Equities for the Long Run? ft. Alan Dunne

[00:00:00] Intro

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

[00:00:23] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Alan Dunne and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor. Alan, great to be back with you this week. How are you doing? How is Dublin treating you today?

[00:00:40] Alan

I’m very well, thanks. Looking forward to our conversation. All good here and looking forward to catching up in person soon as well.

[00:00:47] Niels

I know. Miami next week. It’s going to be fun.

[00:00:48] Alan

Big week in our industry. Yes.

[00:00:48] Niels

Big week in our industry and Katy will be there as well, so I think the three of us at least. Hopefully, some of our loyal listeners will find us and we can have a chat and maybe a coffee. All right. Well, we have some good topics, as I always say, because I do think, generally, they are good. We also have a question, which was good, sent to us.

But before we get into all of this, I’m always curious to know, besides all the topics, what’s been on your radar? What have you paid attention to recently?

[00:01:27] Alan

Yeah, it’s interesting. It’s been a while since I’ve been on here by myself. Obviously, we had a group conversation in December. But certainly, it seems like quite a different market sentiment-wise. This year, we’re already off to a very positive start in equities after a little bit of a dip pushing higher and with all the talk about Fed rate cuts and soft landings.

Part of me having been very cautious on the equity market now is wondering is there going to be some kind of blow-off kind of melt-up or something. Everybody seems to be so bullish. So just very interesting from that perspective how sentiment has changed so much in the last while. That’s one thing.

I’ve just been tracking as well, part of that argument is around a lot of money in money market funds. So just curious, is there a lot of money either sitting on the sidelines or having gone into cash with the high short-term interest rates in the last year that might now come into the market like with equities or bonds or wherever it goes? So that’s a second theme that I think is interesting.

The third thing that I just came across recently was just an article around CalSTERS increasing their facility to take leverage in the portfolio. So, it seems like more of an operational adjustment. They’ve always had an element of leverage in the portfolio, but they are now increasing that. But maybe it does point to some issues (I’m not sure if issues is a strong word) around their less liquid portfolio if they feel that they have to increase their cash facilities.

So perhaps, maybe, they’ve over-allocated to the less liquid side of the portfolio. But it’s interesting. That’s a general trend that we’re seeing of some of these larger institutions; and pension funds increasingly using leverage both from a portfolio perspective and from a more operational perspective.

[00:03:26] Niels

Yeah. I did notice the article because you sent it to me. For those who haven’t read the article, what it’s all about is that they would like to be able to borrow up to 10%, which is $30 billion, so that they, as it says, don’t have to sell out assets at distress levels. Now, when you describe it, it sounds oh, yeah, that’s not a bad idea, that’s fine. But what if these distressed assets become even more distressed?

I’m thinking at some point, there must be a stop loss somewhere. Is it a facility that would encourage people to be, how should I say, a little bit too optimistic about the future and not really realizing that what they’re invested in is crap and they need to get out? (Pardon my French, by the way.) Yeah. So, I think that’s one thing that’s a little bit worrying.

Of course, being the second largest pension fund in the US, if they go ahead and do this, this might of course start a trend with other pensions, and then suddenly you have lots of pensions not having, or not wanting to realize, bad investments. So, I think it creates some kind of (I don’t know what the word is), but it makes it a little bit artificial that you don’t have to recognize losses.

We all know how these things can go pear-shaped if you start not recognizing losses. I don’t think it’s a great thing, but I do understand why they want it. These private investments that are so popular, private equity, now it’s private credit, I guess from the trend following world we come from, we love liquidity. We love the fact that we can liquidate our portfolios in 24 hours, and that’s just a different world.

I think in an uncertain world, which we’ll come to I guess in our global macro conversation, liquidity is important.

[00:05:27] Alan

Yeah. I think it’s about having a balance. There’s been a huge wave of money into private assets in the last decade and the case for it is well made, and obviously in private credit. From the data I’ve seen, some managers’ performance was good last year. Of course, all of these strategies do well in the same environment, in the same regime, when it’s favorable. They don’t do well in the negative tail event, but they all do well the rest of the time.

So, it’s kind of understandable why people have them. It’s probably equally understandable why tactically it may make sense to have more leverage from time to time or the facility to borrow. But, as you say, maybe it has to be in the right hands and appropriately governed and overseen, I guess.

[00:06:21] Niels

Sure, of course.

By the way, I mentioned it’s the second largest US pension fund. They have done 7.2% annualized in the last five years. And in their ’22, ’23 year, they posted a 6.3% net return if someone was interested.

All right, well, good to know what’s been on your radar. Let’s look at the other big thing that we always talk about, and that’s your big macro picture.

In a world that seems to change a lot every time or in between we speak, I’m curious to know what your thoughts are at the moment.

[00:06:58] Alan

I think the big thing everybody is looking at and thinking about is this Fed pivot that’s underway. We had Chair Powell speaking in December and I think it’s fair to say really surprised people in how dovish the Fed had turned so quickly. There’s a lot of speculation as to why that was the case.

Was it politics? Were they positioning ahead of the election this year? Are they planning on getting rates down early in the year to avoid any conflict with the election or maybe even to boost Biden’s prospects who might seem to be a bit more pro-Fed independence or less likely to meddle with their own independence? So, kind of conspiracy theories around that, I guess.

Obviously, the inflation data has been on a downward trend, you have to acknowledge that. If you look at the PCE, the six months annualized, it’s down at or below target. So there certainly has been progress on inflation. I thought what we got this month, with the speech from Waller, was quite interesting. He kind of gives more context to what I think is the overall Fed thinking.

When I read it, I felt it was a little bit self-congratulatory in a sense. He was talking about how two years ago, he made a speech about how the Fed would be able to raise rates and bring down inflation and you wouldn’t see a rise in the unemployment rate or a significant rise, and that’s what we’ve seen. It’s an example of great analysis and great data and great work all around.

So, I thought it was maybe a little bit premature for him to be declaring victory and giving themselves a pat on the back, but that’s certainly what it felt like. It’s interesting because if you read what he’s saying, it’s very much saying the Fed took rates to a level that was restrictive enough to take the slack out of the labor market, and that slack has been unwound purely in terms of the vacancies as opposed to that we haven’t seen a rise in unemployment.

So, the labor market has been very tight. You’ve had these unusually high job openings. You see that in the jobs data. So, vacancies have been very high and that’s where the tightness has been seen. They’re saying they’re able to tighten policies so much just to take the tightness out in that area without starting to see a rise in layoffs and an increase in unemployment. And then they’ll be able to pivot and reduce rates to keep the economy at that level.

So, when you think about it, one, it’s very much a labor market centric view of the world and of the inflation process, which we know has failed in the last couple of years. You only have to go back to 2021 where the Fed was saying we’ll start to raise interest rates when unemployment stays low for a long time, and then subsequently, you’d expect inflation to rise.

But obviously, inflation just jumped up in the first place without the unemployment rate staying very low for a long time. Now we’re seeing the opposite of inflation coming down unrelated to labor market developments. So, it does question if their whole model is correct around inflation.

But also, this whole idea of being able to pick the exact level of interest rates and the economy responding mechanically to it, it’s just totally opposite of the view of the economy as a complex adaptive system that we always like to talk about, and we heard so clearly from Bill White that time. So, it makes me worried that the Fed will get overconfident because it seems to have been successful in what they’ve done so far.

We all know that it’s an almost impossible task to try and calibrate policy perfectly. So, we’ll see. I do think the case he lays out looks reasonable for lowering rates now because obviously policy is tight. But I think foolish is maybe too strong of a word, but to think you can fine-tune policy so finely, I think we’ll find, in time, that that will prove difficult to do.

[00:10:58] Niels

Yeah, I agree with you completely. I think he does seem a little bit too over-optimistic about their ability to control everything. He does, towards the end of the speech (and I quote) say, “As long as inflation doesn’t rebound and stay elevated, I believe FOMC will be able to lower the target range for the Federal Funds Rate this year. The view is consistent with the FOMC’s economic predictions in December, in which the median projection was three 25 basis point cuts in 2024.”

Of course, the market didn’t read that very carefully. They thought three meant six, so they went straight on to go for that. But anyways, we’ll see. I think when we had our group conversation, we all made some outrageous predictions which will make it a bit of a challenge I think for the Fed to keep up.

Now, before we leave this topic completely because we’re talking about global macro issues, I couldn’t help wanting to ask you. This is not a political podcast, of course. But when it comes to politics, we have to admit that they do have an impact on the world economy and financial markets.

We did have a primary election in the US this week that kind of suggests that Trump may be facing off with Biden again later this year, even if I actually, in my outrageous predictions, predicted that none of them will be on the ballot in November, so we still have to wait and see about that. But how do you think markets and economies may be impacted, should Trump win back the White House?

[00:12:41] Alan

Yeah, it’s a great question. In some of the conversations I’ve been having on the Allocator and Macro series, I’ve been asking that question. They may not all have been published yet. But certainly, on my radar, very hard to say. Not providing anything blindingly insightful here except to say that the question I would have is that a lot of what we’ve seen in the last number of years has been related to Bidenonomics.

The nearshoring, the Inflation Reduction Act, all of that focused on developing more manufacturing back in the US. You would say that that’s consistent with a make America great again type platform. So, should we see any dramatic change from Trump? That said, I understand from some commentators that he’s not a fan of the Inflation Reduction Act.

Certainly, we would expect to see more protectionism. He has said before that there would be a 10% tariff on all goods coming into the US straight away. So obviously, that would be inflationary in the first instance. We did see protectionism in his first term, so I think that would be a very reasonable assumption.

I think you’re going to see tensions around a number of areas. One, obviously is protectionism. Two, he’s also said that he’s going to go after his political opponents pretty much straight away once he comes into office. So where does that play out? He was kind of less maybe briefed as to how he could wield his power when he came in the first time, but now he knows what he can and can’t do. So that’s the second area.

I think, with respect to the Fed, that’s a third area, and I think that there is a valid reason for why the Fed might be biased towards Biden because he did meddle a little bit in the last term, but not to a massive extent. He certainly was making comments like, They’ve got lower rates overseas, why can’t we have that as well?”

So, I would certainly expect to see a lot more political interference in monetary policy either directly or indirectly. And then the fourth area I would say is around debt and deficits. Donald Trump doesn’t strike me as the kind of person who’s going to say let’s get our house in order even if it’s politically unpopular. He’s a populist politician.

The last time he was in, he was already running a large deficit when the economy was doing strongly, and then carried on into COVID and carried on with Bidenomics. So, you’d have to say, prospects for fiscal conservatives would be low. Obviously, a lot depends on who’s in the House, who has the Senate. But we’ve seen Trump use executive order.

So, I’d be pessimistic on debt and deficit improvements, and you’d have to be pessimistic on protectionism. That said, when he got in last time, the day of the election in 2016, equities went down and then rallied pretty hard for a couple of years. So how the markets take it? I don’t know. But certainly, they would be the themes I would be focused on in terms of the agenda and how it might influence the economy and markets.

[00:16:09] Niels

I think that’s a good checklist. Now, since that was a super easy question for you, Alan, I’m going to add another super easy question for you, and that is, since we are in the global macro world now, what about China? They’ve kind of gone from this international growth engine to a domestic disaster. Do you follow this? Do you have any thoughts? Or some of the guests you’ve had, any thoughts?

[00:16:34] Alan

Yeah, some of the people I’ve talked to and some of the managers I speak to on the macro side, what we’re seeing obviously this week is an intensification of the concerns around the property side about the debt deflation, etc. And we have seen a policy response in the last couple of days in terms of a 50 basis point cut in the bank reserve requirements. Hang Seng, some of the Chinese stocks have rebounded in the last couple of days.

I think the big picture here is, what’s the policy response? Ultimately, what should it be and what will it be? China is somewhat constrained. When we’ve seen this kind of challenge in the West, say post the global financial crisis, the policy response was, bring rates to zero and quantitative easing.

So, in an essence, that would be an obvious policy response in China. Flood the market with liquidity, that would boost asset prices and should reverse the deflationary trend and could help the property market. But they seem too reluctant to do that because they’re worried about a significant weakening in the renminbi. So, it’s this classic dilemma or trilemma that you can’t control all of the different levers of policy. If you want to control the exchange rate, then you’ve given up control of monetary policy.

They did allow some weakness in the renminbi last year, but they seem to have stabilized it for now. They don’t seem to be on a path towards money printing or QE. What they do seem to be doing is making a grab on global manufacturing. What we’re starting to see, particularly in EVs, we’re starting to see… Here in Ireland, I’m hearing BYD being advertised on the radio all the time.

We’re seeing the European Union becoming very concerned about the threat; Volkswagen under serious pressure in Europe, threat of EVs. Even speaking to people who allocate to China and Chinese equities, making the point that, China and may not even benefit. These companies may not benefit so much because they’ll cut their margins just to grab global market share. But it will be a significant competitive threat and that would also contribute to that general trend towards protectionism that we may see.

So, I think that’s the direction that they’ve gone so far. It’s to try and boost manufacturing in certain sectors like batteries and EVs, etc. We’ll see how that plays out and we’ll see what’s the response. The implication is that if they’re going to have a bigger share of global manufacturing, somebody else has have a smaller share. So that’s Europe and US, and Europe and the US won’t want to have a smaller share. So how does that play out?

So, it seems to be their move in terms of policy for the moment, but is that sustainable over time? Probably not. And how does it play out? That is, in the short term, probably a little bit of a disinflationary force at the margin. So, yeah, we’ll see how that plays out. But whether that’s going to be significant enough of the policy to see China starting to come out of this slump, I don’t think so, but we’ll have to see.

[00:19:46] Niels

You gave me a little bit of a cryptic topic for this global macro segment, which I don’t know whether you feel you already mentioned or not. But you wrote money market funds. Do you have any thoughts that you wanted to share on money market funds?

[00:20:00] Alan

That was just what I’m saying, the amount of cash we’re seeing on the sidelines. We have seen (I was just looking at the data), there’s $6 trillion in US money market funds, which is up about a trillion dollars in the last 12 to 18 months. If you look at bank time deposits, they’re up about 600 billion in the last year or so. That’s where I would expect you probably would see anybody who is going to go into a bank account to try and take advantage of a higher yield will do a time deposit.

If we start moving into this lower, not low rate, but we start moving to a rate cutting environment, will that be the trigger for investors to start to move back into the markets? And is that going to be a boost for equities or fixed income? Certainly, for people in the more mainstream asset management industry, a couple of people I’ve been talking to were saying last year was a tough year asset raising because of this phenomenon.

A lot of people just said, why don’t I just take the 5%, 5.5% in dollars or 4%, 4.5% in euros and not invest in anything, whether it was trend following, equities, or bonds. Will we see all of that reverse? So yeah, I think it’s going to be interesting.

[00:20:00] Niels

All I can say is, when has asset raising ever been an easy job? I speak from some experience, let’s put it like that.

Anyways, all right, let’s move on to the trend following update. We were off to a soft start for CTAs and trend followers in the first 10 days or so of 2024. Since then, we’ve actually had quite a nice recovery in performance. All the indices that we track here have turned positive for the year.

Although the last couple of days, again, we see a little bit of softness, but I think, still, overall in the black. The best sectors, according to my trend barometer when I look at that, are softs and stocks. Now that doesn’t always tie in completely with what managers will see because timeframes will be different from how I calculate things.

But, actually, when I look at some of the managers that I have access to following more closely, it looks kind of right at the moment. Within softs, we have things like cocoa doing pretty well. Within equities, obviously, Japan has been on fire. At the same time, actually, Hang Seng has really continued its weakness to some extent, and that’s actually also worked out for trend followers on the short side.

Now, one of the sectors that I thought could be dividing performance amongst managers this month would be things like fixed income where I think faster models probably would have gone long towards the end of last year, whilst longer term models potentially are still a little bit short. Therefore, because of bonds being off in January, that can make a little bit of a difference. But that’s kind of how I see it. Alan, feel free to add anything if you have any.

[00:23:03] Alan

That would be my thought. We saw that with a little bit of dispersion in December as well. Those faster models would have benefited then and they’re giving a bit back. A similar kind of pattern with respect to the US dollar as well, to a lesser extent.

[00:23:17] Niels

Yeah. My own trend barometer finished yesterday at 25, so that’s still pretty weak, although it did recover some from the exceptionally low readings below 20 that we saw earlier in the month.

As a Wednesday, because we’re recording on a Thursday, BTOP 50 is up 1.17% for the month and therefore the year, SocGen CTA Index up about 95 basis points, SocGen Trend up about 82 basis points, and the Short-Term Traders Index is up about 19 basis points. That, compared to traditionals where MSCI World is up about 1.08% for the month, World Government Bond Index is down 1.5%, and the S&P 500 is up about 2%.

All right. With that, let’s move on to the question which is actually two questions, and it is from Cyprus. Now, the listener did tell me who he is, so that’s fine. But he didn’t want his name to be on air, so that’s perfectly fine.

First of all, he writes, “Firstly, thank you for a great show. A lot of thought-provoking and educational material here. I’ve been part of the managed futures trend following systematic industry for a decade or so, now taking a much slower pace with it, semi-retired. I fell into it by chance as I met an American gentleman who had retired to Cyprus, who was well and truly part of the industry, having passed through commodities corporation and managed futures and managed his own CTA for over 25 years. Once I understood the concept, I was completely converted from my traditional CFA past, and I have been a keen follower of all things systematic.

I know there’s a lot of discussion over the terminology of the various flavors, and I apologize for using them interchangeably. I have been working with him since on our own trading and thoroughly enjoying the ride.

Okay, I have two questions. I was speaking with a high-net-worth friend who has been overly reliant on private banking solutions, of which I’m not a fan, and as a result, has realized the limitations of the 60/40 portfolio the hard way. I have taken some time to go through the concept and the value added of managed futures and CTA and trend. The question he has is, ‘What would be a fair allocation to such strategies in a diversified multi-asset portfolio?’”

Who better to ask that question than a previous allocator?

[00:25:51] Alan

That’s right, for sure. This is a particular bugbear of mine. If you look at most multi-asset funds, I would say, or if you look at the multi-asset allocations of a lot of private bank offerings, they’re not quite the 60/40 but they’re very much a derivative of it. It tends to be like 50% to 60% equities, maybe 20% bonds. There could be some private markets within both the equity and the bond allocation, maybe 10% credit, and very often something like 5 to 10% in hedge funds. But very often, that would be also including hedge funds that are not necessarily particularly diversifying. They could be market-neutral or long-short equity or even credit-type strategies.

So, then you get into a much smaller sleeve where you’re getting allocations to directional strategies like a trend or managed futures or macro. Why is that? One of the reasons for that is very often the people running these portfolios come from either an equity background or fixed income background and they’re not as familiar with trading strategies as we are in our industry.

Also, they tend to, then, have suffered from some common misperceptions. They might say, okay, let’s go in within the alts sector. let’s find the highest Sharpe ratio strategies and we’ll allocate to those. Or they might say, let’s find these strategies with really good risk-adjusted return performance, but they might be really low vol and it’s not going to do a whole lot for their portfolio.

That’s a long-winded intro to getting to the answer, which is it depends. I think you have to always balance the right answer from a pure portfolio allocation perspective, which would tend to point to a higher allocation to trend and diversifying strategies, and balance that with the behavioral element of will the client be able to hold that and be confident enough in holding that through the cycle.

Because obviously, you don’t want to allocate too much and then clients say I don’t really understand it the first time you get into a drawdown. To give a sense of the range of allocations, the typical answer is 5% to 10%. But I would have said, if you think about asset allocation and split the assets between what I would call growth assets, diversifying assets, and then tactical trading strategies, and managed futures (macro would be in the latter category), I would say it could reasonably be 40/20/40, 40/30/30, or 40/40/20. But it’s a number of the order of 20%, and that’s 20% of portfolio risk.

So an important point I would say to be conscious of is to think about the risk allocation that you’ve got to the strategy and not just the notional allocation. One of the big downsides and problems with the 60/40, and with all of these types of portfolios, is they’re dominated by equity risk. That’s fine if that’s what you want, but you’re positioning this as multi-asset, which gives the connotation that the returns are going to be influenced by lots of different assets.

But because equity vol is 16% and bond vol, depending on your duration, might only be 6% or 7%, you’re getting a lot more risk in equities. So, when you start looking at the diversifying sleeve, okay, you could have 40% in there, but if it’s a 5 vol, that’s not going to move the needle a lot.

So, think about the risk contribution. I would say 15% to 20% of portfolio risk, in these types of strategies, would be meaningful in terms of moving the needle. It could be higher or lower depending on the client and their appetite and their understanding of the strategies, but it’s not like 5% in notional terms. That’s just at the margin.

[00:29:51] Niels

I like that answer. Obviously, I’m probably a little bit to the higher side of that. The reason I say that is partly I update on our side a little fun experiment every month. The experiments we thought (because we get this question a lot), is to say, well, we can obviously say what we think is a good average allocation if you have stocks, bonds, and managed futures.

But what if timing was an issue? Meaning what if you really timed it right or wrong? So, the way we thought about that was to say, why don’t we just say what’s the optimal allocation (n this case we’re just basing it on the highest sharpe portfolio) if you started just before a crisis or if you started right after a crisis?

So, we just say, okay, before the tech bubble, or after the tech bubble; or before the great financial crisis or after the great financial crisis, just to see some extreme starting points. In that case (and I don’t recall the numbers specifically), but certainly before and after the tech crisis, the allocation (and of course we’re using our own WMA strategy as a proxy for trend following), you do get quite a high allocation to it, but I think it’s like 16% to 18% allocation before and after, meaning it’s incredibly consistent.

So, the trend following part hardly changes. What changes is the allocation you should have had to stocks and bonds. Then when you look at the great financial crisis from ’07-ish and ’09 as starting points, you actually get a higher allocation to our strategy, but that’s because you get zero allocation to bonds, really. But you do still get quite a big change between stocks and bonds because initially, you should have had some bonds, I think. And then after ’09, you should have had no bonds.

Anyways, I think the point I’m trying to say is that I don’t think 20%, 25% is a bad number. But I would also argue, I think that allocation is the more consistent of the three assets in a simple multi-asset between stocks, bonds, and managed futures.

[00:32:06] Alan

The other thing I would say is I’m saying that 20% in the context of the information that’s been given for a multi-asset. I do work with some investors who will go 50% growth strategies or growth assets, 50% diversifying strategies, and they are comfortable with that. So, it’s not one number that’s for everybody. You have to take into account the behavioral element as I say.

[00:32:32] Niels

Yeah. Absolutely. Our listener has one more question follow up. He says, “Given the straitjacket of the EU regulation, what are the better options to gain exposure? Man, Winton and DUNN Capital all have UCITS, but do you have any good resource or insights to help the selection process?”

I have one suggestion, Alan, but you may come across this more. Are there any public places where you can go and have a look at some of these funds nowadays?

[00:33:09] Alan

In terms of like a fund supermarket, that type of thing?

[00:33:12] Niels

Well, okay, so I’ll give you my resource. One I was thinking of, and I don’t know if you have to register. I think you have to register, but I have a feeling that these gentlemen, even if it was for accredited investors, they would be fine. My source would be the Kepler database which I think lists all the UCITS funds.

Now, again, I would say you don’t have to be restrained by UCITS. I think the offshore vehicles of these managers will be cheaper. You may have monthly liquidity instead of daily liquidity, but you shouldn’t really worry about that if you have a long-term investment horizon. But yeah, I would say that database is one that I would say probably gives a very good overview of UCITS funds for sure.

[00:34:03] Alan

That’s right. It’s a good comprehensive list and has some analysis. Obviously, they have their own platform with certain managers as well. So, I think that’s certainly the case. You can get the UCITS performance data on lots of platforms, the FT as well.

I think in terms of the question around any insights as to how to make the allocation decision, I think, within the UCITS space, the general issue is around how to make the decision as to allocating in the space, which we kind of know about in terms of multi-manager or not, or allocating to a few managers, or trend only or diversified. So, they’re all the typical things.

But also, when we’re working with investors, we’re highlighting that. Often, in this space, investors don’t have a facility to do a managed account so it’s a fund only. So, when you think about it, you’ve really have got to be conscious of the level of volatility again. So, I’d emphasize that because, obviously, if you can allocate to managed account, the manager’s vol doesn’t really matter because you can lever it up or down to whatever vol you want.

But when you’re constrained to allocating funds, you’ll get more bang for your buck if you go with a higher vol offering. So that’s certainly one important thing to think about. Obviously, the fees, particularly with UCITS, the fees are generally a bit harder than the offshore vehicle. And then, obviously, are you getting the commodity exposure or not? So, we’ve got different approaches.

Some managers took out commodities because there were issues around that in Europe. But increasingly, managers are now accessing commodities either via swaps or certificates, but basically overcoming that challenge. Certainly, as a general rule, you’re better off having your commodities in there. So, they would be the things to think about.

It is difficult to get access, as a private investor, in Europe. It’s not like the US where you can just buy a lot of different strategies through the brokerage account. You have to go through either direct to the manager or through a wealth manager. But yeah, it’s a matter of going through the due diligence process as you would with other strategies, but just through the lens of the particulars of the UCITS.

[00:34:37] Niels

One thing I would just add, given the fact that I work with UCITS every day, is just to be aware that there are some funds where you can actually buy them directly. You may have to have the subscription documents sent via your financial advisor, but where you can buy them directly, and therefore, you don’t pay any extra fees to custodians or banks or whatever.

Because I do get a feeling that if you ask your bank to do it, or a platform, they’re going to charge you something for doing it, but you, in many cases, don’t really need them. But anyways.

[00:37:10] Alan

I know on Interactive Brokers, you can invest directly in a small number, but it’s not very large. There are a couple of other platforms in the UK like AJ Bell in some of these. As I say, the industry hasn’t evolved to be like the US mutual fund market by any means.

[00:37:29] Niels

All right. Let’s move on to, actually, the topics of the day. The first one is still within the playground of managed futures because I sent you a question yesterday. The question was inspired by the fact that because many equity indices have recently come out of a drawdown, lots of people were posting charts about how long, in days, had the recent drawdown been and how long do equity drawdowns typically last?

I didn’t have, myself, any particular stats on what about managed futures, trend followers, what about drawdown length? We talk about drawdown depth, but we don’t always talk about drawdown length. My hunch is that they’re certainly shorter than equity drawdowns on average, but I don’t have the numbers. But I know you may do, so I’m excited to hear what you found.

[00:38:31] Alan

Brace yourself. I don’t think the numbers are that exciting. I only did a very cursory analysis last night and this morning. To give context, as you say, the SocGen Trend, and I’ve only looked at it since 2000, and based off monthly data, so it’s not as minute as it could be. Generally, in terms of magnitude, certainly, equity drawdowns are much bigger in terms of the magnitude.

If you think about it over the last 20, 24 years, you had ’07, ’09, that was about 51%. 2000, 2002 was about 44%. You had another drawdown during COVID, 24% or so. There was another drawdown last year, sorry, 2022. Whereas the largest drawdowns for the SocGen Trend Index are of the order of the top five of 15% to 20%. So these are much bigger drawdowns in terms of the magnitude.

In terms of the duration over a period, they’re actually pretty similar. The longest drawdown in both cases was I think 72, 73 months, so six years, which surprised me because the largest drawdown for trend following did rumble on in that period from 2015 to 2021. Now, some of the managers got out of drawdown through that period before the index did. So that’s why I had to go and check that again because there was a couple of upswings in performance for trend following. But for the index as a whole, it did go on that long.

The other interesting thing is when you look at it, the SocGen Trend Index is in drawdown 85% of the time in that period, which is not surprising. We always say trend following is always in drawdown the majority of the time, whereas the S&P was in drawdown 73% of the, which is probably higher than if you took a long-term perspective going back before 2000. I would say that number would be a little bit lower because obviously we had two big equity drawdowns in the 2000s.

In terms of the number of drawdowns, we’ve had 28 for the S&P and 23 for the SocGen Trend in that period overall. So, what do you make of all of that? It didn’t make me feel any more or less inclined to invest in either equities or the SocGen Trend. I know you do see some analysis around the SocGen Trend in a drawdown of whatever so now is a good time to invest.

[00:41:13] Niels

Well, of course, what we should have done, Alan, what we should have done is to say, okay, that’s fine. But what happens if you do 50/50 of those two? What happens to the length of drawdown? I think that’s where the magic happens at least. But the other thing is, I seem to remember that I once saw an article of someone saying, did you realize that the Amazon stock that has gone up I don’t know how many thousand percent in the last 25 years, actually, is below an all-time high like 95% of the time. So, drawdown is a funny thing. It really is.

[00:41:52] Alan

That was one of the points. Is drawdown the right measure, the right thing to focus on? Even when we had that drawdown in trend following, that long one, my recollection of it maybe wasn’t even as painful as the one that was before that, the 2011 to 2014, which seemed to be more a painful one for investors. That’s just my own perspective.

But I certainly think it’s not just drawdown, it’s what’s going on in other asset classes, how the rest of the portfolio is doing. You can still have positive years within a drawdown, so I think as long as people are seeing progress in the right direction, drawdown isn’t necessarily the be all and end all. But it is certainly one relevance.

[00:42:35] Niels

You and I talked to a manager last year, and people have to go and check out and guess who it might be. But we talked to a manager last year in our CTA series, and I think they had been in a drawdown for more than 10 years, actually. I’m not going to say the name. People can do their homework. Once you go to those extremes, that’s going to hurt business. But yeah, all strategies come with drawdowns, and of course some of them can be dragged out a bit. It doesn’t mean that they’re severe. It’s just kind of more boring than anything else.

Good, all right, let’s move on to something that is not related to manages futures as far as I can tell, a paper that you sent over to me, which I don’t think I had time to glance through because you sent a few papers. But this one, I thought, yeah, I’m going to leave that with Alan. So, tell me about this one and why you wanted to talk about it. It’s a paper called “Stocks For The Long Run – Really?”

[00:43:35] Alan

Yeah. I think that might have been the title I thought of. It’s called “Stocks for the Long Run? Sometimes Yes, Sometimes No”. It’s by a guy called Edward McQuarrie, who’s a professor at Santa Clara University in California. I saw this paper being referenced before Christmas and I didn’t have a chance to read it at the time. So, it was on my mind to go back and have a look at it.

It’s a reassessment of what the long-term evidence on equity performance and the equity risk premium is. The title “Stocks For The Long Run” is obviously a hail to Jeremy Siegel, who wrote a book that I have here beside me. It was the piece of research, piece of work, that really formalized, from a data and a research perspective, the case for having equities at the core of portfolios.

It really put the data in a very clear place that showed the long-term outperformance of equities. It showed not just long-term outperformance of equities or fixed income and cash, but also that there seems to be a fairly stable long-term real equity return over three long-term periods. He showed that the real return on equities in the US was about 6.5%, 7% over three distinct (I can’t remember) maybe 70-year periods.

Also, it showed that your risk of holding equities went down the longer the holding period. The volatility of outcomes declined, and also the likelihood that you would outperform fixed income increased the longer the holding period. So that’s why it very much became a no brainer, stocks for the long run.

Well, Edward McQuarrie has reassessed that. His paper is about the fact that you’ve got new data available, particularly for the 19th century. Some people might immediately switch off and say, well, who cares about the 19th century, but bear with me for a moment.

He goes back and he says there were some flaws, not flaws, but some shortcomings in the data that Jeremy Siegel used back in the 19th century, and that there’s a broader dataset available now; more stocks, more data on more bonds in the US stocks traded outside the US.

He gives the example of a stock, the Second Bank of the United States, which wasn’t included in the original analysis somehow. It was the largest stock in the US before the panic of 1837. It accounted for 30% of the market cap. So, kind of like the Magnificent Seven all in one. That stock went from $120 to $150 during this panic of 1837. So, it does sound like some fairly meaningful emissions, you’d have to say, in the old data.

Anyway, so when he looks at the long-term performance again, he’s splits the data up into three periods: 1790 to 1940, 1940 to 1981, and 1981 onwards. Basically, what he says was, unlike the Siegel paper which would have said there’s that 7% real return from equities and a fairly consistent equity risk premium, that that consistency is now not there when you look at the data again. He does say that in the period 1940 to 1981, certainly equities outperformed quite a bit relative to bonds.

Now, obviously, the starting point for yields was very low. That was post World War Two, and the Fed had been basically enacting yield curve control, so bond yields were unusually low in 1940, not as low as we saw in 2020 but they were low. And then obviously, the end of that period is 1981 when yields got up to 18%. So definitely a period where bond yields go from 2% to 18% is going to be very tough. But it was a good period for equities as well.

The way he describes it since 1981, they’ve been pretty even, about the same. Now, I was a bit dubious on that assertion. I’m not sure if that’s quite correct. Certainly, they were pretty close up to around 2009. But certainly, I would have said equities parred ahead since then. But anyway, notwithstanding that. And then if you go back to the 1792 to the 1941 period, actually, bonds did better.

So, what to make of this if anything? Firstly, I would say about the 1800s, obviously, it’s going back a long time so people might say that’s just too long ago to be to be very relevant. It is actually interesting if you look at the long-term economic history of the US and the world. There’s an economist, Robert Gordon, who has written about this.

Basically, economic growth accelerated from 1870 onwards. It was after the US Civil War. And this century, 1870 to 1970, there was a boom in innovation, in productivity of the likes of which we’ve never seen ever. And Robert Gordon, in his book, he points to another economist. He says, between AD81, so basically time of Christ, whatever, since then, to 1880, economic growth grew by 0.06% per annum. So that’s like 6% per century.

Basically, nothing happened for 18 centuries, and then growth took off. So that would be one reason to explain why equities were more challenged in the 19th century. Economic growth wasn’t as strong back then. We did have some periodic periods of deflation. We had the US Civil War as well. So, it doesn’t make sense that that would have been more challenging period.

Does that mean anything for investors now? Well, for sure, you could still have a civil war. You couldn’t rule that out. You could still have deflation again. So, it’s not totally irrelevant I would say. The second thing that he does was, in the Siegel book, he says Siegel also looked at rolling returns, not just taking these three distinct periods but taking rolling 10-year, 20-year, 50-year.

In Siegel’s analysis, there was I think he said a 3 in 5 chance that stocks would outperform. But if you held them for 30 years, it was a 9 in 10 chance that stocks would outperform bonds. So again, very compelling. It’s kind of a no brainer to be long stocks if you’re a long-term investor almost to the exclusion of anything else.

But when Edward McQuarrie reruns the data, he doesn’t find that those rolling periods are as strong, certainly not up to 2 in 3 or 9 in 10, whatever it was. So that is one thing. The second thing he does is he points to the international evidence, and the international evidence is much less supportive about this very strong equity risk premium.

He points to, I’d have to pull up the numbers there, but he points to 20, 30-year periods across lots of different markets. For example, the lowest equity risk premia observed internationally over 20, 30 and 50 years. So, it was a minus 2% over 20 years in Australia. So, stocks underperformed bonds by 2% for the 20 years ending in 2008. We’re not talking about 1800s anymore. We’re talking about recent past.

In Italy, stocks underperformed by 5% per annum for the 20 years to 1979. We obviously all know about Japan. We know about Germany in the war, all of that. But the point he’s saying is that this perception that it’s kind of an unwritten rule, a law of the market that there’s an equity risk premium of about 4% for stocks is not there if you go back long enough and if you assess it far enough in the world, which I think is a fair point and very interesting.

The final part of this paper, which I felt was really interesting to and which is kind of relevant in our world and from an asset allocation perspective, he says what’s important is that you can’t just say there’s an equity risk premium of 4% or whatever. He says it’s pretty much regime dependent. We are in a regime, at the moment, which is favorable for equities. And the 1940 to 1980 period was very much favorable for equities vis-à-vis bonds, but the 1800s were not.

He makes the point, which I think is a good one, we naturally think about looking at more and more data to give a better sense of the sample, that this is a larger sample of history. He’s saying that’s maybe not the right way to look at it because if you mix two different regimes, you’re kind of getting an average, but that’s not that informative.

So, if you take the perspective of say correlation for example, and he shows the 20-year correlations between bonds and equities, they were as high as plus 0.9 back in the 1800s and then went to I think negative 0.9 in the more recent regime. Equally, if you’re mixing a very high equity risk premium with a very low one, and you’re saying the average is 4 or whatever, maybe that’s not as conducive or as helpful as to say that in a favorable regime, it will be this X, but in an unfavorable regime, it might be Y. That gives you much more information as an allocator.

So, his message is once you accept the premise that stocks can disappoint, this all-equity portfolio is less of a no brainer. It’s interesting because the other people who have done a lot of work done on this are Elroy Dimson and Ibbotson, and they wrote this long-term study of 100 years of asset class returns and they call it the “Triumph of the Optimists”, which I think is a good way of putting it because if you’re going all in on equities, you are taking that optimistic view.

Yes, most of the time, you will be right, but that’s not to say it’s a rule that you’re guaranteed over the next 30 years, if you hold, that you’re going to do very well. It could be a favorable regime, it might not be. So, I think the whole thought around what’s the outlook for the regime is very important. And I think from that perspective, that this idea of being equity heavy and equity centric, even the concept of when people talk about expected returns, the expected returns on equities is 8, the expected returns on bonds is 4.

So, then you say, why would you ever invest in bonds because your expected return is 8, you know what I mean? It doesn’t make any sense. But that’s a statistical term. That’s just saying that the mean historically is 8, but it might be misconstrued as something else. Whereas it might be more helpful to say to somebody, in a favorable regime, it could be 10, in an unfavorable regime, it might be zero over the next 20 years, and make up your own mind as to how much of an optimist you feel like and that will determine your asset allocation.

But I do think it helps frame the discussion around adding diversifying strategies as well, not just purely looking at the average of the data over the last so many years.

[00:55:37] Niels

Yeah, we’re going to spend the last five, seven minutes on that because there’s another paper you cited from our friends over at AQR. You touch on regimes, and I think that this is super important. We all know that maybe the last 20 years has been a little bit- because that’s what we kind of remember. I think we all know that they’ve been a little bit unusual for many reasons.

I’m just thinking at the moment, when you just think of how much performance of equity markets are driven by, as you mentioned, the Magnificent Seven and how much money goes into those stocks or flows just purely from products being created to mirror an index where probably you can synthetically design them, where you put most of the flows into the Magnificent Seven because maybe you don’t want to buy all 500 stocks in the S&P 500 for example.

And then on top of that, you have massive concentration of capital because managers like Vanguard and BlackRock, they own huge amounts of these Magnificent Seven stocks. I think that Vanguard owns 8% of Apple or something like that, which is crazy. These products are not price-sensitive. They’re just driven by flows. So, what happens when the inflows we’ve seen for years and years maybe at some point turn to outflows? Who knows?

Of course, within the Magnificent Seven and other big companies, we’ve also been through a regime where buybacks have been the big thing. I think Apple is buying back 80 billion of stocks every year. So, it’s just a crazy time in many respects. Anyway, we’ll see. But actually, that is quite a nice lead in to the AQR paper where they kind of ask whether the next decade will be like the last one. So, it kind of plays a little bit on that. I’ll let you briefly talk about it.

[00:57:46] Alan

I won’t spend too much time, but it’s basically asking the question, what’s the likelihood of the returns that we’ve seen in US equities over the last decade or so being repeated? We often say it’s going to be hard for equity to do as well. But what they actually do is decompose the returns into a number of different factors or the different constituents that drive equity returns, which are the dividend yields, the real earnings growth, whether there’s any multiple expansion, and then the risk-free rate.

Basically, they go through it all- they don’t go through it all in detail, but they go through it all bit by bit. Over the period 2013 to 2023, obviously, you did have real earnings growth as being an important driver, but you also had significant multiple expansion. So, can those multiples expand by as much going forward? That would be very difficult. And then it’s a question of what about the other constituents.

The conclusion is that the last 10 years were unusually favorable. When you look at the building blocks, it’s going to be hard to repeat such a positive performance. That is not to say stocks are going to drop by 50% or anything. They’re just saying that expect more muted returns.

Once you do a fundamental decomposition of the fundamental drivers of equity returns, it points to more muted returns over the next 10 years. But that is even without any potential regime change as we’ve been talking about within the current kind of regime.

[00:59:31] Niels

I think they’re the ones who also go on then to ask this question about whether you really need diversifiers in a 60/40 portfolio and whether CTAs are essentially just vol dampeners, or maybe that’s another…

[00:59:46] Alan

Possibly. As we’re up on time, I think that might be a topic that we’ll have to come back to on another day I think. There’s too much say on that.

[00:59:55] Niels

Fair enough. Fair enough. Can you give us a little bit of a teaser in terms of that?

[00:59:58] Alan

I had a conversation in the Allocator Series with Joe Prendergast at Goodbody, the most recent one. They are a wealth management firm here in Dublin. He was making a point, in terms of how they run portfolios, it’s probably 50% growth assets, 50% kind of safe, diversifying assets. So, it’s kind of a derivative of the 60/40 portfolio.

He was making the point that, actually, if you look at it on a rolling five-year basis, that portfolio does pretty well. It does very well historically at always having an above zero return. A lot of the time, us in the managed futures industry, I’ll include all of us here as part of that, when we’re making the case, often we say, oh, well, it’ll improve your Sharpe ratio. And then the question is, is that relevant for a private investor? As you say, you can’t eat a Sharpe ratio.

It does mean a smoother ride. But just because something dampens vol, is that enough? Equally, we often point a very long data series when we point to benefits of managed futures. We say, look, over the last 24 years, it did X for your portfolio. And people might say, well, my time horizon is more like 5 to 10 years, so how relevant is that?

So, what I was going to do, maybe we’ll do it again, is can you still make the case for the strategies, which I think you can, even just ignoring the fact that you can obviously get Sharpe improvement and volume reduction just purely from the lens of the outcomes on a five-year basis. Because I think that’s the challenge that you get.

Certainly, when I speak to some investors, they’ll say, do we need these liquid alts anymore? Bond yields have gone up. They’re just there to- what are they there for? So, I do think there is that perception. On one extreme, you have people on this podcast who’ll say trend following plus nothing, but a lot of the investors I speak to are more in the if you’re trying to incrementally get them to allocate to these strategies, these are the challenges and the pushback that I often hear.

[01:02:05] Niels

Yeah, that’s fair. We’ll definitely pick this up. Just remind me, Alan, next time we speak. Because, of course, we do want to certainly dig into the whole point about what it really means to diversify into non-correlated strategies and what that does to the compound rate of return, which may smooth the Sharpe but it does a lot of other things which I think you and I can agree on.

All right. Good stuff. Well, before we pack our bags and head for Miami, Alan, let me just say that if you enjoy these conversations, then please go to your favorite podcast platform and leave a rating and review. We always need them, and we always appreciate them, and we always read them. Of course, if you have a question for any of us, you can email it to info@toptradersunplugged.com. I will get it to the appropriate person and we’ll bring it up on the show.

Finally, next week, I will be recording from Miami with Mark, probably not in person, but anyways. So, if you have any questions for Mark, then do send them over and I will do my very best, even if I’m on the road, to make it happen.

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

[01:03:34] Ending

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

Remember, all the discussion that we have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions.

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

Remember, all the discussion that we have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions.

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