Bonds: The Voldemort of Asset Allocation ft. Andrew Beer

[00:00:00] Intro

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

[00:00:23] Alan

Welcome back to the latest edition of Top Traders Unplugged where each week we take the pulse of the markets from the perspective of a rules based investor. It’s Alan Dunne, here, sitting in for Niels who’s on his travels again. Delighted to be joined by Andrew Beer. Andrew, how are you?

[00:00:37] Andrew

I’m great, thank you. Thanks for having me on.

[00:00:40] Alan

Not at all, no. Delighted to chat. Always interested to hear your perspective. How are you? I think I saw, on LinkedIn, you’ve been doing a lot of travel of late.

[00:00:48] Andrew

Well, actually, I was in Copenhagen a month ago, and then Stockholm a week ago, and then I go back to Copenhagen in a couple of weeks. So, actually I have to stop in Miami next week. But by my standards, actually, it hasn’t been too bad. I’ve been trying to stick around home more. Yeah.

[00:01:04] Alan

So you’re back on home soil for the election, I guess. So, a lot of excitement around that.

[00:01:09] Andrew

Yeah, it’s going to be interesting. Something to talk about.

[00:01:13] Alan

Absolutely. Well, we’ll get to all of that market moving stuff in a bit. I mean, we always kick off by asking guests. Anything particular on your radar? So, what have you been focused on in the last few weeks that’s been interesting?

[00:01:27] Andrew

Well, I mean, I think we’ll talk about the ugly whipsaws that have been going on in the managed futures space. But now look, we have the election coming up next week and I wouldn’t say I’m optimistic about it, but I don’t have a sense of hysteria that a lot of other people around me have about it.

And I think whatever happens next week, and it’s likely to be… You know, unfortunately, I don’t think it’s going to end on Tuesday. I mean, we could be talking about this stuff for a year, basically.

But if you just take a step back, we are a democracy, right? People are fighting over votes and counting votes. There are not tanks in the streets. And so, when people get hysterical about the end of democracy…

I know a lot of people who’ve gone to serve this country in the military. I don’t know a single one of them who, for political reasons, would consider upending the constitution. And so, at the core we are a prosperous country where people have a lot to lose. So, I think we’re going to come through it okay.

And there have been some editorials that have been written by somebody named Peggy Noonan at the Wall Street Journal, who I find incredibly thoughtful, basically saying that, yeah, look, we’ve been through a civil war. You know, we’ve been through Vietnam. We’ve been through many, many, many, many very difficult things, and what’s being sort of lost in this is the commonality and the general goodness. It’s just being drowned out by these kind of two lunatic fringes on either side. But I think we’ll be okay.

[00:03:06] Alan

Good stuff. Well, that’s an optimistic perspective. So, we’ll see how it all plays out.

[00:03:11] Andrew

By the way, if I do this as a Twitter post, it means like all hell’s going to break loose tomorrow because I have an almost perfect record of calling things the wrong way when I do something.

[00:03:22] Alan

We can fear the worst. If you are truly a contrarian indicator, then that’s a worrying sign. But we’ll see.

So, we do have a question. But maybe before we get to the question, I mean you touched on whipsaws in markets. So, just to recap on CTA performance, it has been a tricky month, at least.

So, as of the 30th of October, so, obviously excluding the last day of the month, The SocGen CTA index was down 1.97%, SocGen Trend was down 2.8%. And year to date SocGen CTA was up 0.5%, and SocGen trend was down 0.6%.

But yesterday was a tough day for trend followers and, as is always the case, the last day of the month comes to bite many managers, and it was definitely a negative day. So, we will see more downside on the index when the final numbers come through.

And obviously it’ll probably push the CTA and the Trend index into a negative number year-to-date. So, it is turning into a difficult year. I mean particularly when you’re considering there is the cushion of interest rates built in there.

So, any thoughts on, I guess in terms of attribution? Obviously at the last day of the month there was equity reversals. But earlier in the month we had whipsaws in fixed income. What’s your perspective been on the last month and the last few months?

[00:04:49] Andrew

Well, I would extend it back a little bit farther, which is that I think the… So, you know, I’m always interested in kind of the shifts in narrative, in this space, and often it kind of evolves around what’s been working. I’ve talked about it a little bit with Niels on these podcasts.

You know, when we first looked at replicating the space back in 2015, 2016, it’s not that trend was dead, but there were commoditized products coming into trend and so people tended to want to emphasize things that were nontrend. And yes, we’ve talked about Winton and their push into other areas. We talked about, you know, the popularity of things like Millburn and their machine learning and countertrend things like FORT. And then, kind of the unexpected happened, which is in March of 2020 actually, trend did best.

And you know, you take a fund like Pimco’s mutual fund in the US, and it may have been also the rate side of it as well. They may have had some duration in it, but Pimco does well in March. And then the trend guys, by the end of 2020 and the end of 2021, the trend guys are outperforming again. And then 2022, obviously, that’s a really good market for them. Trend guys do better in 2022.

So, by the end of 2022, I think the, you know, the general view was okay, well the real drive for the real source of alpha generation (and I believe this over time, for reasons we can talk about) is medium to long-term trend. If you had to identify the beta, the driver of returns in the space, that’s kind of the sweet spot.

And then if you look at the past 18 months or 24 months, it’s as though the market gods designed a market regime to annoy the crap out of anybody doing medium to long-term trend. Because the oscillations are timed almost perfectly that by the time you start to love a trade, Powell opens his mouth, or the bank of Japan does something, or you know, the Democrats do their bait and switch with Harris and it all of a sudden is working. And so, I think this year just has to rank among the most frustrating years.

Things were working so well for a number of months and then, thank God the industry had gains to give back. But I think this is going to provide a lot of fodder for the, you know, just tons of investors who are broadly critical of, and have this sort of deep seated dislike of the CTA space and trend following, and for reasons I think we can talk about.

So, look, I think it’s going to, you know, certainly cause a lot of debate and living through it, it’s just unbelievably frustrating.

[00:07:25] Alan

Yeah, absolutely. I mean, it is interesting, and I think about it myself, if we were to go back two years, more or less to the day, you know, end of October 2022 or even end of September, you know, CTA, I’d say the five year returns on the index were probably as good as they’ve been.

And you look at the macro environment and you say, inflation is back, more volatile inflation, more volatile macro conditions, rising rates. It’s a perfect backdrop for CTAs and managed futures, you would say. But it just shows you how hard it is to translate a macro picture into performance. It’s just that that performance will come when it comes and it’s…

[00:08:04] Andrew

Well, and look, one of the great things about the space is they get out. They don’t hold things with a white-knuckle grip. And there’s a coldness and a rationality to it. If it’s not working, you know, don’t pretend the markets are wrong, just listen to the markets.

But because of the nature of the oscillations… So, I was writing about how we were positioned in July about being long the Trump trade. And you get to kind of the middle of July and the guy survived an assassination attempt, seeing people think it’s going to be a red wave, and they think it’s going to have three impacts on the market: It’s going to be good for equities, it’s going to be bad for bonds because of tariffs and deficits and everything else. And it’ll be good for the dollar, you know, taken together.

God, I wish we’d held those positions because, looking at the markets today, you’re like, oh, you were so right. You had it. And the market was telling you exactly what was going to happen. And then there were these like, you know, crazy macroeconomic variables.

Nobody on planet Earth thought… After that they thought Biden was going to stay in the race because he had this white-knuckle grip on the race. And then they swap out Harris. Nobody thinks that’s going to work well. And then it works better than anybody expected. And then the bank of Japan comes in and decides…

There’s this great quote on Zero Hedge, which they were talking about the bank of Japan. They said if, you know, whatever is the worst possible decision that you can make at the worst possible time, they’re going to do it. So, they basically set the macro world on fire for a couple of weeks, you know, and then the economic data came in weaker.

And all of those turned out to be head fakes. But, as you know, when you’re in the market and you’re on the wrong side of it, it’s so frustrating.

[00:09:56] Alan

Yeah, no, it’s, it has, you’re right, it has been choppy. I suppose, as you say, if you went back to July, you had the Trump trade, and you had fears of recession however many months longer, you know, so you’ve had that kind of up in the narrative.

[00:10:11] Andrew

To add one thing to that, which is that we’re all very narrowly focused on how annoying it is in the managed future space and the CTA space. Imagine if you’ve made big bets on bonds. I mean, talk about guys there who in early 2020, it was early 2023, it was, this is going to be the year of the bond. You know, rates are going to go down here.

Then rates go up for a period of time, then SVP happens and rates are going down, but for the wrong reasons because we think we’re going to have a global banking crisis. Then rates come climbing back up again. You’re underperforming cash again. So, it’s not isolated to this space, but we feel the sting on our cheeks a little more than other people do.

[00:10:56] Alan

We certainly do. I mean, it is, as we’ve said many times, it’s not the easiest strategy to hold. And this is another year that has definitely proven that to be the case.

So, moving on. I know. I mean, you did mention you were on your travels in Europe, in Copenhagen, and in Sweden, I think you said. I know you participated in an interesting roundtable with all the great thinkers in the manage future space. So, tell us about that. Were there any notable insights coming out of that?

[00:11:35] Andrew

Well, look, I was incredibly grateful to be invited.

[00:11:39] Alan

For our audience it was the Hedge Nordic event. Is that it?

[00:11:42] Andrew

Right, yes. And yeah, so Hedge Nordic and apparently, and I was learning this as I went because I’m always kind of trying to catch up with everybody else. But apparently, every year Hedge Nordic has done these great roundtables where they assemble these luminaries of the industry, and they talk about things that are going on and broad industry trends. And being as typically uninformed and out of the loop as I am, you know, I got invited to this.

It was interesting in that you did have luminaries there from Lynx, the local hometown hero in Stockholm, Katy Kaminsky was there from Alpha Simplex. Aspect was there, Transtrend was there. And then also you had some ETF people. So, I was there and, and Jerry Parker was there, and a couple of other people.

And it was just, it was really interesting. First of all, everyone was incredibly nice and incredibly gracious. I felt a little bit like, I kept making these kind of jokes about having my back to the wall and stuff like that. And I think they all kind of fell flat. I think they were like, you know, please stop.

But it confirmed a lot of the research that I’ve done about the architecture of the space, which is that the big players in this space are in a very, very privileged position in that they have great longstanding relationships with very serious, very sophisticated investors, and their businesses. I mean, no one from Man Group was there. But I have a friend of mine who’s very senior at Man, and he was describing to me, about a year ago, he said, you cannot believe how much of our business is solutions based.

And I think the reality is, if you sit back coldly and you say, you know, what’s going to work well over the next three years (Is it alternative markets versus traditional markets, short term versus long term, you know, are there other statistical things you can, you can layer into it?), it’s really impossible to feel like you have an edge in making that call.

So, what I think the industry has largely evolved to is that we have these sophisticated investors who see the value of the strategy and, ultimately, they want to work with people who are both asset managers, but also solutions providers that have ideas in terms of the exposures that they want to get, the research that they want to get.

And I use an example, actually, in it about Bridgewater, in that, in one of the ways that Bridgewater was able to develop such strong relationships with CIOs of pension plans all over the US, and sovereign wealth funds, et cetera, was that they had a huge part of their business that was purely about providing research and supporting these people. And so, going into it, my view was that there is this loyal, stable core of institutional allocators. And in hedge fund world, you’d say it’s about 300 billion in assets. And maybe you get into more of it when you layer other things into it.

But, but there’s this very, very powerful relationship and dynamic that often goes back a decade or more. And I said that’s really valuable because the person sitting on the other side of the table, the person who’s making the allocation decision, they have their own job to do, they have their own committee to serve, their own messaging around it. And in a sense, there’s this very symbiotic relationship around it.

You know, on my part, I try to do the same thing, but to the rest of the world. In that, when I’m talking about what we’re doing on the replication side, it’s very specific around the feedback that I’ve gotten from people about things that they’re trying to solve in their portfolios.

Now, we’re not trying to solve it for people necessarily on an investor by investor basis, but if 30% of model allocators say (and I can get them to open up and talk about what they want), they say, boy, I really wish we had something that could do this. Then that gives me somewhat of a window that, given the heterogeneity of the investor base (everybody’s got different constraints, different criteria, et cetera), to try to be very targeted about how we can build something that meets the needs of a particular constituent within it.

And that’s why all the discussion about cannibalization, and everyone always asks these questions like, you know, what if you take over the industry? And like there’s no in indices to replicate or whatever. It’s always kind of an absurd question to me because if the whole metric was, is it better to own the S&P P500 versus taking a shot at picking long-only active managers? You would have picked the S&P 500 20 years ago.

But, but people don’t. They want to talk to people who are picking stocks. They want to understand what they’re doing. They like the insights that they glean. It’s often part of their job description is to find that.

So anyways, I found it unbelievably interesting. And then of course I was going all over Stockholm meeting investors, which was, you know, seeing the other side of this as well.

[00:16:49] Alan

Interesting. I mean, what you talk about in terms of those deep relationships, obviously, you’re alluding to largely the institutional space. And then obviously, I guess a lot of people in allocating to ETFs are either in the model portfolio space or they might be in private wealth. So, I guess you do have that market segmentation. It’s not fair to say that different CTAs might be serving different, or at least stronger in serving different particular segments of the investor base.

[00:17:21] Andrew

Again, having gone around and seen a number of institutional wealth management investors; like guys, everybody’s really different. I mean, if you invested in a manager, you had a bad experience with it three years ago, and the decision was to get out of the space entirely, your view is going to be completely different than the guys who have taken it, liked the strategy, but internalized it, or people who have gone down the path of doing QIS and other kinds of products.

So, I think, at least from my perspective (and we kind of talk about the whole narrative side of it) is that over the years I think I’ve gotten a clearer sense as to who is the potential constituent for it. And the bottom line is not about incremental Sharpe ratio. It’s often not even really about… There are things that people throw out about it, but it’s, ‘do I make your life better?’

And actually, I use this example where one of the firms in the room, a current investor with them had come in to see us. And I got to the end of the meeting with them and I said, honestly, I think you have the right pick for you. The way you’re set up, whether these guys have their Sharpe ratio is 0.1 higher or 0.2 higher, or they go through a particular drawdown or something in the context of the way you guys are set up, the messaging that you’ve received from them is totally consistent with how you’re trying to build your portfolio.

At the end of the meeting actually said, like, I don’t think we help you. I don’t think you’re going to look back and say… I don’t think in your particular job configuration that you’re going to come back and say that you’re going to be rewarded because 50 basis points, or 1% of your portfolio, was a little bit cheaper and a little bit easier to invest in.

Whatever the things that might get a guy who’s managing a wealth management portfolio in the US under certain regulatory conditions, that might get him very excited. So, it’s…

[00:19:23] Alan

Well, I mean, I guess that just reflects how the industry has evolved. And we’ll talk a bit more about this later. But obviously, now you have, at the one extreme, you have solutions, and then you have standardized hedge fund products, then you have mutual fund products, now you have ETF products.

They are all different representations of trend following, managed future strategies aimed at different segments of the market and serving different needs. And I guess differences are driven by the requirements of the end investors, which is, I guess, fair enough.

[00:19:57] Andrew

Sure. No one would care if the space was growing. The elephant in the room is the space hasn’t grown, on the hedge fund side and the mutual fund side, in a decade, basically.

And so I’ve described this as creating sort of a Hunger Games mentality. That there’s a finite pool of assets out there, We know who’s got the money. And so, we’ll go in smiling, but we’re trying to bump somebody else out. And my broader thing is that I think, that’s self destructive to growth in the space.

It’s the right thing to do when you’re sitting in front of the client because your only chance is to convince them that you’re doing something better than the next guy. But I think what it does is it gets people to focus, at least outside of that group, it gets people to focus on the relatively slight differences between these portfolios over time compared to the underlying drivers, as opposed to helping people to understand how would you visualize a good experience of owning this five years from now? It’s where everybody’s energy is right now. Even in the mutual fund space, how do we get our fund onto that platform, and then how do we unleash an army, and if we’re going through a period of outperformance, how do we kind of pitch and sell that?

I don’t find it terribly effective because ultimately the decision that people are going to make about it is that you don’t know what decisions they’re going to make unless you really understand what they’re really thinking. And as opposed to what people walk into the room and they say, “I want the best manager with the lowest fees, the highest Sharpe ratio, that does the best in a crisis, that does well during other periods of time.” Not only does that not exist, but it’s also not really what makes a difference to them.

What’s going to make a much bigger difference is… And people talk about it somewhat condescendingly in terms of like, career risk and other things like that. I. It’s not that. There’s always this expectation, from the outside, that a fund manager is pulling the wool over the eyes of their investors. You know, and so one example is private equity.

And so, when 2022 happens, a lot of private equity funds didn’t really mark down. PC funds were marking down their portfolios and a lot of journalists were in an uproar about, you know, ah, they’re deceiving their investors. And I kind of grew up with people in that world. So, I called some senior guys in it, and I said, guys, like, help me out here. How do you feel? I mean, do you feel like you are not being sufficiently aggressive and marking things down? And they said it’s the thing clients love most about it.

[00:22:50] Alan

Yes, the volatility.

[00:22:52] Andrew

Because they’re walking in, they’re getting off the phone with us and walking into a meeting with our investing committee, who sees fire – fires spreading in other parts of their portfolio. And they’re not really in a mood to ask really hard questions about whether we’re not marking this down sufficiently or not.

I think it’s just sort of starting with an appreciation that allocators and people who run funds, if you have relationships that are sort of open and candid, you can have a much more, I think, efficient and productive relationship. And I think it ends up working better for anybody.

I think the problem is that a lot of the distribution business is designed to, particularly in marketing managed futures funds, etcetera, it’s often designed around slipping a fast one by the investor. You know, like, oh, we’ve gone through six months of outperformance. It wasn’t luck. It was, you know, that we knew that we should be overweight or underweight XYZ and there’s huge incentive for people to kind of push it, to get people into it, because that’s how they’re going to get paid. And then invariably it does. And then that’s when you get pissed off investors and space doesn’t grow. Yeah.

[00:24:19] Alan

I mean, everybody has narratives. And I guess people have to think about how they position products. And I think you’re right up to a point. If a manager makes a change to their system and then suddenly has better performance, you know, obviously it’s probably more likely to be random. But the narrative that they made a change, it’s working, tends to resonate better with investors, I would say. So, there’s always a temptation to pull on that.

[00:24:49] Andrew

But that’s also legitimate as well, right? I mean look, people think we are very strange for being proud of not changing what we do in eight plus years. Again, just going back to the heterogeneity of the investor base, there are people who, even if they buy into it, I’m not sure they know how to explain it to people.

So, as you know, we manage an ETF in the US. You can have a conversation with an institutional consulting firm, and the first five minutes, before we get into it, will be that it’s such a pain in the ass to invest in hedge funds. We wish we could invest in, you know, an easier vehicle. We’re getting a lot of pressure from our clients on fees. You know, we wish there were lower cost ways of investing. Our clients really value liquidity, and wouldn’t it be great to integrate?

I mean they kind of describe all the things that we’ve tried to solve and they may eventually but, in general, the reason they would never invest in an ETF is because they’re not going to have hedge fund, hedge fund, hedge fund, hedge fund ETF, hedge fund, hedge fund, hedge fund in a category on a reporting statement. It’s because it’s the hedge fund bucket.

And again, going back to my point is that I don’t think they’re doing anything wrong with their clients because their clients have hired them because they built hedge fund buckets. If the client hires them and says, you know, we want a hybrid, find us, you know, whatever, do these optimizations around it. But that’s not what they’ve been asked to do.

So I think understanding that and being able to have open conversations about those kinds of constraints like that, my goal is to make the whole distribution process much more efficient because I don’t want to waste their time and I don’t want them to waste my time if we’re not going to do something that’s going to make their lives better, however they define it.

[00:26:53] Alan

Let’s pause there for a second. I did have a question that I should have addressed a moment ago, but because it’s not, I mean it is related to this topic in the sense of we’re talking about different products for different market segments. And the question is around the use of capital guaranteed products, which is another segment of the market that used to be very much to the fore.

So, if you go back in time, I guess maybe what, probably 15, 20 years ago, I think Man AHL used to have a big business where their trend program was wrapped in a capital guarantee product. And the way it worked was you took kind of 80% of the value of your investment and bought a zero coupon bond and then the rest was spent on an option basically to track the performance. It can track anything obviously, but it used to be to track the performance of CTA performance.

So, the question is around where have these products gone? Obviously with lower interest rates, they didn’t work, you know, so they were gone for a decade. Obviously, rates have shot up again in 2022. It’s still reasonably high, so it would work. But I haven’t seen this type of product in the market myself. Have you experience of it, or any reason why we haven’t seen a resurgence of this type of capital guaranteed product, in particular with respect to CTAs?

[00:28:16] Andrew

Yeah, I mean, do you know how much of that was in the US versus abroad?

[00:28:19] Alan

It was more in the UK as far as I know.

[00:28:21] Andrew

Yeah, okay. I don’t know the UK market as it relates to this. What I’ll tell you is that, in the US, what we do, as you can imagine, is extremely capital efficient. So, I spent maybe two plus years, maybe three years trying to figure out (this is when interest rates were a lot lower), to try to figure out whether we could basically do something in a principal protected note. And the people that we were talking to were insurance companies in the US. The argument was that if it was principal protected then they could treat it as a bond, and therefore it would end up in their gazillions of dollars of bonds as opposed to being a standalone on a hedge fund basis. And so, all of these things I usually have, there’s some motivation behind why they do it.

Like I’ve heard of people doing principal protected things in Latin America to high-net-worth families. But there it’s more of like don’t worry, you can’t lose your money and we’re going to swing for the fences with this other part.

So, I don’t know all these different markets. What I do know is that, in this market, the regulatory regime shifted in that the self-regulatory organizations at some point decided that this wasn’t really a bond, this was a zero-coupon bond plus a hedge fund strategy. And so that had accounting and other treatments, and people were trying to put private equity. It’s like, once there’s an opportunity people try to find as many ways to do it.

So, I don’t know what’s happened since rates have come back up, but my sense was that the obvious buyer of the insurance company, that wants to get a different kind of exposure, was gone for regulatory and accounting reasons. But broader. I agree with you. I haven’t seen it as much, as well, outside.

[00:30:22] Alan

I just know, from an Irish UK context, that they were more of a feature in the past and less so lately. I think some of it is regulatory as well, even though it’s a capital guaranteed product in terms of if you want to sell that to retail, I’m not sure it’s still regarded as complex because the underlying investment is seen as complex. So, I think that is one angle to it.

[00:30:45] Andrew

But I understand that also, like in the wealth management, from what little I know of the products that are sold in Latin America, they are loaded with fees. And so, nobody’s spending a lot of time analyzing the all-in cost of these things. They can charge huge commissions on it. So, they don’t have a wonderful connotation for people who kind of care about those things like that. But look, I haven’t seen it, and I also don’t know.

There has also just been a huge problem in that, I think after years and years and years of low interest rates, no one wants to give up their coupon. That 3%, 4%, 5%, whatever 5% coupon? We also have products that are in what you call the multi-strat USITS space and those products, by-and-large, have been losing a lot of assets for years. And even in 2023, after having done well in 2022, you think, oh my God, given how much bonds went down. But by the time really 2023 rolled around, I mean we just heard it from wealth manager after wealth manager, why would I do anything but buy short term gilts? And you know, I don’t want duration risk. So, it’s almost like this palpable relief of getting coupons again. So again maybe
you go to a zero-coupon structure.

[00:32:08] Alan

Yes, yeah. The other thing that in structured products world, that had been very popular particularly when rates were low, was what are called auto callables. So, basically selling volatility and betting that certain stocks or baskets of stocks wouldn’t trade below a certain level. I think those have remained popular even as rates have come up because then your total return is even higher now. So, it is curious we haven’t seen more of this, but I think regulatory issues is one thing and, as you say, interest rates.

[00:32:39] Andrew

What people have also done is like the bigger institutions have unpacked it. So, they’re saying they’re going to the guys I was in the room with, presumably, and saying, we want to do 300 million, but we want to manage the bond portfolio, we want to diminish the collateral, we’re going to… And so, you’re basically getting to the same place just without the fiction of this being a staple bond.

[00:33:03] Alan

Yeah, yeah, No, you’re right. And I mean part of the question was then are the return stack products kind of delivering this without the guarantee? I mean basically, all of these kinds of products are using different constituent parts. So, in some cases it’s a bond and an option, or in other cases it’s a bond and futures trading. So, they are all different representations of combining different financial instruments.

So maybe moving on, I know you wanted to talk about ETF performance a little bit and maybe the challenge for certain CTAs, given that as the market has evolved, now we have mutual funds and ETFs competing side by side, and in some cases some providers have both types of products in the market. What was your perspective on this that you wanted to talk about?

[00:33:58] Andrew

So, I actually did a LinkedIn post on this about a week ago. Basically, there is this self-serving assumption that hedge funds are these magical alpha generation machines, that you should be more than happy to go through the headache. I mean let’s use the Most obvious example, like at Millennium, those guys have done a Sharpe ratio of two plus for 30 years.

They have skated through the craziest macro shifts in the past five years and not a scratch on their car. Okay? Like, I mean, unbelievable. And they charge you an absolute fortune, and you know, if you can give them money, just give them money, and you know, hope something catastrophic doesn’t happen. So, there’s this kind of perception that that’s what a hedge fund is.

And then there was the whole growth of this liquid alts world, and in the liquid alts world a lot of the products have been really bad, in liquid alts land.

I mean, if you look at the broad liquid alts space, and I said this basically, if you want to evaluate a space, dig up all the dead bodies. When people look at a space, they tend to say, who’s there today? Who are the five largest guys, how have they done? And you know, for ease, and social validation, and career risk, and everything else, they’ll pick one of the five. It’s probably not the best because he might be a little bit too crazy, probably not the worst, but one of the two, three, or four is probably going to get the allocation.

So, a lot of the liquid alts world, broadly, has a bad connotation because they’re generally being offered by traditional asset management firms who are sitting on this big, gigantic melting ice cube of their traditional active management business. And if you talk to them honestly, they’re like, yeah, in 30 years it’s going away. So, what do we do between now and then? So, they have these big existing distribution forces.

And so, you know, starting right after the GFC, they start taking hedge fund products and putting them into these things. It’s not really more about pushing products out the door. And then, there’s a guy named Ben Johnson, at Morningstar, who has this great expression called the spaghetti cannon. If you shoot enough spaghetti at the wall, a couple pieces will stick. And Morningstar studies this as well. You might have a firm that’s got 12 products out there – not their best, not their favorite, not their high conviction. Twelve, okay?

And so, one of the ways you feed your large army of distribution people is there’s always a winner in those 12. There’s always something that looks good. And because they are higher cost products, they might be 200 basis points on average. Even in the managed future space, it’s 170 basis points on average for mutual Funds, that allows you to pay your sales guys a lot more. And so, their motivation, this army of people, their motivation is to stuff as much of this product as fast as they can during a good period.

And you know, and again, they’re usually coming from very big, reputable brand name firms, lots of resources, et cetera, et cetera, buying them. So, they’re very effective at doing it. The problem is that they’re not that worried about how investors are going to be feeling in three years or five years if it doesn’t work.

So, you look at this broad liquid alts world, and by that I mean mutual funds and USITS funds, and Wilshire has good data on this. You’re talking like a 2% return over a decade. So, maybe less than bonds, over that period of time, but after like 200 basis points in fees, and generally with a very high correlation equities.

So, I’ve called it a failed experiment or a great embarrassment for the asset management industry. But what it did is it kind of fed into this narrative of ah, the reason was because they’re mutual funds. It was a mistake to go look for liquidity as opposed to taking a step back and saying no, people who don’t really know what they’re doing are shoving products into the market to try to make a quick buck, which is basically what happened.

And then, when you stepped onto ETFs, the knock on ETFs, again in the standard hedge fund framework, was Bill Ackman is not doing an ETF. (At the moment I say that, of course, he’s probably going to launch one tomorrow.)

If you take an activist position, where you can’t sell your stocks for a period of time, you cannot have an ETF. You know, having to sell your position because of you’re ETF the transparency of the positions; you could see every day, whether somebody is buying or selling stocks, the limitations. So, there are all sorts of limitations that you actually do run into. So that standard mode -l hedge fund is better than mutual funds.

You know, I’ll hold my nose if I can’t invest in the hedge funds, I’ll hold my nose, invest in mutual fund or USITS version of it. Then the assumption was always when you could never make it work at an ETF.

And look, my contention is that that’s wrong as it relates to the managed future space. Millennium is never doing a mutual fund, they’re never doing an ETF. I get it. But by and large there’s not a lot of evidence that wildly more complexity meaningfully improves Sharpe ratios in the space.

You don’t have the position level transparency issues of… Now, granted if you’re Man AHL, and you’re doing an ETF, and somebody can calculate exactly how much of the heating oil market you represent or something. Okay, that gets a little bit scary from a front running perspective but. So, I don’t think that relationship holds in CTA land.

And there are specific examples of it. Like there are one off examples. I wrote a post about a fund run by Simplify Asset Management called CTA. I have no idea what CTA does on a daily basis. All I know is they seem to be killing it. They’re killing it this year.

Like everyone goes down one day, they seem to be going up. So, doing something that’s very, very different and idiosyncratic. The only point is, sure you’ve got an ETF that is doing really, really well relative to the very best guys in the world who’ve been doing this for a very long time, running big hedge funds and doing it, even in the drawdown.

Recently Katy Kaminsky and Alpha Simplex launched an ETF. Look at that number since it was launched. It’s great. I think since it launched, the SocGen CTA Trend index is down 11%, they’re down 4%.

So again, the perception that oh, it’s in an ETF, and therefore maybe it doesn’t have all the risk controls that you would have in other kinds of products. But people hold onto these things, they hold onto these canons, sometimes because they’re self-serving, sometimes because they’re just anchored to it, and sometimes because they sort of like the pitch, they like the narrative.

[00:40:55] Alan

Well, I think that’s definitely it. I mean if you take Man for example, as you say, Man has an ETF, and a mutual fund, and obviously they have hedge funds, and a solutions business. Their ETF trades at a higher vol, as far as I understand it, yeah, a decent bit more than their mutual fund. But I mean their expectation would be that their mutual fund would have a higher Sharpe.

And what I’m assuming (I’m not speaking on their behalf), but what I’m assuming, based on the fact that they expect a higher Sharpe because you’ve got trend, and other strategies, and trading more markets. So that should, all else being equal, equally a higher Sharpe. That’s the general argument, no?

[00:41:35] Andrew

I mean, just for the record, I think their mutual fund is fantastic. People have asked me, if you could invest in one mutual fund in the space…? if I’m an allocator, I’m picking that fund, in part, first of all, just in terms of who they are, the brand name, the gravitas, they’re the best or they’re at the very, very top tier. But also, I think they know what the mission is of that fund. (I’m guessing you know these guys better than I do.) I think they know the mission of this fund is to provide a single fund, a single line item that’s going to be sufficiently diversified. It’s going to look a lot like the whole industry, but they’re going to dial up their risk controls a little bit more to be a little bit better at the inflection points.

They were. Where’s my number? I don’t know. They were, through last month, they were down 2 last month. And again, they’re not having a great year. But I didn’t look at their ETF, but their ETF is more of a wild animal. And look, I think they’re making a conscious decision. They want to have a toe in the ETF world, but. But they’ve got to make it sufficiently different. And look, they’ve had better drawdown characteristics and slightly outperformed the ETF since it was launched. I would be surprised if that ETF became a dominant ETF over the next five years. I don’t think it was really designed… I think if they designed something that looked more like their mutual fund, but put it into an ETF, it would be more directly competitive with the mutual fund, but it would also have broader appeal. But again, the moment I say that I’ll be wrong.

[00:43:19] Alan

I suppose. I mean, one thing to address. I mean, you’re talking about performance and performance year-to-date. If we’re talking about these types of strategies, which are, you know, 0.5, 0.6 Sharpe, or something like that, , if you believe that the Sharpe, say, from a mutual fund is 0.1 or 0.2 Sharpe more than, say, from an ETF, to actually prove that, I think you need, I don’t know the exact number, but I think it’s 10 years of data or something like that. It’s not one year, it’s not six months.

So, nobody has 10 years because these products have just been launched. So, I mean ultimately, I know we talked a bit about narratives earlier, but I think that’s why the narratives are important because okay, obviously track record is important, performance sets are important. But I think you have to look beyond the track record, given the randomness in the numbers and the fact that to prove anything definitively you need very long time series. So, I mean that’s why I think that the narrative becomes quite a bit important.

[00:44:19] Andrew

You can compare hedge funds and mutual funds, right?

[00:44:24] Alan

You can.

[00:44:15] Andrew

You can compare that, right? We’ve had a lot of data on mutual funds for 10 plus years.

[00:44:27] Alan

But, but then it’s different types of mutual funds and hedge funds.

[00:44:30] Andrew

It’s never going to be, you know, a honey crisp apple versus a honey crisp apple.

[00:44:34] Alan

Yeah, yeah, yeah, yeah, I get it.

[00:44:35] Andrew

If you’re lucky it’s honey crisp versus, you know, Granny Smith. But more likely it’s apples versus artists. So, what do we know about…? Well, obviously we’ve looked a lot at this data because it’s a source of daily data on hedge funds.

So, what you see is that you take the Morningstar US Trend Systematic Category, you compare it to the SocGen CTA index, and they have a 98% correlation to each other. They offer nearly identical performance in the vast majority of the time. With the exception being in the vols, the vols are a little bit lower in the mutual fund. There do appear to be, on the average, in the mutual funds, a few more constraints into it.

So, instead of going up 20 net, which the SocGen CTA Index did, and if it goes up 20 net, it went up 26, basically. And the mutual funds, after 170 basis points, go up 14. So, you lost something. You lost 10 points because of your vol controls over that period of time. The rest of the time they’re almost indistinguishable.

So, we do actually know that you can run these things, you can deliver relatively comparable results. But again, you have to make a calculation how much is losing that 10 points of returns in 2022? You spread that over five years. It’s 200 basis points of underperformance.

[00:45:58] Alan

Exactly. And I mean for some investors that is valuable to get that higher volume, and that justifies going the more aggressive route.

[00:46:05] Andrew

Absolutely. So, people, in criticism of what we do, since we’re trying to replicate pre incentive returns, we’re more volatile. But I believe, not to the maybe to the tune of what Man is doing with AHLT, their ETF, but I believe that actually I think investors can stomach more volatility to a certain point.

[00:46:33] Alan

Within this, obviously we’ve had, as you say, we’ve had hedge funds, and mutual funds, and ETFs. And obviously, within ETFs we have Replicator ETFs. And now we’re seeing more and more Replicator ETFs. We’ve got yourself as probably the first, or one of the first, and the most well known in the managed future space. But as you say Alpha Simplex have a product, and Return Stacked guys, Corey and team, have kind of various representations of that.

I mean, do you think we’ll see more replicators? Do you think the replicating space will get competitive and people start saying who’s a better replicator? Is that going to be part of the next evolution of the industry?

[00:47:14] Andrew

Sure, it already is. I mean, so look, Bob Elliot Unlimited launched a managed futures ETF. To be clear, I’m very good friends with Corey Hoffstein, I’m very good friends with Katy Kaminsky. I am not sitting with them at the desk as they are, you know, doing what they’re doing. So, I’m always one step removed.

So you know, the bet that we made was that again, I come at this not as a quant, right? I got out of business school, I go work for a value based hedge fund guy. I go off and start a fundamentally driven, commodity focused multi manager fund. I launch a relative value fund. I didn’t come at this as a quant but because I loved the nature of it from an investment perspective.

And this is the way I also did a LinkedIn post on this. By the way, I do all my LinkedIn posts when I’m traveling, apparently, because I’m bored and lonely and so. But I did a LinkedIn post on this basically. You know, Roger Federer gave this great speech, and he started off as a commencement speech over the summer, and he basically said, so he says something to the effect of like, I lost 47% of the points that I played.

[00:48:27] Alan

Yes.

[00:48:29] Andrew

And you know, then he described how winning 53% of points translates into 60 something percent of games translates into, you know, translates into 90% of matches. And what I always loved about the idea of replication is that if you think you’re accurate enough with a structural arbitrage, and you can win because, again, we are making one week bets that what we discern to be that the broad factor positioning of the space on Monday afternoon will be sufficiently accurate. And it turns out, using monthly data, it’s about a 90% correlation and is sufficiently accurate over the course of next week. That will be close. We’ll get it directionally right, but the structural efficiencies around trading costs and fees, it gives us a slight edge.

So, if you look at the weekly data, we outperform somewhere between 53% and 54% of the time with a very, very slightly positive skew. So, that’s a poker player who walks into a casino and knows I’m going to lose a ton of games. I mean I will lose a ton of hands. But if I can stay there and have, you know, people say if you have enough at bats, it works.

So that, you translate it over a month and you get into the 60%s, you translate it over a quarter, you’re in the 70%s, you trade it over a year, you’re in the 80%. So as an investor, you know, as somebody like if you say, you know, he’s a trader who wins 55% of the time, he’s an all-star. It’s like your Stevie Cohen kind of category. So that’s basically what we ended up doing.

And here is, by the way, another firm who copies us very, very, very closely, but they add in all sorts of artificial intelligence and other things like that. But in the case of Corey, and in the case of Katy, they looked at it and I think, and look, I don’t think it’s hard to conclude that it works. You can nitpick at the margin, but it is, in a sense, designed to be this adaptive, repeatable process.

What are you looking for? You’re looking for an adaptable, repeatable investment process that generates excess returns. That’s what I found compelling about it, without writing a line of code.

[00:50:48] Alan

So, the question was then the differentiator, is there just one? Obviously, there’s a couple of ways of replicating.

[00:50:56] Andrew

So, what they do is they say, okay, well that’s great, but it’s incomplete. If I know that what most people are doing is looking at 150 days versus 20 day windows, and I can add in more instruments, and I can do other things like that.

Now the process I’m sure they go through is they say what if I have been doing it for this past 10 years? What if I combine that with this replication that I’m now saying, what if I’ve been doing that for the past 10 years, the top down replication, and I combine it and it probably shows them better results. So, then they implement it. But there’s also probably commercial consideration. It’s a little hard to exactly copy the guys who’ve kind of invented the space.

Why would you do that? Now if BlackRock did it, if Vanguard did it, their presence, their brand name, et cetera would overwhelm anything else. Who cares if they haven’t been doing it? It’s BlackRock. They charge at 10 basis points. Who cares?

But for most other people they, themselves, have to tell a story about differentiating from what we’re doing otherwise. Because you know, I always used to say this when we got into the business, I always liked trying to be a first mover. I was a first mover in the commodity space. I was a first mover in Greater China hedge funds. Because when second movers come into the space, they first have to sell you.

They sell the idea. They say, that was such a good idea, we’re going to do it ourselves and we’re going to make it slightly better in the following way. And again, as I’ve always said, the issue here is not relative market share, whether we get X percent, somebody else gets X percent. The issue is, can we grow the pie 20X or 50X? And so, look, as I’ve said with them, I’m thrilled to have them in the space again.

There’s another firm out there, so yeah, I’m sure State Street will probably jump into it at some point. Bob Elliot will do it. And I think what you’ll see, in five years, is that replication will just be a tool in the same way that QIS products are a tool. And it could be delivered in QIS products, in a sense, SocGen’s decision to launch its index is essentially building a QIS product around what historically had been an active strategy, or care framed as an active strategy.

But again, we talk about the heterogeneity of investors. It’s trying to figure out what. You can have a zillion different products designed to meet a zillion different…

[00:53:27] Alan

Exactly, that’s what we’re saying. We didn’t mention QIS, but that is part of the representation of trend following that appeals to a certain type of investor as well. I guess institutional investors who can do that kind of swap with a bank and are happy to try and customize it to their own requirements.

[00:53:49] Andrew

Yeah, I mean, look, financial engineering, you raised the point about principal protected notes. Financial engineering is alive and well. You now have ETFs that are using QIS products. You have USITS funds that use QIS products. So, in all of these things, there’s the underlying investment and then there’s all the structural engineering and everything else that goes on top of it. You know, when we launched the ETFs we managed in the US five years ago it has a number of limitations in terms of the way that it’s set up, and that are limiting for it.

We have spent a lot of time. I’ve talked to people over the past year or two about, again, it goes back to the narrative thing. It’s because we go in and we want to sell people on our narrative and tell them. But, you know, I can tell you that the narrative that I tell people, about what we do, resonates with some people unbelievably well, and they’re excited to hear about it. Other people? They don’t want to hear it.

[00:54:55] Alan

Some people don’t like the reputation.

[00:54:57] Andrew

It’s not an issue, though. So, to me, the question is, as much as we love selling our narrative, you know what’s a lot more interesting? It’s having them tell you what they love.

[00:55:06] Alan

Yes.

[00:55:07] Andrew

You know, like, what’s the ideal product for you? Okay, don’t throw out the 8% a year, 10% a year, never down year. But let’s talk about that. And that’s what I’m trying to do even when they take me on the distribution side. Distribution people are there to raise money. And the people on the other side know the distribution people are there to raise money. And so, it just makes people kind of defensive. What I try to do, when I get in front of people is, is to just, God, can we just…

I mean, it’s almost equivalent to like, let’s just take shots of a truth serum. Bill, what would you like? What’s the product where you say, I wish I had that? I don’t know if we can do that.

But I can tell you about why we’ve done things the way that we’ve done. I can tell you about stories of talking to people who sound a bit like you. And maybe there’s a way to line that up, but there’s a very, very high probability that there isn’t either. And so, let’s save each other a lot of time of running around and pretending that you know, that you’re monitoring it.

And look, this gets back to the human side of the business is that one of the great advantages the larger players have with these long term relationships with clients, it’s hard to fire somebody you’re friends with. I mean you’ve gone out to dinners, you hung out together, you, I don’t know, shot pheasants together. Whatever people do in these relationships. And so, like it takes a lot. It’s one of the interesting things about an ETF that actually appeals to people.

[00:56:47] Alan

It’s easy to fire a manager.

[00:56:49] Andrew

You try to get out of a mutual fund. You submit your redemption request for $50 million. Hide your phone.

[00:57:03] Alan

Okay.

[00:57:03] Andrew

Because they’re going to fly in, they’re going to be all over you once they see that coming, trying to convince you to stay and putting every pressure under the sun. I’ve had people tell me like honestly, one of the things I like the most is that you guys don’t find out about it for two months.

[00:57:18] Alan

Yes.

[00:57:21] Andrew

But that’s okay.

[00:57:24] Alan

So, before we wrap up, just being conscious of time. There was an article which I shared from Bloomberg just earlier.

You’re speaking about financial engineering and it’s about how AQR, and Acadian, and a few other firms are bringing back certain strategies that had been popular during the pre-global financial crisis. And the article mentions the likes of return stacking as well.

But there’s an interesting line in here somewhere. The line is yeah, if you just sell an alternative strategy today, it’s so hard to get anybody to care because the S&P is up 23%.

I mean that sums it up. So, the idea is that we’re increasingly seeing 130/30 type strategies. So, where you lever up to 130% long, and have a 30% short. And the article also mentions, obviously, return stacking as another representation of this. So, I mean, is that something you’re hearing again?

It was certainly something that I heard a lot maybe back in 2019 or so that people didn’t want to give up on their beta to invest in an alternative strategy where the opportunity cost was deemed to be very high because you’re missing out on the market return. Would you say that’s an important consideration again? In your experience?

[00:58:43] Andrew

Well, look, it’s brutal for anybody who’s not in the S&P 500 when the S&P 500 keeps going up the way that it does. But I mentioned before that it’s also, the flip side of it is bonds. I mean, bonds have been, you know, bonds are like the Voldemort of asset allocation right now. Like, nobody wants to talk about them. But you think about it, like every portfolio, if you don’t have 40% in bonds, you’ve got 30% in bonds. Literally every single portfolio has this as a cornerstone allocation. The performance of bonds this decade has been… If this was an active manager, we would have been fired. But remember, bonds for 20 years, were the superman of diversifiers.

If you chart the Bloomberg AG over 20 years, it is like a ruler. You draw a straight line from the left to the right. It has a Sharpe ratio of 0.9, it’s liquid. It has a negative correlation to equities, does 350 basis points more than cash, and had a max drawdown of 3.8%. Literally, nothing looked good relative to that. And the vol was 3, or something, or 4. I mean it was ridiculously low.

So yes, people always love to focus on their best asset at this time. But I think the broader issue is what has happened today. You’ve had much larger than expected drawdowns in bonds. And one thing about financial history is it never goes away. You can’t erase it. Every asset allocator is going to say, what’s my drawdown potential in bonds? And it’s always going to be 16%, not 4%, or something. But the volatility has also gone up.

So, I think, (and I’ve got to run this, and if anybody’s listening to this, run it before me and do a cool LinkedIn post), I think the vol of corporate bonds in the US may be higher than the SG CTA right now. Like it’s, it’s gone from 4 to 8, or 9, or 10, or something. I’m not sure. So, volatility has gone up.

What does that mean? Now, you’re building your models for the next 10 years. You can’t pretend that bonds have a 4 vol. Now, what’s the return expectations over cash? You think managed futures is having a bad year? Bonds are underperforming cash again, the third year in a row, not the second year in a row.

So, I think broadly, in the broader asset allocation world, I think the shift from the ease of 60/40, where everything was working for you all the time, to something that looks like 50/30/20 is happening, not because people know…

With building models, asset allocation, everything else there’s an enormous amount of judgment, and theater, and art, and narrative storytelling, et cetera, as much as there is science. So, you take 30 asset classes. How much is every one of them going to earn over the next 10 years over cash?

What’s the correlation between each of these asset classes? What’s the volatility of each of these asset classes? And run it through a model.

And then the model is going to be like, oh, give me all Bitcoin or something, right? The model’s never going to give you an answer that you want. So, you’re like, okay, let’s not do that again.

You know, cut here, put parameters on it. Then you end up with something which is basically where you started with a lot of work that went into it. So, the transition to something that is not correlated to either stocks and bonds, I think is very, very real.

And then the question is, how do you convince people, at least from my perspective, how do I convince people that this asset class, that 8 out of 10 people have a bad impression of, and the other two have probably had a bad experience with, how do you convince them that this should be there, with infrastructure, private credit, private equity? Look, I mean, I’ll either get that right or I’ll die with my sword of my hand on that one.

I think part of the reason people started doing it was because bonds weren’t earning anything. And when bonds are earning more now, it makes perfect sense. This is a great asset class that’s capital, efficient. It makes perfect sense to put it on top of other things. The risk is that when you package it together, your skis are pointing in the same direction, you go through unexpectedly large drawdowns, and that gets back to people’s drawdown tolerances, which I think are less than people say that they are, which is why we haven’t done it.

[01:03:32] Alan

Okay, well, we’re over time, I think. So. Thanks for coming on again, Andrew. Always great to get your perspective. So next week we’re back. Actually, Niels is back next week. And he’ll be speaking to me. So, if you have questions, send them in and but in the meantime, stay tuned for more content and we’ll be back soon.

[01:03:52] 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 you 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.