Rethinking Bonds: the Changing Role of Fixed Income 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] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Andrew Beer and I, Niels Kaastrup Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor. Andrew, great to have you on the podcast this week. How are you keeping and where do we find you today?

[00:00:41] Andrew

Thank you. I’m at home. I moved to Connecticut in January. I spent a long time north of New York City. I spend most of my time working here if I’m not traveling or in the city.

[00:00:55] Niels

I hear you’re going warm places next week.

[00:00:57] Andrew

Thank you so much for having me back on. It’s great to be here as always.

[00:01:00] Niels

Of course. Absolutely. I was just going to say that I just got back from Miami. I hear you’re going to Miami. It’s very nice and sunny down there at the moment.

[00:01:09] Andrew

You know, it’s cold actually. I was there for a grand total of about 36 hours this week and then I go back for the ETF conference I’m on. It was really not terribly warm. Warmer than it was here at least.

[00:01:22] Niels

Yeah, exactly. You’re right. The Floridians, they complain about the temperature, but I thought it was really nice.

[00:01:29] Andrew

And the hotel that we’re staying at, in Celsius, it couldn’t have been much more than 15, 18 degrees in the hotel lobby. You had people walking in with down coats. They didn’t dial back these industrial strength ACs when the temperature had dropped 20 degrees.

[00:01:48] Niels

Sounds like a Scandinavian summer to me, 15 to 18 degrees. So there we are. All right. We’ve got quite a varied list of topics lined up today which I’ll be excited to get into. Before we do that, I always ask you just because I’m curious and I’m sure our audience is curious as well, what are the things that have come on your radar recently, what are the themes you’re thinking about which are not the things we’re going to be talking about. But just generally speaking, what do you find interesting?

[00:02:16] Andrew

One of things I find interesting, to me, as somebody who’s spent a lot of time studying history, it feels like a very dark time right now. The Middle East feels very dark. Eastern Europe feels very dark. The geopolitical situation seems very dark. The political situation in the US seems comically dark in a lot of ways. So now I think when I talk to people, they think Trump is favored to win a second term, which obviously strikes terror into the hearts of large segments of this country.

But what I find interesting about it on the business side is that is actually driving a fair amount of business optimism. Outside of the headlines and the acrimony and the anger and the unpleasantness of it all, I think there is a view in the business community that we’ve really got to clean up some of this, the extent to which the government is more and more involved in choking business activity in a way. It’s just a very fascinating.

I’ve just seen it in the past several months when it’s become clear that Trump is really now favored to win. That coupled with optimism is fascinating to me.

[00:03:33] Niels

Someone reminded me on Twitter this week about my own 2024 outrageous prediction that neither Trump nor Biden will make it to the ballot in the end, so we’ll see. But I do share your points. And it is, in some ways, kind of interesting that we live in a world where we can certainly say that the uncertainty and the geopolitical risks are heightened to a level that we haven’t seen for a long, long time, yet a lot of the financial markets are doing really well. So there’s a little bit of maybe a disconnect.

Because on one thing, you could say earnings look great, etc., but it’s just not being priced in, neither in credit spreads, etc. It’s not being priced in that this could all go terribly wrong. So we’ll see.

All right. Before we dive into the topics, let’s do a quick review from a trend following point of view, and then I’ll try and tie it in, with your help, to the replicator world of course.

From my perspective, I would say the last week or so, there’s a lot of trends that continue to play out in the trend following world and I think a lot of trend followers are taking full advantage of what’s happening at the moment after a somewhat more choppy year last year, the “Year of the Whipsaw” as you coined it.

Last week, I actually suspect that in a classical trend following portfolio, I think a lot of sectors have been participating in delivering the performance that we’re seeing at the moment, of course with a few standout markets like cocoa which hit all-time highs. And of course, I was little bit curious, because we’ve been talking about cocoa for a while now, so I did look into it.

It turns out that some of the key countries in terms of supply, Ivory Coast and Ghana, they’re seeing something like a 30% to 40% decline in supply due to some seasonality and some winds and some drier weather from El Nino I think was one of the causes as well that they were pointing towards.

Anyways, kind of interesting at the moment. And of course, at some point, Andrew, this will feed into the price of chocolate. So we may not be able to afford cocoa powder on our cappuccino next time I see you, but we’ll see. Other than that, I think other sectors metals, meat for those trade meat, energy, grain, maybe with the exception of something like soybean oil, also should have done pretty well. Actually, also fixed income and equity positions.

So incredibly broad based I would say right now with a few standout markets in trend following. We don’t see that so often. Perhaps the only sector I can think of right now that may be struggling a bit is currencies, not necessarily losing money, but just not making a lot from what’s going on. So I’m curious, when you hear these drivers that I see, what do you see from a replicator point of view in terms of your own portfolio?

[00:06:45] Andrew

It’s a good question. We see a very simplified worldview compared to how you talk about it. I think when Powell started talking November 1st, I was skeptical that this was the end. Our portfolio and a lot of portfolios were very much betting on some continuation of higher rates.

Even a month before that people were talking about like, ah, Powell doesn’t have to raise rates again because of the bond market, because yields have gone up. So when he pivoted and then he reinforced the pivot by basically saying… I was personally shocked by it but that’s not how we invest. We’re just trying to figure out what you and other- actually, not you, but smart guys are doing in the space, the bigger, more diversified funds.

But I’ve sort of come to the conclusion now that the hiking trade is over. You can book end it. The big trade, getting it early, it being a early contrarian trade, and then by the end of last year, if you were short term, you were already out of it and probably doing pretty well in protecting yourself. If you’re longer term, it took a while to get out of it, but it’s over.

So we see the action is gone in fixed income. We have slight flatter trades out there. It’s nothing terribly significant. But what I find really interesting is I used to talk about the portfolio in 2022 as being in crash protection mode. There was a period of time where it was just bearish everything. And now we actually see it going risk on. So we’ve seen equity risk dial up.

I think the most interesting thing that we’re seeing ties into something else that we’ll talk about with the US versus EM or international versus EM bias. And then also in the currency markets, our currency portfolio used to be very simple, but it’s also the decline of the yen. The yen, it’s just incredible. I think it’s down 6% this year. So if you’re concentrated in that, it’s been a big benefit.

But I think the underlying theme, in terms of what I talked about, is underlying all this dark macro stuff, I think there is a different level of widespread optimism and risk-on that we’re now seeing in our portfolio and I see it anecdotally when I talk to people.

[00:09:05] Niels

Yeah. I’m actually impressed that your performance is kind of keeping up with the index in a period where there’s a lot of smaller markets that are actually doing the heavy lifting for trend followers like us and not the big markets nor the big sectors. So yeah, good on you.

[00:09:27] Andrew

We may be lucky. We’ll see.

[00:09:29] Niels

It’s better to be lucky than flat I guess, but there we are.

[00:09:32] Andrew

It’s working for now.

[00:09:34] Niels

Sure. Now, my own trend barometer finished the month- not the month but finished the week or as of Thursday at 43, which is still somewhat neutral to weak, which kind of ties in with what’s going on for the SocGen Short-Term Traders Index which is up 71 basis points for the month but it’s still down 22 basis points for the year. For those who don’t know, my own trend barometer is more short-term timeframes that’s in the algorithms.

But as I mentioned early on, the index or the CTAs and trend followers as a whole are actually doing okay so far this year. We have the BTOP 50 up 2.25% for the month of February already, up 3.5% of the year, SocGen CTA Index up 2.4%, up 3.4% for the year, and the trend following index SG Trend up 3% and up 4.21% for the year.

Comparing that to the traditional markets, MSCI World equities are up 2.37% and up 3.54% for the year, World Government Bonds down again in February, down 1%, roughly, and the S&P 500 is up 3.77%, obviously making new all-time highs this week, and up 5.52% so far this year.

Now, I don’t know if this is the right time to mention this, or maybe we’ll talk about this. Are we going to talk about equities and stock picking and breadth and stuff like that later on today? All right, then I’ll save my points for that. So you sent over a really good list of topics, Andrew. Although I think the first one, we probably have touched on before, but you may have some other views thinking about it today, and then we’ll go on to some topics we definitely haven’t talked about before.

But actually, I think the first one is very relevant. It’s something that almost comes up one way or the other in the meetings that I’m having at the moment, and that’s, should you replace bonds with managed futures, but also vice versa. Because obviously, bonds have suddenly become very interesting compared to a while ago, at least in terms of what they pay. So I’m very curious to hear where we’re going to go with this from your perspective, Andrew.

[00:11:57] Andrew

Sure. I say that almost as a thought experiment. People are not going to jettison bonds from their portfolios. But having done this for a long time and having spent a lot of time- I was a history major and I like thinking about longer-term things, but also fascinating in terms of how people look at recent history and how they interpret it.

I think what’s happened in the 2020s as it relates to bonds is earth-shattering from an allocation perspective in a way that people haven’t fully processed. Because in the same way that when interest rates started to come back up, most allocators, going into 2021-2022, had essentially low rates bets throughout their entire portfolio.

If you like tech stocks and you like the S&P 500 which was largely tech stocks and being driven by tech stocks, it’s hard to have that view unless you think interest rates are going to stay low. If you’ve been loading up on Double-A rated corporate bonds, the 1.5% yield and a 10-year maturity, if you think interest rates are going up, that’s economic suicide.

REITs, real estate, people are buying office buildings at low single-digit cap rates. So this was a trade that went through everything. I think taking a bigger step back, the great trade of the 2000s and 2010s was owning bonds, and I think people don’t appreciate how unusual that period is. So may I bore you with a few statistics?

[00:13:33] Niels

I’d love that. Sure.

[00:13:36] Andrew

Okay. Just running some numbers this morning, since 1990, cash has earned you 3%. It is rational to think about how much better I am going to do than cash over that period of time. By the way, my stocks, I’m going to use the S&P 500, home country bias, and I’ll use the Bloomberg Ag for the measure of bonds.

But basically, since 1990, stocks have done 700 basis points more than cash, which is what people call the equity risk premium. And bonds have done 200 basis points more than cash. But also the volatility of stocks has been around 15% and the volatility of bonds has been around 4%. So when you look at it, they actually have identical risk adjusted returns, Sharpe ratio of 0.5.

Now, as Warren Buffett would say when they’d say if you didn’t have Berkshire Hathaway, what would you do, and he said, I’d put 95% of my money into the S&P 500 and 5% in cash and not look at it. Stocks over that period of time since 1990 have got about 28 times, and bonds with much less risk have compounded and gone up 4 times over that period of time.

But in that, the 2000s and 2010s, the single best thing you could own was bonds. So here are those comparative statistics. Cash does 2% over that period of time. This was the great bond bull market. Cash does 2%, stocks do cash plus 4, which we’d forgotten about because we forgot that we had a lost decade for equities in the 2000s. And bonds do cash plus three.

You think, well, okay, cash plus 3 is not that big of a deal, except for the fact that also the volatility came down to somewhere in the low threes. So the Sharpe ratio of bonds, with just that incremental increase in returns by 100 basis points and a drop in volatility, was 0.9 for 20 years. You had a max drawdown of 4%.

The incredible thing is when you look at the S&P 500 versus bonds over that period of time, for 16 of those 20 years, stocks have been outperforming bonds from the beginning. It’s a straight line from the lower left to the upper right. So what that did is there’s a feedback loop. By the way, bonds had a correlation of minus 0.1 to stocks over that period of time.

One of the big trends in the background has been the whole wealth manager world has gone toward model portfolios. When you’re building model portfolios, you’re looking at the past and generally extrapolating it out to the future. So you’ve had basically building asset allocation models on the basis of an unsustainable bond market. Think about bonds, think about how strange bonds are relative to equities.

Let’s say the company has bonds with a maturity, average maturity of seven years. It means that essentially, the equivalent would be every year 15%, 14%, 15%. Everything gets retired and they have to keep reissuing it. How does the reissuing process work? When you read in the paper and they’re like bonds are rushing things into the market because of this temporary drop in interest rates and credit spreads are really tight.

You have investment bankers and smart corporations try to sell bonds when it’s cheap for them to do so. On the other side of the table, you’ve got guys who are in the business of buying bonds. They’ve got one hammer and they’re going to buy bonds no matter where they’re priced. That guy cannot sit there and say, oh, screw it, I’m not going to buy bonds for the next five years. He’s not going to have a job.

So the structure, the industry structure is not designed to really give you the best risk-adjusted return on bonds. But it happened for 20 years because of this overriding drop in interest rates, because of the Fed’s paranoia about deflation and constantly stepping in and quantitative easing over that period of time.

So now look at the 2020s. In the 2020s, cash was earning 2%. Stocks had been on a tear. They’ve done cash plus 1000 over that period of time, and this has been a volatile period. Volatility has gone from 15% to 20% in this decade. And so stocks with that incremental increase in returns, but also a little bit higher volatility, the Sharpe ratio has gone from 0.5, which would be normal, to 0.6.

Bonds on the other hand are down 1% this decade. This is the part that people don’t talk about enough. The standard deviation has doubled to 7. So you’re doing 300 basis points worse than cash, but your standard deviation has gone up by 7 and your max drawdown has gone from 4. You had a max drawdown of 4 over 20 years. Your max drawdown is 17% and you have a positive correlation of 0.6 to equities.

If this continues, there is no economic argument, from an asset allocation perspective, to having bonds in your portfolio, and it’s not going to get to you like this obviously. But my point is that think about where we are in 5 or 10 years from now and you’re an asset allocator building a wealth management portfolio.

You cannot pretend that bonds have no risk anymore. You can’t pretend that bonds are this perfect hedge anymore, because now you can point to a period where they clearly failed. Everybody who had a 40% allocation to bonds over the past four years has failed to diversify. It has cost them.

So, when I talk about managed futures and I could tell you the stats on managed futures, which you know as well. If you compare managed futures to bonds during the 2000s and 2010s, bonds were much better. You had identical, roughly zero correlation to stocks, but you had a third of the volatility. You had a much higher Sharpe ratio. You had a third of the drawdown.

It was simply a much better way to diversify your stock portfolio. Ultimately, all of these models are designed to protect you from equity volatility. Yes, you made 28 times your money over 34 years, but you go through brutal periods where everything looks like it’s on fire. So you have to have an iron spine to weather it.

But this decade, your protection didn’t work. I’ve seen a curious thing recently, which is we see these surveys of investors, and a really, really surprisingly high number of people are saying I want something that has very, very low correlation to stocks and bonds.

That’s a reflection of the fact that bonds and everything that’s linked to bonds, whether it’s REITs, whether it’s property, etc., is just not working anymore as a hedge against the thing that would have made you 28 times your money, but what was very volatile. When I think five years out and the guys that I know are building asset allocation models, there’s going to be this existential reconsideration of whether 60/40 is the right starting point.

As they shake up that model, then the question is, what can we find out there? Usually, they’re constrained. If it’s a sovereign wealth fund, they can do whatever they want. They can put it all in Millennium and Citadel or whomever else. But what can we find that has low correlation that actually helps to diversify equity risk?

I’ve said this a million times, the absolutely, utterly obvious answer, if you care about liquidity, if you need to invest in a UCITS fund or an ETF or some sort of a vehicle, is managed futures. So there will be this natural buying tailwind associated with the strategy. I think it’s the opportunity for it to really go mainstream, but this is where I get into all of my pedantic messaging issues.

[00:21:59] Niels

I like what you just mentioned. Obviously, the argument, the data argument as such, has been here for a number of decades. The data you run today is going to look very similar to the data you ran 10 years ago or 20 years ago, meaning yes. And as John Lintner wrote about in 1983, adding managed futures to a stock and bond portfolio makes absolute sense, which he later got a Nobel Prize for.

But I guess what’s happened now is what you point out to, that we now have a recent example where people really got into trouble. And of course, where we in a bigger picture would say, well, maybe the 40 years we had prior to 2020 was a unique period, and especially the last 20 years leading into 2020 was an extreme period, and now we’re just going to go back to normal.

If you go back to normal, that means that most of the time, stocks and bonds will be positively correlated, so you won’t get the protection that you got in the first 20 years of this century. So that’s the change that I see as well. But what it will take to change investors’ minds, I’m still struggling with personally, I have to say.

Because when I meet people nowadays, and even if we have a very good argument on our side, people will say, well, now that I can get 5%, 5.5% on fixed income, that’s very tempting. So why should I even need a CTA product? Even if we can argue to them and say, well, you’re really giving up very little because we have so much cash in our products that you get that inside the ETF or the UCITS or whatever you buy, you get that as well. So, you’re really not giving up much but you get this wonderful non-correlated return trade on top. I still find it to be a really hard sell, Andrew.

[00:24:07] Andrew

Sure. Well, first of all, there are a million different kinds of investors. We faced the same problem last year. Cash was the obvious thing. Actually, in January, people were talking about it being the year of the bond. They were flat out wrong for 10 months, and then they got bailed out in the last two months of the year. But again, this also goes back to the industry structure.

The industry structure, you’re an advisor and you’re looking to your clients, and the psychology there is getting that quarterly coupon is deeply comforting and satisfying for most investors. The idea of capital protection and not losing money. “I worked my whole life to make money, I don’t want to lose it now.”

I have an 89-year-old dad, he shouldn’t be swinging for the fences on anything. It doesn’t incrementally matter to him. The psychological value of seeing it, boom, it hits his account every quarter, matters a lot to him. So people will make decisions on the basis of their job profile. Bill Ackman has this great expression basically that incentives drive everything.

So what has happened is a whole industry has been built around this. Vanguard will go down with a sword in their hand about 60/40 portfolios because they’ve told to everybody for 25 years that this was the simplest, most straightforward, easiest way to achieve your financial goals and they were right for 20 of the 24 years. So it depends on the target audience.

My guess is the typical pension plan, which had largely gotten out of managed futures by 2020, will have an allocation in three or five years. These guys move really slowly. But they do like statistics, they do like looking at historical data, they spend a lot of time thinking about these kinds of things.

I would add one other thing. Not only have the 2020s been disastrous for bonds. One of my partners that I work with, he always used to say that one of the disadvantages of financial history is you only have one history. When he was doing his PhD in physics, you could run a million different scenarios, 10 million versions of what could have happened and you can then look at outcomes and things like that. We’re stuck with one version of history and so are they.

They can never claim that bonds don’t have a lot of drawdown or risk. They will justify it because they were the ones who also told their clients that they would never go down like they did. I’m sure there’s not a single consultant out there that told their clients that bonds could go down 17% across their portfolio at the same type of stocks, or that the correlations would turn positive.

But the other thing that happened, and I think this is where we just talk about the history, is 2022 is in the record books. 2022 was not supposed to happen from every allocator who had invested in the space, had a bad experience, and then told their clients the space was dead. But there will be new generations of guys who go back and look at it.

I spoke to guys yesterday who don’t have any exposure to managed futures, and they don’t have the baggage. So the point is that I’m not suggesting that you’re going to find people with 60/40 managed futures portfolios, S&P managed futures portfolios. I would argue every last breath not to do that if you’re in the wealth management business.

But I think the other thing is, and we’ve talked about this a lot, I think the marketing investing in the space is tough because bonds feel safe. Stocks don’t feel safe, but we’ve had decades of people from stocks for the long run and people be it Warren Buffett and everybody else saying, never give up on stocks when it’s down. If you’re going to do anything, buy them, buy the dip, all this other stuff. There’s a whole language around it.

What I run into in the future side is it’s a strategy that is complicated to explain. People like to get in and talk about the weeds very, very quickly. The guys who built and run these businesses like that level of detail. The pension plans, the family offices and others like to hear it as well. It’s interesting. It’s fascinating. My God, cocoa, let’s talk about cocoa.

But for the other 99% of people out there, it just scares them because they don’t know what a futures contract is. Some of them don’t know what shorting is. They know about these concepts in general but they’re just trying to help their clients to grow their money and have a smoother ride, and to sleep at night. So there’s always a risk for them, whereas they want to help their clients do that.

The more complicated, opaque, difficult to explain an investment strategy is, the harder it is for them to help their clients to achieve those financial goals without agitation. So I don’t know how the whole thing is going to play out. But one of the disconnects that we’ve been trying to solve is that if you’re an asset allocator, you’re the guy building those model portfolios, you love things that are index-like.

If you decide to fill an asset allocation bucket with a single fund… In a sense, as I said, AQR did an incredible service for the space when they launched AQMIX in 2010. Because they came out with an institutional quality managed futures product that they themselves were going to build and run and it was priced at 121 basis points.

So for an institutional investor or wealth management firm, that was a step function in quality and pricing relative to what things were. Not of their own faults, but rather allocators misinterpreted that. They thought I love managed futures, AQR are the smartest guys in the room, I’m just going to fill my full asset allocation bucket with AQR.

So that mutual fund went to $14.2 billion at the peak. It was I think 60% of the overall managed futures space. That is a really, really- what’s that?

[00:30:32] Niels

How much of the managed futures space you said?

[00:30:34] Andrew

I think it was 60% of the managed futures mutual funds space.

[00:30:37] Niels

Mutual funds space. Okay, yeah.

[00:30:41] Andrew

Because model allocators would say, they’d go through this analysis of the SocGen CTA Index and they’d say, hey, I want 5% on this, I’ll put it all on AQR. Then over the next five years, because of however AQR configured their models, AQR underperforms everybody else by 20%. So imagine now you’ve made a 5% allocation to space and every time you sit down, you’re like the one guy we picked has done worse.

So the feedback loop was not to say next time I’m going to pick five guys, next time I’m going to spread my bets. Because one of the constraints these guys have is that when they invest in US large-cap stocks, they pick an S&P 500 index fund, or one or two funds. An institution will pick five guys, these guys have to pick one.

So the opportunity that we saw was for that particular audience, and those guys care about fees, they care about the vehicle, we’re going to try to give you a way of getting broad-based exposure to the space, something that looks sort of like an index even though it’s synthetic and simplified because ultimately, that’s what they’re looking for.

In five years, if the SocGen CTA Index does five a year, can this thing do five or six or something with a 90% correlation and not go through long, sustained periods of underperformance? Part of that, though is these guys are not familiar with the space. The hedge fund analysts at a family office or an institutional investor, they spend rightfully 90% of their time thinking about stocks and bonds and whether they add a little bit of EM or they get out of EM and stuff like that.

So this space has to be packaged in a way that they feel is understandable, logical, predictable in the sense of being index-like. That’s my theory. In several years, we’ll know if it gets any traction or not.

[00:32:44] Niels

Yeah. Obviously, you guys have had traction, and so has the industry as a whole. But of course, I’m still surprised by the under-investment for sure in the space with that level of evidence on our side. But we will see, and we’ll talk about it as it comes.

I think we’ve covered a lot of the things that you put in your first point that we wanted to talk about. I just want to make sure, is there anything else that we left out? We’ve talked about the practical issues that they face. Do you want to move on?

[00:33:26] Andrew

Sure. My concluding point is no one can erase 2022. Back to your point about why not just invest in cash as opposed to managed futures, look, collectively, we blew it last year. We’ve been telling people that as soon as rates are higher you’re going to get cash-plus, right.

Let me dig into my little napkin notes here, but from 2000 through 2020, the SocGen CTA Index, net of all fees and expenses, did 200 basis points more than cash. So in a sense, it was like a watered-down, risky, volatile, confusing version of protection that you would have gotten from bonds when bonds were the great thing.

Now look at this decade. Same cash was 400, and Sharpe ratio 0.5, correlation to equities at minus 0.2, max drawdown of 10%. All those stats look great. But then everyone had said when interest rates are higher, we’re still going to give you cash plus, and the space gave you cash minus a lot last year.

So the proving ground is going to be this year on the other hand, the opposite is true. So we get to the end of 2024, let’s say the overall space now had this incredible 2022, this comparatively lousy 2023, and then interest rates settle at 3% on the front end or something and the space is up 6%. That happens again in 2025, cash plus something, then the pieces fall in place for meaningful asset growth.

[00:35:01] Niels

I think one danger is of course always to look at calendar years. Calendar years mean nothing really in our industry because we know that that’s just not how trends of evolve, that they take any notice of what month we’re in or anything like that. So I think it’s very dangerous if you go out and you promise people just because rates are high over the next year or whatever period that we’re going to give you x. This is a super long-term cycle.

Even an example from the firm that I work for, sometimes I come across investors. We’re in our 50th year, 50-year track record in a few months. We’re sitting at all-time highs as of yesterday, and people will still ask me from time to time if I think trend following still works as a strategy. And I’m thinking well, there’s 50 years of evidence of that.

So I think it’s an ongoing journey. This is also why the narrative is important. Because even though we have all the evidence now for this decade, it’s still going to take some time as you rightly said before it fills us in. But the good news is that they can’t just change the data. I think that’s an important point.

[00:36:11] Andrew

To me, it’s such an interesting question when people say do you think is trend following still works? Do you think value investing works? There’s something about managed futures where people love to kick it.

Part of it is that if you didn’t have managed futures in 2022, and 2023 rolls around, you are dancing. You’re doing a victory dance. You’ve somehow been proven. 2023 wasn’t terrible. We underperformed by more than I would have expected but then we’ll probably bounce back this year. There’s going to be noise in what we do.

But overall, this space, coming off of 2022, but people were so focused on you got caught on this whipsaw, you got caught on that whipsaw. But I think that’s what their job is. They sit and they think about what’s the tough question that I can ask that’s somehow going to shed light on it. I’m going to get these guys and push them back on their heels, and they’re going to figure it out.

Have at it, guys. To me, the whole point of trend following, and again, it goes back to who you’re talking to, this question is, how tactical are you guys? You honestly think that you can tell me today not only what every asset class is going to do? I’ve talked to a consulting firm, they have 45 different asset classes, they model them out for the next 20 years. You think that’s going to be more accurate.

So to me, they said, why should we add a 46th thing for managed futures? I said because it does something you don’t do. There’s no way. I don’t care, if somebody told you World War Three is starting in a month with a 90% probability and all markets are going to crash, you’re still not changing your portfolio. You’re going to walk into that propeller blindly because it’s your job. You’re not supposed to move.

On the other hand, here’s a strategy, and I’m still wrestling with a better way to describe it than managed futures. But here’s the strategy that’s nimble and can be contrarian, and faster. So if you’re a long-term investor, you want a part of your portfolio to do that. But this whole idea of does it work, I find those questions irritating.

[00:38:30] Niels

Well, let’s move on. I think they are some of the things that we’ve already talked about, at least touched on. You wrote to me, let’s discuss whether the hiking trade is over, what comes next. I think you touched on that a little bit already. You mentioned that the whole space now is risk on. We talked a little bit about that.

But then you raised another point, and that is who fared better, short-term or long-term guys? What are your thoughts around that? What was your thinking about it?

[00:38:55] Andrew

Back to your point about calendar years, if the year ended on October 31, there would have been multiple years in a row where long-term trend following did better. But November-December sucked if you’re a long-term trend follower. I guess the way that I look at simplistically is, and by the way, I should say that our replication models are better at picking up longer-term trend than they are at picking up shorter-term trends.

But in the US markets in particular, we compete with guys who part of their claim to fame is that they introduce a lot more short-term models into what they do. So we spend a lot of time studying it and these guys may have magic modeling tricks that we don’t have.

But when we look at shorter-term trend versus longer-term trend, what people love about it is you are faster to get out of the inflection points. What people don’t like to talk about as much is you are subject to getting short-term whipsaws and head fakes.

So when we look at just the long-term expected returns and how, in 2022when you get a decade of alpha from long-term trend following, you guys have multiple decades of alpha from trend following, longer-term trend following, that to me is the thing that’s really valuable from a portfolio perspective.

But we had two brutal inflection points last year. You hit March and things collapse, the rates go absolutely crazy in March. And if you’ve got all of these tripwires in your portfolios, you get out faster. Now, the irony of it was by the time things settled down and we weren’t going into the recession by June and the banking world was saved and the carcass of Credit Suisse had been consumed by the UBS whale I guess, and then rates started going back up again, those guys were wrong footed.

So when I was looking at us versus these guys, yes, they did much better than us for three weeks and then much worse than US and you and other people and AlphaSimplex and other people over the next six months. And then they did much better in November-December, and then we’re wrong-footed again in January because they had gone too risk on, too early, too long bonds etc.

So I think I think my view on it, I would say as an asset allocator, I think if you’re thinking about investing in this space, your priority is to find long-term trend however you get that. But the advantage of shorter-term trend is it’s comforting. It may not increase your Sharpe ratio over a longer period of time.

Look, when a long-term trend reverses sharply, it’s horrible. You’re like standing under the propeller. Somebody pull me out of here. But having done this, you do get these head fakes in the market. So shorter-term trend has this sense of it sounds great. Oh, we’re going to get it earlier, we’re going get out sooner, and you just don’t talk about the fact that yes, but in the meantime, you’ll be bloodied by these week-to-week movements.

So I think in the US actually, what we’ve seen people doing, since that has value as an allocator at least from a storytelling perspective, if not from an economic perspective, we see people actually pairing what we do with one of those strategies and then basically being able to say it we’re somehow getting some diversification, getting broad-based exposure.

It’s quite rational. And if we end up getting paired with these mutual fund behemoths as part of an allocation, that’s great.

[00:42:42] Niels

Yeah. It’s obviously a discussion that comes up from time to time. There are periods clearly where you’re right, where this narrative of short term is so powerful that a lot of the flows will go in that direction but then people realize that actually, in the long run, they’re just better off taking the volatility that comes with the longer-term timeframes. At the moment, that’s what you see with some of the short-term guys where the flows are going out quite significantly.

In the last five years prior to 2024, the Short-Term Traders Index only beat the SocGen Trend Index one year, that was last year. It was down 1.77%, the trend index was down 4.17%. So not by a lot, and it lost out a lot over the prior four years in terms of performance.

Then you mentioned something, you say that we could maybe get into a wonky discussion about stock selection not adding value today like it did in the ’90s. That I’m going to leave to you to guide me into that one.

[00:43:56] Andrew

I hope you guys don’t think this is a pedantic history lesson, but my first job was in 1990. I was an M&A investment banker working for this guy named Jim Wolfensohn who ended up running the World Bank, and Paul Volcker was the chairman of the firm, which is where I got a little bit of taste of what Volker went through in the 1970s and ’80s.

But the interesting thing about it, one of the things you do when you’re an M&A banker is he spent a lot of time, we’ve got this client, they want to buy something, and you do a lot of this analysis looking at what are called publicly traded comps for that industry. So they sell widgets. Let’s look at all the widget manufacturers and do a financial analysis of the profitability, etc.

What you found back then was that if you looked at a given industry, there were companies that were obviously the A players and there were a lot of companies that were the C players that were still around. Now, there were fewer of them that were around in the early 1990s than say the early 1980s and 1970s because leveraged buyout firms were out there.

The M&A world and takeovers had started to basically, if you’re really a badly managed company, somebody, activist or somebody would kind of shake it up. But the world back there in general was, and again, we’re coming out of the 1980s where the big horror in the 1970s was when Japan is exporting cars to the US, it’s not only that it’s great for consumers, but it shines a light on the fact that a lot of American industry was really kind of rotted over time.

You had these corporate boards who weren’t really paying attention. Concepts that you think about today like, should I repurchase stock, what’s the optimal level of leverage, how do I think about optimizing cash flow and return on capital? This was really, really rare stuff.

So the opportunity that LBO firms had was an ability to apply these more sophisticated ways of looking at companies and figure out and separate the wheat from the chaff. But broadly, by the early 1990s, if you’re a stock picker, you could still look at an industry and say, okay, this company is terrible company but they’re really cheap, but I’m guessing somebody’s going to come along and shake it up, and lo and behold.

So you could buy the bad companies, expect something to happen, or the pricing of these companies was not as great. A lot of this was based on this growing belief that what companies should do is really focus on what they do well. In the 1970s and early 1980s, there was this idea of conglomerates, GE. GE is going to have this management playbook and they can just buy companies in any industry and make them better and take advantage of it.

That idea was essentially discredited by the early 1990. A lot of LBOs and people would buy these companies, they’d break them up, they’d sell off the pieces. They sort of realized that actually, you could add a lot of value. And there was also a view that people in manufacturing, like all the talent was going to finance and consulting and these things that people viewed as not additive to the country’s GDP over time.

So the dominant view about companies during the 1990s, 2000 to 2010s was focus on what you do well, focus on return on capital, return capital to shareholders to drive up your stock prices. That was driven by stock options. That was driven by independent corporate boards. If you didn’t clean up your act, you were going to get acquired and thrown out.

So it was a phenomenal period. Profit margins went up. And this is again going back to Warren Buffett who I think in 100 years people will still think was one of the smartest people ever in finance. People said, why would you buy the S&P 500? And he said, because you’ve got 500 incredibly hungry smart guys who run these companies, go to the office every day, try to figure out how do I make money for our shareholders and for myself obviously, and you’ve got corporate boards who wanted to do that.

So American industry really turned around. Now look at the companies that are dominating it. Take a company like a Microsoft or Alphabet. These are in a sense the modern version of the old industrial companies, and they’re conglomerates. Microsoft is in the cloud business, these businesses that didn’t exist 10 years ago. But it wasn’t discovered by some VC firm who invested in a company and they become the industry disrupter.

These guys are taking the cashflow in their businesses and they’ve become the capital allocators. They’re the ones who are bringing AI to the world. They’re buying up competitors when they think they’re competitive because they know about threats from competition. So they’re buying up companies.

You basically have these Frankenstein versions of the conglomerates of the 1970s but are run by guys who are unbelievable. They are the hardest working, smartest, full-throated, rapacious capitalists trying to figure out how to avoid having their companies be disintermediated, etc.

So the AI thing to me over the past year is a really, really challenging thing to allocators because it’s not supposed to happen. You’re not supposed to have these gargantuan industry players also be fastest and smartest about figuring out how to get in and dominate this new industry and deploy tens of billions of dollars overnight in yet another race to be first, to be fastest, to dominate industry share.

So I think when people look at things like the Magnificent Seven versus other companies, the other 493, whereas, yes, I’m sure you can have valuation disparities where you’re overpaying. I think somebody just told me that you have like a 50 PE on it. But on the other hand, they’re also much, much, much better as businesses than anything that we’ve seen.

So just part of what’s fascinating is where we started, is when I see this view of potential optimism also around say the US economy and US stocks at risk on, it seems integrated into this idea of when you’re betting on US companies, if you had to bet on the Magnificent Seven, it doesn’t seem crazy to me to be betting on these companies.

I think that’s what hedge funds started to realize about a decade ago, was yes, they might be expensive, but they don’t obey the normal laws of competition where you’re a dominant player and then these other disruptors come in and they start taking it away from you and you’re kind of desperately clinging to this melting ice cube, and 20 years later, somebody else is the dominant player.

These guys know that history. They know. They know what happened to Xerox and Kodak and Polaroid and all these companies, so they’re spending all their time trying to figure out how not to make that happen.

An interesting analogy I think for hedge funds, for wonky hedge fund people, is last year was the 25th anniversary of long-term capital. I was talking to journalists and others about it and I was saying the thing that you have to realize, is we look at that and we’re like, ah, this means one of the multi-stats is going to blow up. Those guys have been spending 25 years thinking about how not to be the next long-term capital.

I think it just shows the limitation of some of these historical analogies in that, I think when you’re thinking about these analogies, you have to think, has the world changed and why has it changed, and what does that mean? So, if you’re now a stock picker, where we started this, and you’re giving money to a multi-strat hedge fund, you’re relying on Ken Griffin and Izzy Englander and their teams of geniuses to figure out how much to put in this particular strategy, when to cut risk, etc. You’ve abdicated or you’ve outsourced the hedge fund picking process to these guys and you’ll pay them a lot of money for it.

By analogy, when you own Microsoft stock or Alphabet stock, you’re also outsourcing part of the stock picking and capital allocation process that you would have done 30 years ago.

[00:52:46] Niels

Adding to all of that is the even crazier thing that the Magnificent Seven are now the Fabulous Four, because this year is very different. Almost 75% of the S&P 500’s total return so far this year comes from Amazon, Meta, Microsoft and Nvidia. So it’s even narrower. It is crazy. Not a lot of breadth in that market, unlike what we see in the managed futures space at the moment where there are lots of different trends.

Is there one or two topics that you want to just touch on? You mentioned some hedge fund flows before we wrap up, or is there anything else you wanted to? You mentioned the dollar.

[00:53:34] Andrew

I just did follow up some data this morning which I just thought was interesting. One of the stats my partner sent me is, as you know, in the US, the broader asset management space in the US, ETFs have been taking market share for a decade, decades at this point. In the US, we were just looking at the managed futures, ETF space versus the mutual fund space.

The mutual funds space, I didn’t check these numbers closely, but I think it’s basically the mutual fund space peaked at about 28 billion in the third quarter of 2022. It’s down to 17 billion now. So you’ve not only had that from giving up profits, but you also have meaningful outflows.

The ETF space which in 2022 I think there were two or three ETFs out there, maybe four ETFs, the number of ETFs has doubled and ETFs are now about 10% of the overall space. So I think by analogy, people have fought doing these kinds of products in ETFs in the past because ETFs tend to be a more price-competitive market.

There are lots of reasons why it can be harder to sell an ETF in some of the major wealth management platforms. I think just by analogy, you’ll see more people come into the ETF space. As we’ve talked about, one of your guests is supposedly on schedule to launch their ETF in the managed futures space sometime in the first quarter.

So going back to the broader point of that adoption there needs to be more voices out there making the asset allocation arguments. In the ETF world, if we’re at 1.5 or 1.7 billion across all the funds in the space, you’re still talking about 0.2% of the ETF world for a strategy that has more demonstrable diversification benefits than anything else that we’ve found in the ETF world.

So I think we are at the very, very, very beginning of what’s going to be not even a decade-long process but probably a multi-decade-long process. It feels like it’s building momentum and getting traction.

[00:55:48] Niels

I do worry that the final success for this industry, Andrew, will happen after my retirement at some point in the next 20, 30 years. But I will hope that you’ll continue talking about it so I can just listen to people talking about the successes, the inroads that we’ve finally made, made it to a 2% allocation of the overall equity or assets under management in equities, for example.

[00:56:17] Andrew

We’ll be the old men quoted in some book.

[00:56:21] Niels

It’s like in The Muppet Show, these two old men sitting and bitching about these things every week.

Anyways, did you want to talk a little bit about- you talked about flows, stock pickers losing money in the hedge fund space, you talked about the dollar before we wrap up? How do you feel about it?

[00:56:37] Andrew

A guy named Costas Mourselas, from the Financial Times with Lawrence Fletcher, wrote a very good article the other day on this kind of existential crisis in equity long-short hedge funds, which have lost 150 billion in AUM. When we talk about flows and what the future is going to look like in 5 or 10 years, I think we always underestimate how slowly people move.

Investment ideas become canonical and you get these industries that get built up around it and end up supporting it, whether it’s everybody should have 40% of their portfolio fixed income, whether it’s hedge funds and the different categories of hedge funds. Equity long-short really has an added value in a very, very long time. And I say this as a guy who runs an ETF that replicates equity long-short.

One of the great ironies of replication of things outside of managed futures is you basically we’ve proven that the industry can be replicated through simple factor exposures, and also, in some ways, proven how uninteresting it can be as a diversifier. Which is why managed futures has been so pivotal to our success, because you can say A, in our opinion, we think you can replicate it, and B, it’s amazing from a diversification perspective.

But equity long-short, the stock picking thing is a real problem for them. Why are you paying somebody 1.5 and 20 to own the Magnificent Seven? Shorting hasn’t worked in years, and years, and years. So, to me, an article like that, if those guys had called me and wanted some pithy quote grenade, I would have said that the question isn’t why these guys have lost so much money. The question is why they still have so much today, anyway.

I think that’s where it takes a very, very long time for these ideas, which the economist Paul Krugman would called Zombie ideas, once they become canonical, it’s very, very hard for people to give up on them. So the change is coming, but it will come in a slow, halting, frustratingly slow manner. So hopefully, you and I will not yet be retired when it really starts to kick into gear.

[00:58:56] Niels

Finally, the Financial Times also had an article about the dollar. I think you picked up on that, hedge funds ditching the dollar trade.

[00:59:03] Andrew

At least in our portfolio, we’re sort of back to this king dollar trade. I think that’s where we started, where there’s this very strange, if you read, you get drawn into CNN or Fox or something, it sounds like everything’s just sounds and feels horrible and depressing and an angry and all these other things. But I think when you look at AI, you look at technological developments, on the other hand, the resilience of the US economy through these rate hikes, if you throw the other stuff aside, there is this optimism.

One of the things that I just find interesting, and of course with managed futures, it could obviously change relatively quickly, is just a sense that I think the big theme a year ago was that we were in for a decade of resurgence of Europe. Emerging market was historically cheap, it couldn’t get any cheaper. There was this view that there would be this valuation normalization that would occur across different areas with almost with sort of an anti-US bias. At least right now, I see a lot more optimism ironically because I don’t think people think it’s wonderful for democracy or a lot of other reasons, but I think there is this pushback on what people view as just an astonishingly unfriendly environment for businesses.
The prospect of some lifting of that and some return to appreciation that capitalism is the one thing that drives wealth. I think if we start to see a pushback ahead of that direction, I think it’s very positive, and the US is well positioned for that.

[01:01:04] Niels

To draw on my Danish heritage just to put a little interesting observation, and that is, you’re absolutely right. I think a lot of politics at the moment is focusing on the negatives. There are a lot of negatives, I don’t dispute that. But actually, the one party that is seeing the biggest surge in a positive way in Danish politics is actually a party where they really just talk about all the good things, especially about the young people and the opportunities instead of just talking about all the negatives about it.

I think if that’s the kind of messaging that is starting to win support, that’s a good thing that we can start talking about all the positive, just like you and I about all the positives of trend following and managed futures. It’s a bright world out there.

[01:01:56] Andrew

The discourse here is not productive, so I’m glad to see that. There’s a book called The Rational Optimist, which I recommend everybody to read. It basically talks about how easy it is to be consumed with pessimism, and how often that view is wrong, and why somebody like a Warren Buffett would look through all of this and have confidence in these things over longer periods of time.

I think that’s the side that we’re missing, which is that when you look at something like climate change, but then you remember how many smart people are trying to figure out how to solve this, how many resources they’re being given to try to figure this out, almost in the same way that whatever your view was on COVID, it was a really interesting period of time where it was almost like we had this alien invasion.

Countries around the world, there was initially like fights, you can’t fly here and we’re not going to fly there, and shutdowns and lockdowns, and all sorts of crazy stuff. But there was a general collective sense that humanity was against some external opponent. So, it sort of brought together in a sense.

All central banks were kind of working together. Everyone was working to make sure the financial markets kept functioning. Governments were, in theory, sharing information and stuff. That’s just all fallen apart recently, but hopefully, the pendulum will swing back and we won’t have this further geopolitical descent.

[01:01:58] Niels

One of our guests on the show end of last year, Neil Howe, the author of The Fourth Turning said, things will get really, really bad, but they will get so bad that the world actually will wake up and realize that that is just not the way forward and the next generation of leaders will take over and actually community in support of, and working together will be the way we- eventually, and it’s unfortunately not tomorrow, but eventually, things will turn around again.

[01:03:58] Andrew

I was talking to somebody in his young 20s and he was talking about the current political situation in the US and whether democracy was on its last legs. God, hope I’m wrong, but I just don’t see it. When we’re talking about the fact that we have somebody who whether he is actually an avowed authoritarian or truly democratic whatever your view, the guy is in court.

The discussions or not have his political opponents been thrown into the back of vans an accidentally fallen off buildings. The conversations are, is it justified for politically motivated prosecutors to prioritize going after this guy for things that I think most people would think in many circumstances or some of the circumstances are not remotely commensurate with the prosecutorial action?

But it’s happening at that level. The question is, is the Supreme Court to going to… We have a functioning court system. I think this is where I just encourage everyone, God, read history. You want to see a democracy falling apart, read about Weimar Germany and what happened there. It takes a lot more than this wonderfully prosperous economy that we have that goes through hiccups to get people out into the streets and engaging in violence to overthrow a system.

So there’s just been, particularly since October, where it seems like people have just given up on actually reading books in history and they’re getting all their information from 30-second videos. It’s lunacy.

[01:03:58] Niels

Which is incredibly worrying given the fact that probably most information today is curated for us as individuals. So what is the truth anymore? Well, the truth people can get on this little channel because we talk about the truth when it comes to trend following, systematic trading.

[01:06:11] Andrew

We’re truth-tellers. This is where everybody should go for all of their information. Don’t I sound old?

[01:06:16] Niels

We deliver the good and the bad here. But yes, it’s super interesting. And of course, with so many countries going to the elections or having elections this year, it will be a very different year when we talk a year from now, for sure. Anyways, let’s leave the politics aside because I normally tend to avoid too much of that.

But what I will say is that if people like these positive conversations about the bright future that trend following and managed futures have, and all the other stuff that we talk about of course, head over to your preferred podcast player, Amazon, Spotify, Apple, whatever it is, and leave a rating and review. It certainly helps. And of course, even better, if you would also share the podcast with your friends and family, we would be ever so grateful.

Next week, we’ll probably leave the politics aside because we’re going to be joined by Rich and I’m sure he has something up his sleeve. That will be another masterclass more into the weeds was the word I was looking for, the weeds of some of these benefits that we see at least in this little space. Of course, if you have any questions, you can email them to info@toptradersunplugged.com and I’ll do my best to bring them up.

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

[01:07:50] 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.