264 Systematic Investor Series ft. Andrew Beer – October 7th, 2023

[00:00:00] Intro

You’re about to join Niels Kaastrup-Larson 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] Alan

Welcome back to Top Traders Unplugged where each week we take the pulse of the markets from the perspective of a rules-based investor. It’s a slightly different Systematic Investor episode this week as Niels is away traveling. So it’s me Alan Dunne sitting in for Niels while he is away for the next few weeks, and today, I’m joined by Andrew. Andrew, great to see you. How is everything on your side?

[00:00:43] Andrew

Everything’s great over here. I was thinking as you were saying that I wanted to say something like I’m the least systematic of the people who show up on the show. But thank you guys for having me back. It’s great to be here.

[00:00:53] Alan

Good stuff. Well, obviously, it’s my first time doing this job. So hopefully, you’ll be able to help guide me through as we progress. So it will all be very casual, I’m sure. Before we get started, I know we have a number of very interesting topics just in terms of markets and managed futures and trend following. It’s very early in the month as it stands. As of the fourth of October, SocGen CTA up 50 basis points, SocGen Trend up 84 basis points, and the SocGen Short-Term Traders Index up 1.2%. So positive but probably too early in the month to draw any major inferences. From your perspective, Andrew, what’s been on your radar over the last while since you were last on?

[00:01:39] Andrew

It’s a recurring theme. I just got back from a road trip to Europe and so I had the opportunity to spend a lot of time with investors in Germany and the UK. I always spend a lot of time with investors here. The thing to me that is so fascinating right now, is that the evidence is building up that 60/40 portfolios are broken. We just ran some numbers this morning, where basically, if you go from the sweet spot of the Fed put era in the 2010’s, a 60/40 portfolio in the US had a standard deviation of around 6%. It’s 12 now. I mean, 12.

So think about this from a wealth manager’s perspective. Every single one of your clients thinks they’re on this slow moving train and they’re on some crazy rollercoaster. I mean, 12 for this is like the depths of the great financial crisis. Now, we haven’t seen the 40% drawdown in equities that we saw back then. I think the thing that’s incredible to me about it is that no one’s really talking about it because they don’t have a plan as to what to do. What do you do? You’ve just come to the realization that your conservative balanced portfolio looks more like an aggressive growth portfolio. What do you do? How do you go to your clients and explain that and what would you do?

So we’ll talk about it, but I think the obvious answer is people need things that don’t go up and down with stocks and bonds because that’s what’s driving it. Basically, the correlation structure has flipped overnight, and it could be this way for 10 or 20 years.

[00:03:11] Alan

Yeah, interesting. I was talking to Niels about this a couple of months back and you’re making the point that last year, how many articles did we see about the end of 60/40, but they did kind of dry up a little bit as equities rebounded and bonds did okay in the first six months of the year. But as you say, more recently, the correlation has slipped to positive. Obviously, bonds have definitely been the big focus in markets this week. We had US 10-year yields touching up against 5% and Ray Dalio saying that the US may face a debt crisis.

During the week, I actually had the pleasure of interviewing Ed Yardeni. It’s going to be out as a Global Macro episode next fall. Ed is actually the guy who coined that on vigilantes, or wherever. It was very timely to get Ed’s thoughts on markets. But it is, as you say, this is the challenge from an asset allocation perspective, this positive correlation between bonds and equities. It’s very interesting. Commentators pointed to the magnitude of the declines now for the likes of TLT and all of those long duration.

[00:04:20] Andrew

The thing is that it reflects the historical nature of how a lot of the modern wealth management business really came into existence. It came into existence in the past 30 years. During that period of time, in fact, stocks and bonds did a really good job of hedging each other. But you can actually see it becoming less over time, like during the dot-com crisis, equities got slaughtered. But we went into that with bond rates quite high and so with the Fed cutting everything else, bonds actually went up a lot. So it really worked.

The GFC, not so much. GFC bonds, Bloomberg was flattish. So great, you weren’t down 40% like you were with your equity portfolio but it had already lost a bit of the bang for the buck from a diversification perspective, then you get rolled out in 2022 and it’s in the other direction. I think part of the reason people are having trouble facing it is what I said, which is that they don’t really have a game plan. It’s better for them to hope.

I think this whole year from a macro perspective has been to just hold on and hope with a white knuckle grip that we go back to the 2010’s, because then everything was working the way it was supposed to. We start with taper, and then the data doesn’t cooperate, then we get sticky, and then from sticky, we go to the mini banking crisis. People just jumped on it and they were like, okay, this proves that, rates are going right back down, and we’re going to have a recession by June and it’s finally hitting us.

Since then, it’s been this frustrating realization for people that know, the world really has changed and people need a new toolkit. So that’s why I’m having fun carrying around my portable soapbox and loudspeaker.

[00:06:02] Alan

Good stuff. Before we get into the meat of the topics that you had brought up, I had seen an article on Morningstar which relates to what we’re talking about now, so maybe it’s a good opportunity to talk about it. The article is called “Market Wizards Wave Their Magic Wands But Investors Miss the Magic.”

It’s all about, as you say, I guess a growing appetite for trend following and managed futures, but does highlight some of the challenges investors have in terms of, well, I say timing, but the idea of it should be not to time it, but the fact that investors do try to time allocations to all strategies and assets but they seem to be particularly poor at timing allocations to trend following. Your fund gets mentioned within there as evidence of the growing appetite.

[00:06:53] Andrew

Evidence of filing it and near the top.

[00:06:57] Alan

What was your perspective on it?

[00:07:00] Andrew

Look, I think Morningstar occasionally writes great research pieces and this is one of them. Morningstar are the best guys in the business at looking at this investor psychology issue and what it means for actual realized returns. They have this report they do every year that basically talks about it. So interestingly, the area where it’s always the worst is in anything that looks like a hedge fund. B

The thing to understand about the broad hedge fund industry is that these are very, very profitable products. When you compare it to selling a long-only value factor xyz product, you can charge a lot more for these things. So if you can charge a lot more, you can pay your salespeople a lot more. When you have one of these things that’s doing well, it tends to get an additional turbocharge on the distribution side.

So people go out and the mythology of it taps into it. It’s so ironic to me for something like trend following where you’re supposed to do things that remove you from heuristic biases and other things, but a lot of the marketing the business is built to tap into that to the extent possible.

So look, credit to them for writing it. I think the narrative around managed futures has gone through a couple of shifts. In 2020, the narrative was that it was debt. It had been arbed, whatever the trend opportunity was, like Vamos definition of value stocks, like the small cap premium, all the things. It was an intellectual curiosity, but by the time people really got interested in it, it was gone.

Then 2021 to 2022, remember, back then people were saying the only way managed futures funds make money is by being long treasuries, basically, and all they’ve been doing is riding this downward drift in rates over the period of time. I wrote a little paper back then basically saying that makes absolutely no sense. These guys are completely in a different direction. If it goes in the other direction, they’ll benefit from it. So the first thing that happened was a breakdown of the narrative that the space was debt. But the legacy of it was to try to find the guy who’s going to do much better than everybody else.

The way people do that, because manager selection is a painfully efficient process. If you and I look at the same fund, other than staring into the white of the guy’s eyes and trying to figure out whether he’s doing a good job and working hard, etc., we don’t really have a lot of competitive advantage in terms of information. So he doesn’t secretly tell us that he’s got some great model that he hasn’t told any of the other investors.

So you ended up with people buying back into the space and buying with this legacy saying if we’re going to time it, we’re going to find the guy who only goes up, all that stuff. That’s breaking down. I got to tell you, on my European trip just now and also in terms of dealing with the guys back in the US, if you have a statistical bone in your body, this is a strategic allocation, particularly in this world today.

The problem is that often people with statistical bones in their body are talking to people who don’t have a statistical bone in their body. That’s the next step. That’s the next hurdle. But I think Morningstar hit on something, but I think we’ll look back on this in five years and think they were absolutely right in identifying an issue, but people are smart and they figured it out and they learned.

[00:10:05] Alan

Yeah, it’s interesting. Some of the magnitudes of the numbers are very stark that they quote. So basically the idea of this study is to show what the annualized returns for each of the various funds have been, but then to use dollar weighting calculations to calculate what investors have realized. The gap for AQR’s high vol is 9%. So the total return over three years has been 14% but investors have realized just over 6%.

It goes along the same for Pimco, same for all of them. I think there were one or two where investors actually did better. But it’s interesting that you put some of the blame on the managers themselves and their marketing machines.

[00:10:50] Andrew

I’m gonna leap to AQR’s defense, which may cause some of your listeners to faint. But look, I think AQR has been a very, very, very positive force in this industry. It goes back to 2010. So, before 2010, when they launched AQMIX in the US, the typical model of most hedge funds worth their salt in the space didn’t want to dirty their hands by dealing with the US retail world. So there were firms out there like Equinox, Low Corp, Salient and others that basically said, we’ll do the dirty work, we’ll go around and talk to these RAA riff raff that you don’t want to deal with. You can still have fun with your pension plans and your consultants.

So they put 100 basis point fees on and then they would either set up swaps or other things to pay people their full fees. The argument was, essentially, we’ll be your distribution, we’ll find you other sources of capital, but you’re going to make just as much as you’d otherwise make. So maybe we’ll get you $200 million, but it’ll be in $5,000 increments. But that’s our job. So AQR came along and they dropped a bomb on this business model. So what you had is a whole series of funds that had 300 to 400 basis point expense ratios when you worked through it.

That’s what caused Bloomberg, in 2013, to put out this cover article that says how investors lose 89% of every dollar that’s made in future slots. It was scathing, and from what I understand that it is totally, the SEC kind of hit the ceiling and things quietly changed after that. But AQR came out with an institutional quality product that they ran. What I understood initially is that they said, look wait, we don’t have the time and resources, we don’t need to deal with guys who can put a million dollars into this, so we’ll do it $5 million dollar minimum etc. But they came with an institutional quality product in a mutual fund.

What was not AQR’s fault was that people looking at it said, well, okay, clearly I want exposure to this space. Clearly, AQR are just freaking geniuses that are falling out of the windows of that place. So I’m going to say I want this to be an 8% allocation in my portfolio, I’m going to give it all to AQR. If AQR had just matched what the SocGen CTA Index had done over the next five years, no one would be having the discussion.

It got to $14 billion in assets. It was half of the US mutual fund space. So imagine again if we said okay, in the $3 trillion hedge fund industry, one guy has a trillion and a half of it. Then AQR, as everybody does in the space, went through a frustrating period of underperformance. What happens with allocators at that point, the first thing they have to do is they hold on and they say, don’t worry, it’s going to rebound because they don’t want to say that maybe they were over concentrated, etc. Over time, as the long winter went on, you start to see them shooting it more and more, so AUM’s go down 90%, 95% or something. Then of course, because this business is designed to torture fund allocators, they come roaring back and they’ve had incredible numbers since then.

So the Morningstar stats, while instructive, I think are, first of all, it’s not AQR’s fault if people make that false allocation. I think the fact that they brought that product to market had a hugely positive impact on the business. Third, people have learned from it. I don’t talk to that many guys who say it was AQR and I left AQR back then, but I’m going to put it all with xyz fund today. Everyone thinks about diversification, so people learned from it. But again, these are all the positive stumbling steps forward in this business where it goes from being this kind of cottage industry to just becoming a mainstream asset class that people can decide how they want to access.

[00:14:47] Alan

Good stuff. Well as you said, the upturn of it all is to encourage people to maintain managed futures and trend following as core allocations, core strategic allocations and not time it.

Interestingly, when you’re talking about AQR’s entrance into mutual fund space is possibly a good segue into the first topic that you brought along today. That is commoditization and you say that the CTA business has been on a long and bumpy road towards commoditization. So what do you mean by that? What are you thinking in terms of moderation in managed futures and trend following?

[00:15:29] Andrew

Sure. Let’s talk about it more broadly in the hedge fund industry. So I went into the hedge fund industry in 1994. Stuff that’s easy to do today that people don’t think about was really hard back then. I’m going and I’m trying to buy bank loans, because there were bank loans. You had to hire lawyers to negotiate agreements on a one-off basis. There were guys who specialized in going out and talking to banks, and you would have these kinds of one page write-ups. Super inefficient market.

I did some of the first secondary purchases of a limited partnership interest in private equity funds. That’s a huge $100 billion plus business today. Back then I was going door to door to Japanese financial institutions who had these holdings that they invested in the 1980’s, had no idea what was in it, whatever. I had to do all the valuation work, do all the documentation, etc. So you could buy stuff at incredibly cheap prices by virtue of these deep structural inefficiencies in the market.

Shorting was complicated. So my exposure to the managed futures space was actually, sorry, the broader commodity space was back in the early 2000s when I started a fundamentally driven commodity business that became something called Pinnacle Asset Management. What struck me about the space was that I knew about futures contracts, they’re sort of obvious things that were out there, but I never really thought about futures contracts. In the late 1990s, one of the things that caused the commodity markets to take off in the 2000s was the fact that some academics actually did the work to try to come up with the returns of various commodities, including roles.

You don’t have to think about this in equities. You buy the equities, you add back the dividends you get over time, it’s not hard math. But somebody actually had to do the work of coming up with a return stream. So that and the conclusion that they came to was this is as good as equities with no correlation.

So that was manna for asset allocators in the 2000s, then you had the brick, boom, etc. So the point is that the arc of this business is always toward people finding something that they can do that is esoteric, and then the more and more people learn about it, the more people make on it, the more people invest in, etc.

So to me, I look at managed futures, and I wasn’t obviously in the space back in the early 1990s. But I do remember what computers were like. I do remember what access to information was like. I can tell you, there were not a lot of people in my class at Harvard Business School who were thinking about going and firing up their IBM 486 laptop or whatever the hell they were using at the time, and then trying to pull down futures data and then understanding what trends were.

Consequently, the people who did it made absolute fortunes. John Henry owns multiple sports teams because he was really early into doing this stuff. So the early generation guys got it. But now what’s happened? Now you go onto Twitter, and there are really smart guys who aren’t even in this business who run their own trend following models and debate with great intensity as to whether these are the right parameters and set the right window, exit everything else.

It’s the same thing with GameStop. Who knew about delta hedging of options in the early 1990s and you’ve got people doing it on Reddit. So I think what’s happened with managed futures and CTA’s in general is there has been this long path of dissemination of the information. Not everybody who’s amazing at doing this in Melbourne stays in Melbourne. People leave and they start their own firms. People leave Man AHL and they start their own firms. People who invest in it, learn about it.

So it’s been this long path and that’s a natural and very, very, very positive development for allocators, because the more allocators understand about the space, the more they can then think about how and why it fits in their portfolio. Before I pause, the last thing I would say about it is that people associate commoditization with something negative.

So I think by 2000, if you’d said, I think this space has been through a 30 year path to commoditization, they would say, ah, and that’s my reason for not investing in it. But nobody says, you know what, cars have become commoditized, I’m not going to buy a car, I’m going back to bicycles. Like I’m going to go back to my horse.

What ’21 and ’22 showed was that even with compression of fees, dissemination of information, etc. The space is still structurally the most valuable allocation you can put in a portfolio of stocks and bonds. All commoditization does is put more wind in your sails because it means that pricing comes down, access improves, etc.

[00:20:15] Alan

I think it’s interesting. The word commoditization can be a bit divisive, I think, particularly within the industry. From a couple of perspectives, one is managers will say no, it’s more complicated than that. Equally, back in the kind of the winter for trend following, etc. There was this year, well, it’s all the same, it’s all commoditized. Managers will continue to pick the point, which I think is valid, that it’s not all the same even though maybe it has got a bit easier to do it.

You have to make all of those decisions in terms of what vol, drawdowns, how to allocate your risk, whether to vol size or not, whether to vol adjust, which markets to trade, all of this stuff. So is commoditization the right word? I’m wondering from this perspective if it doesn’t mean that there’s one benchmark yet in terms of this is the way to do it. There’s still lots of varieties of trends.

[00:21:19] Andrew

Sure. Yeah. Look, equity investing has become commoditized. It doesn’t make equity investing, but what it does is it gives you a framework for thinking about, do I want the big easy thing. What is commoditization supposed to mean? It’s supposed to mean, first of all, I don’t have to think that hard to get exposure to it.

00:21:39] Alan

I guess to use the equity example, I’ve thought about this before, you could run a value equity strategy of, say, long the low PE stocks and short the high PE stocks, and that would be as you say a simple, long-short value equity strategy, which would be easy to do now, probably easier than it was to do 20 years ago. It doesn’t mean that that’s the best way to express an equity value strategy.

[00:22:05] Andrew

Right, and that’s why we have massive dispersion. Look, I think there’s a lot of disagreement about what people even mean. I’ve talked about this a lot. Semantically, it’s a very strange space. So we start with CTAs, which is a regulatory term. Nobody says I’m going to set up a business investing in interval funds, so that’s weird. Then it becomes managed futures, which is sort of a repelling expression. Futures contracts scare people. They associate them with infinite loss. Managed is just sort of a cold term.

Then in the mid 2000s, we weren’t really involved at this point but I wrote a bit on it was this idea of really, the big driver of managed futures as a broader category is trend. Banks started to come out saying, it’s not that hard. To do a basic trend model, you do whatever your crossover model is, you pick it, etc.

Now, when we looked at it, we said, actually, it’s a lot harder than that. First of all, if you take 10 quants and you ask them to build a crossover model today, they are going to be within spitting distance of the SocGen CTA Trend Index. The moment they go live, it’s going to be like you, I don’t know, dropped a firecracker in the middle of a room full of cats. All their products are going to go in different directions because of the number of parameters and specifications you have to make.

So one of the ironies or one of the complexities of the space is to get agreements on what we really mean by core underlying trend. Because it’s simple to say, oh, well, trend is the big driver but you do 50 versus 100 versus 250 by 20 and you’re in a completely different ballpark.

So the tautology of it is that there are a lot of smart people doing it on a day-to-day basis. So again, our view is that there is actually no pure easily underlying definition of trend that you can do, because then what you would do is say, okay, no, the real driver is a 250 over 20 moving average, and therefore, that’s the simple one.

When we’ve looked at it, we’ve said, okay, but guys are smarter in this space. It’s working better, and other times, it’s not working other times. They do, as you say, all these various things. So part of the complexity, which I don’t think will ever be solved, is there won’t ever be a one-line formula that says this is trend.

What I would say, having come from other parts of this business, is that’s always true. So the S&P 500 is everyone’s blanket definition of equities. It’s not a great definition of equities because of its market cap weighting, because of its US bias, etc. But what it does is it’s the intellectual crutch for people to say equities and it’s the intellectual crutch for people to say, how would I have done over the past 50 years? That’s where the hedge fund indices come in.

[00:25:07] Alan

Yeah, fair enough. So is that where you see, does that mean the SocGen Trend Index, is what people will refer to as trend over time? How do you see that evolving?

[00:25:17] Andrew

I think so. If you look at when we started in 2016, the trend was not cool, 2015, 2016, sorry. Trend was not cool. Non-trend, other things other than trend were cool at the time. We saw this sort of inflection point in March of 2020 when trend did better, and then trend has done better since then.

So if you look at the guys who’ve been successful and who’ve been raising assets, they rhyme a lot more closely to this clustering of people who do trend. In other words, within the SocGen CTA Trend sub-index. People look a lot more alike than on the other half, on the other side of it.

So what there is, is there’s creeping consensus as to the things that tend to work overtime better, why they tend to work overtime better. So particularly for the bigger guys, at least I think if everyone agrees that we’re all kind of in the same, roughly the same parameters in terms of how you do it. I don’t think you’re going to find a guy in there who’s like I’m doing a five day trend.

The debate is when people say, well, are you picking a medium term trend or a long term trend? First of all, nobody has a precise definition of it down to number of days, but there’s this kind of expectation that that’s probably where the core underlying driver is. But within that, again, because of the complexity (back to your example about equity long- even when you say value), in 1994, 9 guys out of 10 who were somewhat academically inclined would have defined value as low price to book versus high price to book. Zero guys will tell you that’s value today. They’ll tell you it’s cash flow, it’s price to revenue.

People keep changing their doctrines over time. But the reason this is really important is because there’s never a perfect definition of any asset class. But what you need is a broad agreement that something is sufficiently representative of it, that you can get comfortable with the predictability of it given certain risk return criteria over the coming 10 years.

So part of the issue was single manager risk, and the Morningstar study where we started this, is that a lot of the capitalist business is tremendously confident of what’s going to happen over the next 10 years. They have no idea what’s going to happen over the next six months, but they feel very confident telling you what the relationship is going to be between the S&P 500 and non-US equities, etc., etc., etc. They’ve got all that mapped out. It doesn’t mean they’re accurately doing it, but it’s a timeframe of what they’re talking about.

So when you go to a strategy like this, they want to know that what they’re investing in is going to have some predictable relationship to those assets. The reason is because they have to. It’s how their business is. If you’re a fund selector, you can’t come to the conclusion that there are no funds you want to buy.

If you’re building model portfolios, you have to come up with the best way that you can to think about how to construct a high return relative to risk portfolio for your clients. In order to do that, we’ll always do these heuristic shortcuts to get to it. So I think the miniature space is heading in that direction. So for me, commoditization is, I recognize it’s an inflammatory term, but it’s really about reaching some sort of a consensus as to what we like about the space and what we find predictable.

[00:28:55] Alan

I hear what you’re saying, and I think I recognize and agree with the broad thrust of how that is evolving in a marketplace. I guess the other point you might say, in terms of the commoditization point is a lot of the value maybe a lot of managers add is in knowing how to to run and continue to run a trend program.

As you say, it’s easy to, maybe easier at least to mechanically set it up. But maybe a naive investor might be tempted to re optimize the parameters every year. Whereas a more sophisticated trend follower knows not to do that and knows more about what are the thresholds in terms of statistical evidence to make the changes, etc.

[00:29:37] Andrew

By the way, I don’t, by any means, mean that if the information becomes more broadly disseminated, people know how to use it well. Even brilliant quants who’ve designed trend following models that they thought were simple have hit the windshield sooner than you could possibly imagine. So I’m not at all suggesting that people can’t and won’t make mistakes, that there won’t be a lot of dispersion. Look, two different value guys can look completely different. It’s just the nature of specifying parameters, you could end up with very, very, very different results.

[00:30:10] Alan

No, fair enough. But it is certainly true that we have seen this evolution of the industry from, you talked about maybe if you went back 20 years ago, or even back to 2010, most managers had their flagship program, and then we had, as you said, the entrance of AQR under the growth of the mutual fund space and then managers maybe having two products. They might have a management fee only product or program and maybe the flagship.

Now we’ve seen the further evolution of space obviously with the growth of ETFs. So you can have a manager with a flagship and a mutual fund and an ETF. I think Man AHL has just launched a trend following ETF to complement their mutual funds and their other offerings. So how do you see that evolving? What’s the implications for investors and allocators, do you think?

[00:31:01] Andrew

Well, first of all, hey, America and Man AHL welcome to the sandbox. We are absolutely thrilled to have you in it, because the challenge, we’re on the cusp of a billion dollars again. We got a billion till we went down and now we’re back up. So we’re between one and two basis points of the ETF world. This is a greenfield opportunity.

AlphaSimplex, if you’re listening, please join us. The job here is to convince those trillions upon trillions of dollars of assets as to how valuable this is. People have often asked us why more people don’t do what we do. Usually, the answer is that they, a competitive dynamics issue called commitment. The guy who wrote the book on I wrote it in the, I want to say the mid 1980s. He was a professor at Harvard Business School, MIT public Ghemawat, and what he basically said was, you make a decision today and it has all sorts of implications over time. You can’t easily unwind decisions once you make them.

Look, I think a lot of people have looked at the same trends or issues that I’m talking about, if you come from a world of 1.5 and 20 or whatever it is in their flagship funds. They can see opportunities, but if they do something that’s too close to their existing products, they fear cannibalization. So hats off to Man AHL and to American Beacon first for coming in with a mutual fund that’s, yeah, I think they’re 150, 170 basis points or something, but a great mutual fund, a world-class product that people can buy in small increments, and now they’re coming into the ETF world.

The challenge that they’re going to face, you would think, okay, the theoretical challenge they’re going to face is, as I understand their business, they’ve got four types of products. You’ve got the evolution product at the top, which last time I looked, the numbers were incredible, you’d pay anything to be at it, it was capacity constrained, all sorts of other things. Then you had the core hedge fund product. Then you had the mutual fund, which was a simpler version, essentially, a more constrained version of that, and then you had the ETFs.

So the very, very best thing for Man AHL is in five years from now is that the most expensive product net of fees does better than the second most expensive product is better, the third most impressive. And so the fear that a lot of people have on cannibalization, I’m going to come back to why I think it’s completely overstated, is that you’re going to have investors who are going to say I’m pulling money out of the diversified fund to go into the ETF and that’s going to be negative for Man NHL from a revenue perspective.

I think 95 times out of 100, that won’t happen because people invest in funds that they like for various very different reasons. The people who invest in, even coming back from Europe, when I talk to people, they view UCITS funds, and Man has a great UCITS fund that certainly can’t say a billion dollars and it certainly doesn’t cannibalize the rest of their business. But they view UCITS funds as inferior, watered down. If they can on behalf of their clients, they’re going to go into the hedge fund because it’s better for them. They’re not paying the fees. Their clients are paying the fees, but it’s more prestigious for them to go to the hedge fund.

I’ve met with allocators who bought into Man AHL 15 years ago, they’re still talking about today as evidence of their intelligence and sophistication. So the ETF world versus the mutual fund, there are always going to be these bifurcations. Now, there are going to be a lot of people out there who run ETF-based model portfolios. They can’t buy the mutual fund to begin with. They’re going to look at it and say, my God, we have one of- probably or arguably the best player in the world. Among the handful of best players in the world who are doing this is now offering it an ETF.

Now what it would be fun to see, from a product construction perspective, is how far they felt they needed to push it away from higher margin products, because it’s 95 basis points, which is not cheap in ETF land but it’s obviously a lot less. So out of the gate, this thing flew up in one to one. It was up between like 8% and 9%. Everybody did well, Man’s mutual fund goes up half that, then we have a couple of bad days, it comes right back down. I think you mentioned it was a 15 Vol.

So the really interesting thing, from a product construction perspective, are they trying to give you the mutual fund with an ETF or is there a commercial incentive to keep it sufficiently far apart that people will view them as distinct products? I don’t know, but I’m sort of dying to watch how this plays out.

[00:35:47] Alan

Well, it seems to me, obviously, as you said, the higher vol, obviously, the clear line of demarcation is in terms of the number of markets. I don’t have the data for products at hand, but I imagine that a mutual fund trades 60 to 100 markets, and this is trading I think maybe 20, and then obviously, as you say, flagship and evolution, you’re into alternative markets.

[00:36:11] Andrew

This goes back to the stuff that we’ve done. How awkward is it going to be if 30 does better than 70 or 30 does better than 100? Again, we’ve looked at that issue.

So where the industry should go is that if there was sort of rational allocators and rational business, we would say, all right, we’re not going to pay you much for the 30 over here and you’re going to run a much more expensive product over here for positions 31 through 70 and we will pay even more for 71 through 150 or whatever. But it’s not rational, right? Because the moment you make that decision, you as an allocator, say, I’m going to buy the ETF because it’s cheaper, and if that does worse than the mutual fund, you could have bought, it’s your fault. You made a mistake.

[00:37:02] Alan

But it really seems to be more of a case of, is this case market segmentation in the sense that there are dedicated ETF investors who have to invest in ETF structures and are willing to accept that maybe the product isn’t perfect. Maybe it’s not the managers best product, but the benefit of being in an ETF structure outweighs that. Is that how you see that kind of ETF marketplace?

[00:37:32] Andrew

I think so. Look, I think also the ETF, that’s our focus. That’s why we did an ETF. My job is to convince Man AHL, PIMCO, etc., their job is to walk in and explain why they’re better than the last guy who just came in. Right? They have an audience on the other side who has statistical wiring in their brain, they love the strategy. The question is, who they’re going to invest with and how much?

The hedge funds in the ETF is almost a derogatory expression. Anybody in the ETF world who said, I am going to get out of my S&P 500 and xyz bond allocation in order to invest in something that sounds cool, is regretting it years later. So there’s a huge bias against doing it.

By the way, the ethos of people on the ETF side, if you’ve climbed up the rungs of a firm that builds ETF-based model portfolios, you haven’t had to build the skill set to be able to evaluate Man, AQR, etc., because there have been no good options for you to do so.

In general, people don’t know what futures contracts are. They assume futures contracts go to zero. We got asked the question to do due diligence about, I guess we’re short the two-year treasury and the due diligence question that came back was, what if the two year treasury goes to zero? Right? What do you mean? If the price goes to zero, we’re rich. If the yield goes to zero overnight, it’s a huge problem but we’re probably using whatever we have left to buy bottled water and head into the woods.

It just shows you the education side of it that we’ve gone through years and years ago on the US mutual fund side. In large part, I think Europe is going through it now but in a somewhat delayed sense. People think cheaper is easier or obvious. It’s not. Because if you go cheaper and it doesn’t do as well, you can get blamed.

The whole fund selection business is what’s the scenario when I get blamed for making a bad call. If you buy the ETF and the ETF goes down 30 but the mutual fund is down 8, that’s a huge problem. So I’m sort of curious about the higher vol of the ETF as to whether that’s factored into their thinking.

[00:40:01] Alan

I have heard the argument made that active ETFs are going to be the big growth going forward. Obviously, all of these are active ETFs and passive ETFs obviously being just more index products. Why is that? Can you explain why do people say that active ETFs are going to displace mutual funds? Again, is it just ease of use or are there more structural reasons for people suggesting that?

[00:40:29] Andrew

Well, part of it is it’s super boring to cover the slow undulations of the asset management business, so people describe things with great hyperbole. I mean, come on, there’s $20 trillion of active mutual funds and a couple 100 billion, it’s not even in the same category.

By the way, there have been a lot of false positives and people that are active ETFs were going to take off years ago and they didn’t. Ark kind of broke the mold on the disruptive tech side. JP Morgan and a handful of other guys who’ve done these outcome-oriented products have been breaking the mold. One thing that ETFs do have, first of all, at least in the US, there’s no tax efficiency, there’s no reason why you would necessarily want to do an ETF or mutual fund. Some guys really liked the transparency.

So we in a sense, I don’t know, maybe got lucky or something in that because our portfolio is simple. If you look at our portfolio in the morning and then you look at your Bloomberg Terminal at two o’clock, you’re going to have a very good intuitive feel as to whether we’re up or down. The positions that we have are going to look pretty obvious to you. If the Yen is going down, we’re probably short the Yen. If crude oil is going up, we’re probably long crude oil.

So how people end up using that with a lot of these things, it’s a tool that you can use badly. That goes back to the timing issue. If you say, like in 2022, if you said these guys are short equities and I think the markets going to fall apart in the next month, and therefore, I’m going to add this as an allocation, my read ratios, first of all, don’t do it because our positions today might change. But rather, I think it’s a lot of just the comfort that people have in being able to see it. They feel like it’s less likely that they’ll have these blow ups.

Now, when I glance really briefly at Man and KMLM, Mel Lucas has what I think is actually very good; it’s an index based product, but it’s their index so it’s this kind of circular thing. It’s like having an index of my own stock picking. But the portfolios are more complicated. I think there’s just sort of a mathematical limit to where you can look at a portfolio and feel like you have an intuitive feel for it without having to say, okay, well, that’s where they are oil, but what about natural gas? And what about this? And what about that?

[00:43:03] Alan

Is that transparency, just from that perspective, the value of it just said, oh, we know if it’s going to be up or down when we look at it later on that day or are people using the transparency of positions to feed into their overall portfolios and then be more tactical from that perspective would you say?

[00:43:20] Andrew

Here’s where I’ve seen people use it well. I always tell people, the biggest mistake you make in managed futures is going to zero. In June of this year, you decide that the great inflation trade is over, may or whatever inflation trade is over, everyone had a bad first quarter, and we’re getting out. How do you get back in?

Well, then it goes up 5%, so you get more confident. Okay, but now, have you missed it. Now what if you’re the guy who buys it up 5% and then it reverses and goes right back down? Now you’ve compounded your problem.

So what happens is when people get out, they kind of secretly hope the space doesn’t do well to validate their decision to get out of it. They won’t get back in, they’ll fight getting back tooth and nail. I’ve seen people do this with stock and bond portfolios where they’re like, we’re terrified of what’s going on in the economy, sell all of our stocks. Good luck getting back in. you’ll be tortured for two years trying to figure out what the right moment is.

Where I have seen it useful is in the following way. Underwriting funds is time consuming. It takes a while to get comfortable. So you’re an investment advisor and it’s early 2022. Whether you intended to or not, you’ve got a low rates bet across your portfolio. You are way overweight tech stocks as they’ve done better than everything else. You are long all of these bonds under the assumption that rates are going to go up again. So now you start to get nervous. It is extremely hard for that person, for the same reason, for the person to say I’m carrying on my playbook because of an inflation print that comes out in January, or I think the Ukraine war is going to drive commodity prices through the roof for the next 10 years.

Those big macro calls, If you get it wrong, you’re out of business. So how do you address it? One thing you can do is you can say, well (this what people do broadly), I’ve got a 60/40 portfolio, I’m going to 58 and 38, and I’m going to 4% cash right now, until I wait till things are better.

So one guy that I know did something really clever. He said, I can’t really get out of my bonds, because if I get out of my bonds, even though I’m worried about it, what if I’m wrong and sort of raise the issues? He said, but I’ve got this ETF, if I can see the positions this morning. They are? Surely the Treasury curve, yeah. They’re long commodities. We were long crude oil at the time in the first quarter of last year. So he said, look, and I have it in my portfolio anyway. So just at the margin, I could take it from 5 to 10 and essentially derisk part of the other 90% of my portfolio without going to cash.

You’ve got to be playing at an A level to do that. This is not a do at your home kind of thing, because you’ve got to really understand the dynamics of managing it. But that’s the power of the visibility of the underlying portfolio.

[00:46:27] Alan

Okay. So it sounds like you see the ETF space here to stay in terms of managed futures and trend, but obviously, you’ve just been back from Europe and I think it’s probably fair to say the UCITS market and that kind of liquid alternative space in Europe, for want of the better expression, has been slower to evolve? What’s your sense on trend, managed futures within the UCITS category?

[00:46:52] Andrew

I wish I knew. Look, if I have one skill set, it is a dogged pursuit of disparate pieces of information and then forming some sort of a mosaic and then testing whether that’s reasonable or not. It is so hard to do that in Europe. Because the more I learned about Europe, the more I realized that using the Spanish private banking market in the same sentence as the wealth management market in the UK and the xyz market in Germany, these are, well, they’re different countries, they really are.

So when we talk about UCITS, at least in the US, I can draw analogies between Texas, California and New York, even if maybe not on political grounds, I can draw it on economic and industry structure grounds. My general observations about Europe is that they’re pushing toward moving to model portfolios, but they’re still learning and digesting the lessons that we went through a decade ago in the US.

So again, AQR is a phenomenal example. People assumed AQR could do no wrong. It was their favorite thing to own. It was the obvious allocation. It did worse than they expected, maybe not that what, as an answer, those guys would say was sort of a normal spectrum of outcomes, and then they struggled with it for years and how to explain it and did it mean that they were bad allocators.

Europe, I think, is still, it feels more like a story driven market to me. So what I see is among the more statistically inclined guys who are building model portfolios, who are kind of more sophisticated guys doing fund selection, we completely see eye to eye on the benefit of trends, managed futures, etc., as an asset class. Getting it from there into the portfolio with a language where the adviser who actually talks to the client and where it ends up in their portfolio, that I think is more of a struggle in Europe than it is.

I think part of it is that in Europe, Europe’s response to the hedge fund crisis of the GFC was a bit different. There was much more fraud. European fund of funds were sometimes much more up to their gills in Madoff. It was a 10-year hangover from that. So on the one hand, a lot of firms jettisoned the idea of investing in hedge funds at all. But those that do for a reason, it’s a little bit paradoxical, I’m not sure I understand why, I still think you should only invest in the hedge funds themselves. Part of that is that UCITS constraints are a little bit trickier. So if you look at PIMCO’s mutual fund versus its UCITS fund, you’ve got a four-legged horse and a three-legged horse.

[00:49:58] Alan

So no commodities.

[00:50:00] Andrew

No commodities, right? When we first started doing it in 2015, in a UCITS fund, sort of a multi-strat product, we didn’t use commodities. Our entry back into it is UCITS. So again, the market has evolved where it’s easier now to use commodities, but it’s still complicated and expensive.

So I think there’s this sort of combination of the messaging, the belief that UCITS funds are, by definition, you’re not going to have a great experience investing in UCITS funds. A lot of them are smaller and scale becomes a real problem. If you’re a multi-billion dollar investment advisor in the UK and you’ve got a 20% limit on how much you can own and you can only put 80 to 100 million, it sounds like a lot to us, but for them, it can be hugely problematic because it doesn’t even move the needle of your portfolio. So like the stories that say sometimes it’s easier to invest in a large global macro fund than it is in managed futures. I’m still figuring it out.

[00:51:01] Alan

You’re still figuring it out. Within Europe, you can have a UCITS ETF. Isn’t that correct as well? But your product, it’s a UCITS.

[00:51:10] Andrew

We’re straight old fashioned UCITS. Yeah, so ETF, one of the great irritations of ETFs is that people, UCITS funds and mutual funds are just easier, and that if somebody wants to put $5 million into it, if somebody says the NAV at 4pm was $30 and you give them money and you get it back at NAV. The complication of ETFs, even under easy circumstances, is that you’re buying these things in the market.

A lot of people who are making the allocation decisions are not really traders. They’re not thinking about things like, oh, we’re going to work the order, and my God, nobody puts in a limit order, nobody puts that in a market order 3:58pm on Christmas Eve.

So when we looked again at the architecture of the European market, we could see that people were having struggles with this, depth of the liquidity to ease of trading. It’s hard enough to explain managed futures and why people should have it without having to go down and adding complications on the liquidity side. It was a real issue for us in the US until last year when things kind of coalesced and came together.

[00:52:25] Alan

Okay, so maybe wrapping all of that up together, and also bringing into perspective of fee and fee structures, how do you see that? What do you think the landscape looks like over the next number of years between ETFs, mutual funds, or UCITS, private placement funds? How do you think investors and allocators will view all of those distinct categories and give reasonable fees in each case?

[00:52:50] Andrew

I think it’d be all over the map. Institutional investors are very, very much, I should say, a lot of institutional investors are of the view that one of the ways they can drive value on the allocation side is by beating up people on fees. No question.

So I go to a large allocator in the UK and they look at something like the net of fee returns of the SocGen CTA Index which is generally after the normal headline fees, and they think we’ll beat that just by swinging a big bat. I think people will push toward incentive fees. They’ll drop their management fees and load up on incentive fees.

You cannot do that in the US. I’ll come back to that in a sec. But in Europe, what you’ll see are more UCITS funds with very, very low management fees but incentive fees. And it’s a bizarre quirk that when in the wealth management business, which tends to be very fee sensitive, people will tell you what the management fee is, what the headline management fee is on your client report or when they calculate your own costs. But whenever there is a performance fee, it’s like an asterisk. Well, we can’t calculate it today, but it’s going to be something.

There’s a psychological thing that people feel like if they’re making money when we’re making money, it’s okay. They hate it when they’re making money and we’re not. In the US, you can’t do that. So basically, you cannot have incentive fees in US mutual funds or ETFs, so you’ll see more competition, probably on the management fee side over time if it follows other parts of the business.

If that happens, it’s going to happen in a world where you’re getting a BlackRock coming in. BlackRock is turning their models and making managed futures a 2% allocation across and Vanguard’s doing the same thing. In which case everyone is going to be making so much more money on size than they are on an incorrect dollar. So that’s our bet, basically.

[00:54:57] Alan

The question that does come up then in relation to that is capacity. Is that a concern if we move to that kind of world where things are getting more widely embraced and, as you say, people are managing larger amounts at a smaller margin?

[00:55:13] Andrew

I don’t think so. You guys are going to have people on this who are going to be more, probably, granular in the weeds on this than I am. If $100 billion comes into the space and everybody decides that heating oil is their favorite position, okay, that’s not a good thing. By the way, it’s all doing ETFs, then there’s going to be an entire industry that’s going to spring up to front run these guys if they can figure it out, they’ll recreate their bodies. This is what happened in the commodity space in the 2000s.

Again, I mean, the way we look at it, and it’s just sort of a different construct, is we think 70 or 100 instances, whatever, they’re only going up or down or sideways, and when they do it, they tend to move in clusters. I don’t think volatility in the markets is going away.

In a sense, I do think that the Fed put was this pernicious force you couldn’t figure out why it was to two decimal places, but it was this pernicious force for trend following because they didn’t want things to trend too far in either direction. How that played out is obviously very subtle.

So when you look at what was driving returns last year, it was all interest rates were moving. The dollar was going up against pretty much every currency, all commodities were going up for a period of time, equities were going up or down. So I still think managed futures is a drop in the bucket.

By the way, Man, on their ETF thing, has this great little three minute video on trend. We already talked about the drivers of trend. I think it’s slightly different and I think it’s because I spend so much time with allocators. My view on the reason Alfa generation in trend strategies is so lumpy but massively punctuated in a year like 2022 is because even if everybody knows that the world is changing fast and they need to change their portfolios, they’re still not going to because there are always false positives that the world is about to change, and if you buy into it, you’re out of business. You de-risk and the markets don’t go down.

So when you look at something like the inflation trade, to me, it played out in lockstep, which was we start to see the evidence come back in early 2021. Druckenmiller comes out and says, there’s nothing in the data so far, but I can see these different things converging so I’m assigning a higher probability than zero. He goes out, he shorts treasuries, he goes and buys commodities. I think he also bought a Yen, which I don’t think worked. And then the evidence starts to come back. But every allocator, who had built their portfolios, who has had success by being in this low rates world, they cannot move until the evidence is so blindingly obvious and everybody is moving in lockstep with them.

As the world moves more and more and more towards model portfolios and long term asset allocation decisions, which is the right thing to do most of the time, then the need for something that is nimble, totally indifferent that it was long one position now, and that can flip back and forth without fear of being embarrassed in front of its clients. Can you imagine if these were discretionary macro traders? You’d be like, you’re insane, like you’re this emotional, crazy person who’s just following what the latest trend is. But it turns out, it works really well. Part of the reason it works really well is because even if they agree with you, they can’t put on the trade. So I don’t think it’s going away. I think that’s why 2022 happened.

[00:59:02] Alan

Very good. Well, we’ve run out of time more or less. One thing I wanted to get your perspective on before we wrap up. The FT had an interesting article just today called the Alpha of Ugliness, it says, but beauty gets the flow, highlighting apparently some research suggesting that less attractive fund managers, hedge fund managers, are better, but more attractive are obviously better at raising assets. So any comment on that?

[0059:28] Andrew

Yeah, well, you know, I mean, what a clinical we. Thank you for sending it over. We read it with great interest, and we’re immediately trying to create an AI version of ourselves. So let’s grow the hair back. I’d like to, wouldn’t we, would I be a little less pink. Thank you very much. I think we’ve done okay on the return side.

I’m a huge skeptic of a lot of these studies when they say we’ve isolated for this factor. Okay. Sure. But on the other hand, I can tell you there’s a ton of evidence in business that looks at and do matter a great deal, whether you can make the inverse, there used to be a running joke about private equity Titans as to why they were so small. The average height of the great private equity Titans was well below that of an immediate person and the assumption was like they’ve got a short man’s complex and therefore, they’re all going to be billionaires. Okay, maybe, but on the other hand, I don’t know, they weren’t spending their time playing football.

[01:00:36] Alan

Exactly. Well, that’s one debate I’m sure will rumble on. So Andrew, thanks very much for joining us today. It’s been great fun speaking.

[01:00:45] Andrew

My great pleasure as always. Thank you so much.

[01:00:47] Alan

Not at all. So from all of us here at Top Traders Unplugged, we’ll be back soon, so stay tuned and take care.

[01:00:55] 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.

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