, Euro Yen, maybe Mexican peso, but they were all the currencies like the resource currencies, like Australian dollar, Canadian dollar, probably not contributing positively this week.

Then we had higher energy prices, of course, probably a small drag on performance this week, since I would suspect most trend followers have a short exposure. The softs and the meats probably did okay. Then we have, finally, the grains and the metals, in particular, markets like corn, wheat, and aluminum where there probably were some losses this week. Otherwise it was a solid week for the industry.

My trend barometer finished at 36. It’s still not showing any great consistency for trend followers. But, on the other hand, if you’re not losing too much money while it’s low, that’s probably a good sign.

The numbers; BTOP50 was up 1.2 for the month, down 2.6 for the year. SocGen CTA index up 1.48 for the month, down 8.28 for the year. SocGen Trend up 1.88, down 5.57 for the year. Short Term Traders index up 28 pips for the month, down 1.83% for the year. So not much drama, really. Equities are doing well for the month, up a bit, MSCI and S&P, up pretty well about 8%, 9% for the year, while the bonds are losing a little bit of money this month.

0:13:57 Niels

All right. That was that. Andrew, we’re going to have to talk about some of these great topics that you brought along. I found a couple that I thought would be interesting.

Now, you told me, before we pressed record, that you had not had time to listen to much of the CTA series, and that’s fine. But you also told me that people had talked to you about it. So I’m curious what they’re telling you, because of course, I was kind of hoping you would listen because I’ve been very diligent in trying to ask all of these big managers about replication to help you get feedback on what managers think about what you guys are doing. So you’ve got some catching up to do my friend. But what did people tell you so far?

0:14:50 Andrew

Well, I think everybody’s concerned about replication, including not just funds that are doing this, but also investors are asking, “Are we too concentrated? Do we lack sufficient diversification? Are we too slow?” I mean, those are the issues that we worry about.

We’re not fools. We know that we are trying to do something that is generally very, very complicated. We have chosen this way to do it, because we decided back in 2015, it was the most simple and efficient way to get exposure to the space. By no means do we think it’s perfect.

We don’t have position level reports, we’re not trying to drill down to the level of the 47th most important position. Those are very legitimate concerns and our job is to look at them rigorously. Obviously, myself, I fell in love with this as a way of doing it back in 2015. So I’m never going to be fully biased in it.

If somebody came along and came up with a magical way of doing this and it’s better than ours, it would be a very sad day for us. But honestly, we’d have to pivot our business and find a way to adopt it. There have been numerous periods, over the past seven years, or seven plus years that we’ve been doing it where we’ve said, “Here’s a new tool. Do we think it works? Do we think it enhances the whole using trend following models?”

One guy that I think very highly of, Corey Hoffstein, has launched an ETF in the US that seems to combine a factor based replication with his own essentially trend following signals. and then kind of merge those in some fashion. We’ve looked at doing that in the past, and we’ve never done it for a variety of reasons. So, the concerns are very legitimate, and our job is to try to give a candid response as to how concerning those should be for investors.

0:16:44 Niels

Yeah, that’s fair enough. But anyways, maybe next time, since I know you’re going on a couple of cross-Atlantic trips, maybe you will have time to listen in and then I can drill a little bit deeper into this topic with you.

Anyways, you brought along some topics that I also think are very relevant. Obviously, at least to begin with, we’re going to stick to the topic of replication, and you said there are a few things that people focus on at the moment.

There’s a focus on drawdown in terms of what you’ve experienced and DMF compared to the drawdown that the SocGen CTA index has experienced. Why don’t you talk about that a bit? Then we’ll dive in.

I may have some comments to each of the points but I’d love to hear the points you raised.

0:17:33 Andrew

Yeah, so our drawdowns since the peak last fall are larger than I would have expected. We’ve been doing this since the end of 2015, in Europe, and then in the middle of 2016, we started doing it in the US. That’s the basis of the strategies that we run in an ETF, in the US.

From the peak, historically, what we’ve seen is that replication on the way down, has roughly matched or even has a slightly lower drawdown than the index as a whole. Within the index there’s always wide dispersion. Some guys are going down a lot, some guys are cutting their risk earlier, there are all these variations in it.

When you go all the way back to the early 2000s, if we had been running the same models and same strategies back then, you actually do see periods where replication does worse than the index. I don’t know, candidly, what was going on back then. The farther back we go in hedge fund land, the more opaque it all becomes. But from our life experience, if you told me last fall that the index would have had a 10% drawdown, my guess is we would have been done 12% to 13%. The simple driver is that if hedge funds go up 10%, they report up 8%; they drop 10%, they report down 8%. So, if they have an eight vol, roughly over time, we’re going to have a 10 vol, because we’re aiming for pre-fee returns and we don’t charge incentive fees. So you’re naturally going to have that.

From the peak last fall, and given that everyone gave up gains in the last few months of last year, I would expect it to give back more on it. Then in January and February, I think the concentration of our portfolio clearly hurt us. We underperformed in both January and February. I think our best explanation, really, is that under the long history of hedge funds the deepest, most liquid positions tend to be safer during really bad market conditions.

If you’re a bond investor and you have a highly liquid bond, and you have some marginal bond that you own X percentage of the issue on, if things go south you tend to lose 30% on the little bond if you’re losing 8% on the big bond. It’s kind of this liquidity asymmetry of the markets. But I think what happened in January is that our concentration, plus some timing issues in terms of how we rebalance, cost us, maybe, 500 basis points. Which is significant on a two month basis, but really not that significant over time when you just look at the variability of returns.

Then we get into March, and March was the second worst month for the CTA index since 2000, and we match it perfectly on the way down. I would love to have missed on the replication side and not go down as much, but we were both down roughly 7%. It’s been a weird sort of combination of three things in a row. That being said, it’s something that we have to address with people. Now, when you look at our numbers over time, you’ll see a drawdown that exceeds that of the index slightly more than I would have expected, and to try to make an assessment as to whether those things that happened are likely to persist.

The only one that I would say that we’d have to really focus on is January in February, and underperformance. Are those two months representative of a broad change in the markets (that I think you and I have even talked about in the last webinar) or are they isolated events where we think things will go back to more normal market conditions?

0:21:06 Niels

Just remind me, so many things happened, what was so unusual, you said in January and February, from your point of view? I don’t remember them as being so unusual, really just a bit of volatility.

0:21:21 Andrew

What I think happened, if we had not just been invested in treasuries, but have also had been invested in British, German, and Japanese fixed income; if we were diversified across that. Going back to the diversification argument, the crazy thing about the first three months of the year is that it was a one factor market. The very best replication of the SocGen CTA index, of the first three months of the year, was one factor. It was just do the two year treasury and nothing else, and you would have a correlation of 9.2 and within 100 basis points of net performance with really, really high tracking over time. What I think happened with us, when we look at it is, if we’d had, for instance, the Mexican peso, that would have helped us. If we’d had Canadian fixed income, I think that would have helped us.

When we look at a period like this, we always try to find what we wished we’d known about on December 31st, and then held through that two month period. As we look at it (and you can never get a perfectly crystal clear picture as to the differences because we can’t see, obviously, the exact positioning and weighting of everybody in the portfolios, and what’s driving their numbers), the general construct is we take about 10% of the positions of the space, then try to match preview returns, and that works really well about 90% of the time.

On average, because we’re cutting out lots of fees and expenses, we expected to do 300 to 400 basis points better than the overall space purely through efficiency. If you look at, on a rolling one year basis, we tend to outperform but 90% of the time, which is the sort of astonishing thing when you’re talking about an ETF versus hedge funds with minimums, monthly liquidity, etc.

10% of the time we will underperform, and the question is why? If you look at, not from the peak, but over a rolling one year period, we’re actually pretty much in line with the SocGen CTA index, in part because we did so much better in the first nine months of last year; in part because of that 20% fee, because that was a huge boost to our performance. We’ve given that back plus a little bit more since then.

I don’t know. You may know better as to how it was impacting your portfolio but we clearly missed something.

0:23:52 Niels

Yeah. You bring up a couple of interesting points, and I think you and I have kind of discussed some of these in the past. First of all, I have to just mention that it sounds like performance fees can be a good thing, because they also come back when they’re not crystallized.

0:24:10 Andrew

It’s true, except this year. If I were an investor who’d paid a lot of incentive fees last year, I might be asking for a rebate this year, but that’s a that’s a different conversation, if I’m a long term investor.

0:24:20 Niels

Well, that’s very early days, right? But there are a couple of interesting things, and I’m going to try and see if I can remember them. You talk about the influence, say, that the two year note had in that period as a “factor.”

If I look (I think we talked about this before), in a period of time that we saw, maybe the last 18 months, or even more, almost two years prior to 2023, trend following returns were reasonably orderly, and they came predominantly from fixed income. You trade a lot of fixed income, so I imagine it was relatively easy to capture that, so to speak. I’ve always wondered.

I guess you could say that in the very long run, in the last two decades, probably, I think that’s certainly something we’ve always been reminded of (let’s put it in a gentle way), by some people, that, “Oh, but trend followers, they’ve had it so easy. All those returns came from fixed income.” That’s true, because that’s where the most steady trends were. However, that doesn’t say anything about the future.

So I’m still of the opinion that if market conditions and performance drivers, in our world, change dramatically from the last 20 years (meaning not fixed income, and you can certainly tell me why I’m wrong if I am), but I do think it’s going to be harder for strategies like yours, given the fact that at this point in time you rely a lot on fixed income for the replication. There will be periods where it’s driven by commodities.

It may not have been shown in it for many years, but they will come at some point. Equities, you may be able to capture that. Currencies, you may be able to capture. I don’t know. So that’s just in my mind, I’m thinking, ‘Yeah, if you have a lot of fixed income, and you replicate a model, the last 20 years, and certainly the last couple of years, there would have been a lot of tailwind for that kind of strategy. That may not be the case in the future.

This year, we’ve seen that particular sector can be difficult. Of course, it will be, and it should be from time to time, it should be difficult. So the question is, isn’t that the thing that you need to address? Meaning that yeah, if once we get into fixed income difficult periods, we’re going to have to do something different in order to keep up with the more diversified managers, if I can put it that way.

0:27:12 Andrew

Yeah, I think to me, I guess I would go one step below fixed income. So last year, for instance, in fixed income our standard models were diversified across rates, currencies, equities, and commodities. We only have 10 instruments. It’s a very limited pool. So it’s three Treasury futures contracts, three equity futures contracts, two currency contracts, and two commodity contracts.

Last year, if you look at the attribution, we made money in commodity, we made money by being in oil, we made money by being short the yen, (essentially our single biggest position gainer), and then we made money in being short treasuries. Taking it one step deeper, again, it’s all been driven by one trade. Commodities going up influences people’s expectations of rate…

There’s about a week period where, right after the war started, commodities spiked, and people thought it was recessionary. In Europe, in the first fund that we did, we excluded commodities for UCITS reasons. We actually saw a frustrating divergence, because the model basically said, commodities are going up, rates are going up, we can’t buy commodities so let’s short more treasuries. Then when they diverged it cost us in the first quarter of last year.

The underlying driver of all of this has been, what’s the Fed going to do in a month? That’s the one trademark. I think what happened to me, what happened with the managed futures space, starting in 2021, there were pretty serious people who were saying that inflation could come back. The structure of the asset management business, the vast majority of it, model portfolios, institutional investors, etc., they are built to move slowly. You’re talking about people who have 10 year, 20 year, capital markets assumptions, and they’re totally confident in terms of how European stocks are going to do relative to the S&P 500 over the next 10 years, but they have no belief that they can tell you what’s going to happen in a month or two.

Query whether, if you went back and looked at their predictions 10 years ago, they’re as accurate as they think they are, but it’s their business. Their job is that they’re supposed to be the steady hand at the wheel. The investment world has been trained that, don’t be flighty, don’t sell at the bottom, don’t do all these things. So the whole asset management has a narrative around not selling at the wrong time. By the way, managed futures does not. That’s something that I think we collectively have to address.

There’s not a compelling… If my bond portfolio is down 20%, don’t worry, I’m going to get it back at maturity; my equities are down 20%, if anything, buy more at the bottom – look at the past seven years. Value stocks underperformed by over 8 or 10 years. Well, the next 70 years will be great. Right? Everybody has a well constructed narrative that has some fundamental grounding.

For about the first 18 months, when I talked to long-only investors, they couldn’t change. They had low rate bets throughout their entire portfolio. They were up to the gills on Fang stocks. You could not possibly support those valuations in a higher rate environment. They had AA rated bonds with 10 year maturities, at 1.5% yield. It was just by doing the simple stuff, you had a massive low rate bet.

For about 18 months, you had a handful of macro hedge funds who were flexible and said the world has changed. You had managed futures funds who were basically contrarian. People’s expectations could never go, “Okay, I’ll give up that there are going to be no rate hikes in 2022. Maybe there’ll be two.” Then once you’re at two, “Maybe there’ll be three or four.” People were fighting it, because the fear was that I would go back to my clients and say, “Hey, I was totally wrong at the end of 2020, when I told you that rates would be low for the next decade, and we had to find a way to make money in the context of it.”

The problem is that by last fall, it had become a consensus trade. On November 13th last year, I was in Boston with long-only investors and this was the day the print came in, and the yen took off, and everything was kind of reversing, and we’re watching it. It’s like we’re stumbling into propellers, left and right, in our portfolios.

I’m seeing the long-only guys across the table, and they’re just as upset as we are, but they’re making money because they’re equities just want to accept that they’re watching their benchmarks fly away, because they’re underweight tech stocks. They’ve cut the duration on their bond portfolio. The struggle over the past six months has been that a lot of the consensus trade really bought into the inflation trade.

We’ve, in a sense, all, collectively, been in a crowded trade. Which is why you’ve had this laser-like focus on what the Fed does next, and what the next inflation print does which is not really helpful from a long term investment perspective, but it’s what’s driving this kind of insane schizoid market.

0:32:25 Niels

Yeah, absolutely. The other thing, so the week before last I had Rich on and we were talking about DBMF because of these articles that had come out; and whether it was decoupling a bit from the benchmark or not. I think we concluded that it probably wasn’t. What we found was, interestingly enough, (and I’m sure you’ve done the chart), Richard prepared a chart just for he and I to look at, and in the period since inception, there are already two other periods where the two naves meet.

It’s kind of like the DBMF outperforming for a period of time, and then it underperforms, and they meet, and then it outperforms, and then they meet, and now they’re meeting kind of again for the third time. I don’t know whether that’s actually probably in a sense what you should end up expecting to some degree. Of course, then you can make the argument saying, “Yeah, there’s going to be periods of time where we’re out performing.” But there are also going to be periods of time when someone could raise their hand and say, “Well, it’s exactly the same.”

0:33:38 Andrew

Take a step back. This is also the expectations. If we said that for the next 20 years we’re going go through periods of up or down, but we’re going match the performance of the SocGen CTA index, net of fees with comparable volatility and with a high correlation (correlation is close to 90% to the index), but it’s in an ETF with daily liquidity. That would be a staggering victory.

The reality is, one of the issues with the DBMF is we started actually doing the strategy in July 2016. But because of regulatory rules, when you start an ETF, even if you were doing exactly the same thing beforehand, it’s like you’ve started from day one. When institutional investors look at us, going back, they say, “Well, show me at least since July 2016,” and you can look at that period. Even with the recent drawdowns, in general, we’ve been kind of beating this idea of outperforming by 300 basis points or more.

Back when people first started doing replication in pre like 2006, 2007, when I first got interested in the space, it was the Holy Grail. If you can just do what hedge funds are doing, but offer liquidity, low fees, transparency, and these other things to make it a more client friendly vehicle, that was considered the Holy Grail of hedge fund investing.

People have tried a lot of different ways to do that. The only thing that’s worked well is replication, and it only works in limited circumstances. You can’t do this to Millennium. You can’t do this to Citadel. You can’t do this to distressed debt managers or merger arbitrage. But you can do it with equity long-short, and you can do it with managed futures.

In the 2010s what happened was, because the industry’s overall returns were so low, and that they were in many cases sitting under this high crushing burden of fees. If you’re in a lower return environment, and cash is earning zero, and you have high fees, guess what? It’s not surprising, you’re gonna have dead money in these strategies. That’s when people started to focus on outperformance. What most people did is they said (if you look at the broader UCITS hedge fund world or the mutual fund UCITS world), the overall returns are embarrassingly low. The overall returns of all hedge funds in these areas is like 2% per annum over a decade when everything else is going up. You cannot make maybe half or 40% of what actual hedge funds are doing.

You can’t make a credible argument that they should be in any portfolio, anywhere, from an asset allocation perspective. But if you find the one guy who was up 10% three years in a row, or the one guy who was consistently doing 500 basis points better, you’d make an argument that guy should fill your asset allocation bucket. As an allocator, that’s insane.

That’s basically saying I want exposure to hedge funds, but I’m gonna pick Fred’s hedge fund because he’s been doing well. But it’s what allocators had to do because they were under pressure to include these things in their portfolios. What it meant was that they would give money to guys at the top at the peak performance, and then they would underperform.

If you look at the broader liquid alts world, that 2% that you would have made is certainly not impressive, but based upon how money flowed, they actually made less than zero by investing in the space; by chasing hot dots. So you’re right.

We may find ourselves, if it turns out that the world has changed, and we lose some of what’s been a pure fee and structural advantage over the past seven years…. Just to put it in context, from back from when we started, we still roughly doubled the performance of the SocGen CTA index with a little bit more volatility. That’s all fees and efficiency.

I think the interesting question that it raises is that in other parts of the asset management industry you have more of a fragmentation of products. You can get direct exposure to the S&P 500, but then you add that to a concentrated bet, to a guy who started doing something meaningfully different; not with high overlap to the S&P 500. I think the diversification question gets into a really interesting discussion as to whether funds in this space should be unbundled in some fashion. I’ve got to go through sort of the mental model as to how people think about that.

0:37:52 Niels

So when you say, they should be unbundled, I’m not entirely sure what you mean by that.

0:37:57 Andrew

Okay, let’s say a reasonable person looks at replication with 10 positions, and let’s say that we think that the broader managed future’s space, on average, (just to pick a number), does 100 positions, (that’s a little bit high, but just use it as a simple number). What percentage of the returns do we think will be picked up by those 10 positions over the next 10 years? 50%? 70%? It’s not 20%. It may not be 100%. Let’s say for just argument’s sake, let’s say it’s 50%. Then I see managers over here, and I say, “Well, look, I fully agree with you that positions 11 through 100 are really valuable. They’re, in fact, more valuable on a Sharpe ratio basis or something, than positions 1 through 10.” But what would happen in a normal asset management world would be I would then offer two products. I would offer a lower cost, one through 10 product, which is what we’re trying to do, as opposed to a higher Sharpe ratio. In a sense it’s almost what Man has done with evolution (you can get those guys on a call and they can tell you more specifically what they do). The argument, when I’ve looked at the numbers, the numbers are incredible.

They basically made the argument that we can find 290 other markets that, even with higher fees, even with capacity constraints and all sorts of other things, we can generate much, much, much higher Sharpe ratios because we are willing to find these really esoteric markets, and at not insignificant costs, build the trading infrastructure to be able to access those markets, and deliver that back to clients.

If positions 11 through 100… Think about the difference. Let’s say there’s a 400 basis points cost differential, with implementation costs and everything else, between the top half of your portfolio and the bottom half of your portfolio. The bottom half of your portfolio has to do much, much, much, much, much better to carry the top half if you can get that efficiently.

0:40:12 Niels

Yeah.

0:40:14 Andrew

There’s an analogue in the equity long-short world and other hedge fund areas where people say, “Well, these are my 10 favorite positions, but I’ve got another 30 stocks that I like.” What allocators have wrestled with is maybe I just need the 10. But the problem is the 10, you can often copy yourself, because you can see what positions they are on through things like 13 F filings. Part of the challenge that equity long-short has had is justifying a one and a half and 20 fee structure for the whole strategy when somebody who has the capabilities can do it; can, basically, often copy the biggest and most important positions, essentially for free.

0:40:57 Niels

Yeah, you know that I like discussing these things with you. We don’t have to agree on everything. We agree on some things. As I’ve said to you before, I think what you guys are doing is a great service to smaller investors who could not otherwise get exposure to the space, I think that’s fantastic. I don’t necessarily agree that strategies like yours have to be sold as, “We’re 400 basis points better,” because I actually don’t necessarily agree exactly.

0:41:30 Andrew

I agree, I completely agree, that’s just what we do.

0:41:31 Niels

Exactly, yeah, because actually I think that the fact that you can do this daily liquidity, and it’s an ETF, and so on, and so forth, is a great service to investors, and it should be enough. Of course, I also am of the opinion, having watched these managers now for 30 years, it is still the same 5 or 10 names that are on top of the rankings. Once you just zoom out a little bit, they do perform pretty well. It’s not that hard for institutional investors to pick a decent group of managers, so to speak.

I always thought it was funny that, (and I know why they do it), but I still think it’s funny that they feel they have to replicate an index. I mean, I think you can find five managers that will beat the index for them. I mean, they should be able to at least.

0:42:21 Andrew

First of all, I expect very, very, very little, to get very little traction with institutional investors who are currently invested with hedge funds. The reason is, so first our primary focus is providing an access vehicle. I think the structure of this industry, I find managed futures incredibly interesting, fascinating sociologically, because I think the industry grew up with a very, very loyal core group of allocators; that they tend to be more quantitatively sophisticated. They’re working at pension plans, they tend to have a lot of time to evaluate all 20 of the constituents of the SocGen CTA index.

In a sense, having talked to a lot of those people, it’s what they like to do. It’s not their money. It’s what they like to do. They’ve been hired to do this job. They’re going to keep doing it. I think, Man, actually… I think if you talk to Abby, Abby will say that you need lots and lots of positions for underlying managers to diversify.

AlphaSimplex gets you pretty darn close to the SocGen CTA index over time, with maybe a little more variable. We and AlphaSimplex end up being quite close over time. You can put two guys together, three guys together, and you achieve much of your diversification goal.

What I think is fascinating is the language around the industry is geared toward the guys who liked the space, and the marketing is geared towards… It’s been a relatively flat pool of capital for a decade. So, if you look at the US mutual fund space, there’s about 20 billion in assets today, and there was 28 billion when we started, in part because AQR was 14 billion of it.

Here we are with a strategy that has more diversification value in a portfolio, than private equity, private credit infrastructure, REITs, commodities, you name it, and it’s 10 basis points of the mutual fund world in the US. It’s five basis points of the liquid alts world which is populated by garbage products.

So why is that? Because I think the language of the space is about talking on technical terms to people who want to hear it, because we’re all selling quantitative leverage long-short, derivative based black boxes. Ours is the most open of the black boxes because you can see our positions every day. I don’t know what you’d really do with it. I don’t know how you would look at our positions and say, “Well, this makes me feel really good about our returns over the past few days.”

0:44:56 Niels

You can replicate it.

0:45:01 Andrew

I actually love that ETF idea. It would be such poetic justice to have the DBMF plus one day ETF at 10 basis points less. But the language of the space, other than Abby and a few other players, you’re really talking about single managers who are pitching the space a little bit. Mostly why they’re better than everybody else is because they don’t have to really convince people about the space because they’re already sold on it.

In a sense, what they’re saying, and I call it kind of this “hunger games” of marketing, because what they’re trying to say is I’m better than them because I’m marginally cheaper or I do better in these kinds of markets, I have more instruments, I got rid of my equity risk, I’ve got stop losses. What they’re really doing, and I’ve described it as walking into a car dealership, and they’ve disassembled all the cars. They’re pointing to, well, look at the brake system over here versus that over there. For 99% of the investors who should be using this in their portfolios, it’s terrifying. It’s terrifying. There’s no visceral way of saying, “Oh, I feel really good because…”

I think the one that’s probably the most compelling is when you say I have stop losses, and we’re going to get out before anything really bad happens. When we’ve looked at it, and we said, “It sounds like a great idea.” The problem is, we think it’s a coin toss as to whether you get stopped out when you want to be stopped out, or stopped out when you don’t want to be stopped out.

Like you mentioned, it should be a good week for people if rates are going up this week. I think there are plenty of guys who did get out of their fixed income positions by virtue of these other things, not good for them. But on the other hand, it was great for them in the last two weeks of March. So really, what I’m focused on is primarily, and whether that means we match the performance over time, if we did 200 basis points or worse over time, net of fees, but we could still deliver the vast majority of the benefits to the other 99%. Then my job is, I’m the guy on your podcast who knows less about this space in a lot of ways than everybody else. So, I’m the guy who has to translate what this means for an investor and how they live with it as an allocation for the next 10 years.

0:47:19 Niels

I think the reason why I point to this point, and I so enjoy and appreciate that we can have this conversation, and that is just as you pointed out, it’s about setting expectations. I think there’s a danger and disappointment if you go out and you say, “Well, we’re going to do this plus 500 or 400 basis points.” I think that’s going to be a hard thing to do over 10, 15, 20 years. But you know, we’ll have this discussion in 2038 and then we’ll see.

0:47:54 Andrew

First of all we’re pragmatists. I’m not Cathy Wood, in the face of evidence, I’m not going to change my mind. We are totally open to the idea that we may need more factors over time. It is very weird for a quantitative firm. I hope you and I are having this conversation in 10 years, and you open it up and say, “Tell me all the changes you’ve made in your model over the past 10 years,” and we say zero.

But during that 10 year period of time, every month and every quarter, we will be having heated internal debates as to whether this is the time. You know, we’ve seen four years of evidence that the Mexican Pesos, everybody loves the Mexican peso, or crypto has come back from the grave and people are using it meaningfully in their portfolio.

We could find ourselves with a 15, 16, 17, 18 factor set. But it’s a very, very high hurdle for us to do it, because what we’ve also seen is that the more you change stuff… One of our collective competitors out there really changed what they did around 2015. They were trend, trend, trend, trend, trend and then they became machine learning, machine learning, machine learning. Just looking at their numbers, what it looks like is the machines learn to be anti-trend. If they present a 30 year track record, it’s like saying I was a value investor for 25 years and I’ve been a growth investor for five years. That’s kind of a big deal in terms of a change in the underlying strategy.

That’s what we mean by the unexpected. That’s why they can go down 20% in March of 2020 when other people aren’t because they’re catching falling knives when most people are pivoting out of things. Talking about the five guys who’ve been around doing this, just to put it in context, when we started in 2015, 2016 there were 49 mutual funds and ETFs in the US, there are 19 today.

This business is really good at shooting the wounded. The ones that you see today, five of the six guys you see today have outperformed the SocGen CTA index. I don’t know anybody on earth who knew six or seven years ago that those guys would, because in fact, what they had bet was that AQR would outperform everybody else.

AlphaSimplex has, they were the second largest. AlphaSimplex has done better than the index. AQR did worse for a period of time. It has come roaring back and is an incredible firm. But last year there was one fund that was down 35%. GSA went through a very, very bad period, and then they dropped out of the business. There is always this survivorship bias.

The reason it’s important is the guys who are looking at the space, they don’t hear from the guys who aren’t around anymore. They open the book on the space, they do a screen and it makes it look easy, because the biggest guys today are the guys who happen to have outperformed, with the exception of AQR.

Why we focus on these issues is we’re trying to give people who are looking at the space for the first time a whole playbook as to the issues that they should address. It’s not clear. I go to meetings right now where there are wealth managers on the platform where the American Beacon Fund with Man AHL is on it, as is the AVI Capital Fund. Pimco is on it as well. There are incredibly good reasons to invest with those guys.

If I was an advisor invested in the Dan Ivascyn Pimco Fund, for the past 10 years, I’m a hero for my clients for having that allocation. If Pimco comes to me and says they’ve got something that can help in a truly inflationary environment, Of course, I’m buying it. Of course I am. If I have a client who has a lot of centi-billionaires who are invested in the Man AHL Diversified Flagship Fund, and I want to get exposure to the same space, of course I’m going to use their fund.

I’ve probably known about these guys for 20 years. There are tremendously good reasons to pick single managers. If I want diversified exposure to the space and I know Abbey Capital, of course I’m gonna pick Abbey Capital for it. What we’re trying to do is not to take money from those guys, because I wouldn’t move money if I was in those shoes, but rather to identify… We’re talking about maybe a trillion dollar pool of assets that has $4 billion invested in the space. It’s really a drop in the bucket.

0:52:58 Niels

Absolutely, and I very much agree with your point about changing models and all of those things. That’s definitely one of the things that investors should be very curious about and ask detailed questions about because, of course, a track record is made up of different iterations of the model. It’s actually one of those things that I spent most of my time talking about on our side. I completely agree with that.

It’s been a little bit, about an hour or so. In terms of your topics, Andrew, to bring up one other topic before we wrap up. Is there anything else that you sent over that you wanted me to bring up?

0:53:50 Andrew

I’ll leave it in your hands.

0:53:51 Niels

Yeah, I think we covered most of it. I sent this article to you because it showed up in some kind of social media feed earlier today. It’s a newspaper article that came out probably in the last 24 hours or so, in the English newspaper called The Guardian. The heading is: Top 10 Hedge Funds Made 1.5 billion in Profit from Ukraine War Food Price Spike. Then he goes on to say, “Analysis covering the first quarter of last year raises questions over the role of speculators in inflating food prices.” Now, of course Q1 last year has been conveniently chosen as a period. It’s an article written by an “activist” of some sort who wanted to make a point.

The environmental editor (who’s now an expert on trend following), Fiona Harvey, seems to have not been questioning any of the stuff she’s put in her article. It’s one of those things that is so wrong, on so many levels. It’s late here in Singapore, but I’m kind of tempted to write a little, but maybe I shouldn’t. Before I comment, I’m going to just read a couple of quick quotes from the article. The article says (amongst other things), “Hedge funds have emerged as some of the biggest winners from the global food price spike that followed Russia’s invasion of Ukraine, with the world’s 10 biggest hedge funds alone making profits estimated at nearly $2 billion. The findings compiled by On Earth, Greenpeace’s investigative journalism unit and the nonprofit journalism organization Lighthouse Reports have raised fresh questions over the role of hedge funds and other speculators in inflation food prices, as the global cost of labor crisis continues to bite.” And then it goes on, and on, and on. Then it says, “Olivier De Schutter, co chair of the International Panel of Experts on sustainable food systems and UN Special Reporter on extreme poverty and human rights said, ‘Hedge funds and financial speculators have made obscene profit by betting on hunger and exacerbating it.’”

The reason why it’s important is that, again, this is a narrative that is coming out there. I don’t know how many of the people in our space read The Guardian, but you know, maybe they do. Of course, it doesn’t mention much about the fact that actually these prices peaked at the end of March 2023. Here’s the important point, I’d love to hear your thoughts as well. The important point is, of course, I was just quickly eyeballing some charts, because they specifically mentioned the Trend index or CTA index. When they say the top 10 hedge funds, I think they mean the top 10 CTAs. This is why it caught my attention. I did notice that some of our friends in the industry had declined to comment. I’ll comment for them, I guess.

The point is, of course, that when you look at a chart (I haven’t checked all positions), it looks like that trend following strategies would generally have become long, a lot of these grains, way before 2022; I mean, sometime in 2021. That’s where the breakout happened.

Okay, so fact number one, we did not buy any of these to push up prices. We did not in fact push up prices at all, because prices didn’t move up. Now prices started to move up before the war in Ukraine. Obviously, they didn’t know that Putin decided to do this. Then, of course, they spiked after the invasion and moved up significantly, and there was a lot of chatter.

From a trend following point of view, and this is very important, especially if there’s people out there listening today that may think. “Well hang on, maybe they did push up the prices.” Actually, I would say it’s the opposite. First of all, those who do just static position size, as we’ve talked about before, they wouldn’t have touched anything, really, after they got into the trade in 2021. Nothing really should happen. Therefore, it’s certainly not them.

People who are doing dynamic position sizing, which is the bulk of the people that they are targeting in this article, actually would have done exactly the opposite. As markets spike, and as volatility explodes, after the invasion, we were selling into these rallies. We’re not trying to push prices down. That’s not why we did it, but we actually dampened the rise of these food prices as March was going on, and prices were rallying because of the expansion of volatility. Our firm did, and I’m sure all of our friends in the industry were doing more or less the same thing. In fact, this article is completely the opposite of what happened and this needs to be called out.

It’s a journalist, she’s an environmental journalist. So what does she know about trend following? Then you have an activist. There’s nothing wrong with being concerned about higher food prices. That’s not what I’m saying. I’m just saying it is wrong to pick out 10 CTAs that probably did the exact opposite of what they’re being called out to have done. So, that’s kind of my little Saturday night rant from out here.

0:59:51 Andrew

You’re not going to sleep tonight, my friend.

You know those guys who have a sports team that like always screws it up? I’m a liberal. I am a social liberal. I was on the board of UNICEF for six years. I worked on trying to find ways to get medical supplies to where they need it faster, and better, and more efficiently. I look at it and it is moronic. Even coming out of the Biden administration, about blaming oil companies for making money when oil prices go up, after having constrained the ability of oil companies to actually invest to create sufficient supply.

I think it’s just a problem with the discourse today is that people are starting with the conclusion that they want. And QAnon, who started with the assumption that there must be some global conspiracy of pedophiles who are really secretly running the global economy, and therefore, we’re going to find information, (to cherry pick a phrase), that we think can support it. Or if we can’t find it, we’ll just make it up, and they’ll create this kind of echo chamber. It’s the same thing that’s happening on the left.

CTAs, the idea that they have some how created a global food crisis. I’m sure by these standards, we’ve also created global warming, we’ve created the international arms trade. I mean, if you wanted to focus on guys who profiteer in situations like this, it’s merchant commodity companies. This is what they are built to do, the same guys who have been chased for providing bribes to emerging market countries to get mineral rights and other things.

There are plenty of easier villains out there, in the context, then guys sitting there pressing ENTER on on their computer models. It’s frustrating for me, because I think that without capitalism, how do you pay for Greenpeace without people making money to be able to pay for Greenpeace? We have to find solutions to this stuff without vilifying for the sake of what they think is an easy punching bag. So, very, very disappointing, because I think there are very serious issues that we have.

It seems like my team, historically, I don’t recognize them anymore. I mean, they have abandoned hard or rigorous thoughts. I know people who were battle hardened liberals with meat cleavers for minds, who want to come up with solutions that achieve these outcomes, and they’ve just been scared away by all of this nonsense. I don’t have anything to add on the criticism side other than trying to get worked up better.

1:02:57 Niels

They do mention that probably “big food” probably also made a substantial amount of money. I’m sure they did actually make a substantial amount of money, probably more by design, and then what CTAs did.

I think we did it from our office here in New York and Singapore, with 12 hours difference. So, one of us sounded very fresh, and the other one sounded very tired.

That’s just how it is. We want to get a podcast episode out every weekend. So, I appreciate your time, Andrew. I think on this note, we’re going to wrap up the conversation. I hope you enjoyed it. Of course, you can head over to iTunes and leave a rating and review so more people can find the podcast.

Next week, I’m going to be joined by Nick Baltas. He’s back. Nick is of course, Head of Systematic Strategies at Goldman Sachs. Make sure you send in your questions for this episode. I’m sure it’s going to be incredibly insightful, as it always is, when Nick is on. You can email them to info@toptradersunplugged.com and I’ll do my very best to bring them up.

From Andrew and I, thanks ever so much for listening. We look forward to being back with you next week. In the meantime, as usual, take care of yourself and take care of each other.

1:04:15 Ending

Thanks for listening to the Systematic Investor podcast series. If you enjoy 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. And 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.