TTU128: Marty Bergin, Owner & President of DUNN Capital Management

[00:00:06] Marty

People are constantly believing that the markets have changed. I do not believe that the market has changed. The markets may be controlled. There are outside influences, but that tends to just stretch the markets out. It’s like a rubber band. It just stretches out and then they snap and you’re right back into what you would expect to see the markets do. So, trending environments, they may take longer to come to fruition, but when they come, they come back with a vengeance.

[00:00:48] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we will 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 product before you make investment decisions.

Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:44] Niels

Hey everyone, and welcome to another edition of Top Traders Unplugged where today, Alan Dunne and I are joined by Marty Bergin, the Owner and President of DUNN Capital Management (which also makes him my boss for full disclosure), as part of our mini-series focusing on the one investment strategy that beat everything else in 2022, namely trend following and managed futures more broadly.

First off, Marty, it’s great to have you back on the podcast. Thanks so much for joining us today. We really have been looking forward to our conversation. I hope you’re doing well. I know you just recovered from a little cold.

[00:02:18] Marty

Yeah, thank you very much. It’s been quite a while since I’ve been on the podcast. It’s nice to be back and it’s nice to be joined by Alan. I haven’t done one with Alan in the past.

[00:02:30] Niels

Absolutely. Now, before we dive into the various topics, Marty, that we have planned for, maybe just to set the stage for the conversation and to give our audience a little bit of context, do you mind just talking a little bit about the background of DUNN? Also, perhaps you can share the type of strategy that DUNN focuses on and where we stand today in terms of the business as we head into 2023.

[00:03:00] Marty

All right. Well, I think everybody knows we’re a trend follower. We’ve been around for quite a long time, over 45 years. William Dunn, who is the founder of DUNN Capital, is actually one of the fathers of the industry as a whole. He was actively involved in the regulatory background for CTAs and managed futures. He was the main researcher at DUNN originally. He designed the systems. We’re completely systematic. There are still elements that Bill designed, back in the early ’70s, that are in the system today.

Of course, as technology has advanced and capabilities have grown, the systems are much more technologically advanced than they were back at that point in time. But we essentially are still doing the same thing that Bill designed in the early ’70s. The firm has transitioned. Bill is no longer involved in the day-to-day activities. The firm transitioned to me. Basically, my job is to not screw anything up and keep it moving forward.

We’ve been growing assets fairly consistently. I think our focus has been not only on the research but also on education and trying to educate the world, basically, on the advantages of systematic trading as a whole but also trend following as an example of that. So, that’s where we are today. We’re about $1.4 billion under management and consistently, the growth of AUM has been very stable and consistent, especially over the last five years and we’re very proud of that.

[00:04:58] Niels

Yeah, absolutely. That’s a great context for conversation. Now, Alan and I have created a list of topics that we’re going to be discussing and we’ll go back and forth between us. So Alan, why don’t you as always just kick it off with the first topic we want to discuss with Marty?

[00:05:17] Alan

Well, it’s a very interesting point you make that, essentially, the models that were developed in the 1970s, their essence is still evident in what you’re doing today, Marty. So what is it about the markets, do you think, that there is a strategy like trend following that is so persistent in terms of the return stream you can get from it over time? Where does that come from and what gives you confidence that it will be there going forward?

[00:05:48] Marty

Well, I think it’s over my head about where it comes from. It’s been very robust over the years. Basically, momentum strategies have been around since investing began. Over the years, people have gravitated to this idea that momentum is dead or trend following is dead from time to time and it’s been proven over and over to be a false narrative. I think the key to what we do is to not lose focus on trend following.

So in other words, as time has gone and advancements have been made, I think a lot of our competitors have tended to gravitate away from trend following. Some of them had publicly said, “We don’t believe in trend following anymore. We believe there’s other things that will do a better job of capturing alpha.” Over time, maybe their performances improved some times, but then when the trend following is needed or that environment kicks in, they’re no longer able to provide that alpha.

I think we’ve done a really good job of not losing focus on what we do, which is trend following, which has been proven over the last year. There are a lot of trend followers, or people that purport to be trend followers, that didn’t make outsized returns last year. Now, they may have been profitable, but I don’t consider single digits outsized returns when, in that type of trending environment, you should be really knocking the ball out of the park.

[00:07:35] Alan

Sure. I guess when you put that question to a lot of other managers, one perspective is they may say we still believe in trend following but you have to balance that with keeping people invested in the strategy over time and making the strategy more digestible for people and in that aim, there could be a benefit for smoothing out returns, adding some other strategies that can contribute performance in those trendless periods, while still maintaining the characteristics, the risk, the broad risk profile of trend following. Is that something you have shied away from and is that because you philosophically disagree with that? But does that give it a bigger challenge in terms of keeping people invested in a pure trend strategy?

[00:08:25] Marty

It’s not something we would shy away from, but I think there’s an honesty that’s involved. You can’t say that you’re a trend follower and you’ve made changes within the system that have gravitated away from trend and not fully disclose that. So I think there’s a place for an all-weather type strategy and we’ve actually been doing research in that area and at some point in time, we will probably offer an additional strategy that may be moved more in line with all-weather. But we won’t be presenting it as a trend strategy, we’ll present it as an all-weather.

You want to present something where the investor has a clear choice that they’re making. I also believe that most investors are smart enough to realize that trend represents a portion of their portfolio development, and they have other strategies that are built around that to balance their portfolio. It’s not my job to come up with a strategy that answers all their needs. I don’t want to be all things to all people. We do what we do, we do it very well, and that’s what I want to continue to offer.

[00:09:37] Alan

Absolutely. Would you say, when you look at yourselves versus peers, is that the big difference that you would identify, that singular focus on trend versus everything else?

[00:09:51] Marty

Yeah, I think that’s one of the things. But I think the other thing that differentiates us is… So, why did people start gravitating away from trend? Because they had problems being competitive in a performance environment, correct? Well, I think there’s other ways that you can add that performance in non-trending environments. One is through risk management, and another is through portfolio development. One of the things that we’ve really done is we’ve enhanced the risk management aspect of the program.

One of the things we do is we’ve got an exit strategy that’s built into the program, which has been helpful over the years. But more importantly than that, we’ve adopted this adaptive risk profile where we actually change our risk target given the market environment. So in other words, we will add risk in a market environment that’s positive to trend following and we will reduce risk in market environments that aren’t trending. That’s made a very big difference. So even in non-trending times, we’ve been competitive, from a performance standpoint. That’s our goal.

We’re trying to offer people an alternative, basically an insurance project or a hedge, to their portfolio without costing them a lot of money. So, during the times when the rest of their portfolio should be working fine, we should still be making some money. We’re just not doing as well as equities might be doing or some of their other strategies. But then when times changes, when everything else is falling apart, we tend to kick in and make a big difference in their portfolio. That’s the goal.

The other goal is to educate people into the idea that this isn’t a strategy that you move into when you see things going south, but this is a core holding that you should hold within your portfolio. We’re almost impossible to time. I can’t time it and I probably know as much about it as anyone.

[00:12:07] Niels

Let’s stay on the topic about focusing on trend because I think that is a key difference. But also, as you say, Marty, that we’ve made some improvements, of course. To some extent, Cliff Asness wrote a paper last year where he questioned whether the industry had become too concerned or focused on Sharpe. But what I hear you say is that there are ways to improve trend following without necessarily deviating from trend following.

So, how do you balance that in your mind? Does it drive your view whether we should try to deliver trend following in a nicer package, so to speak, with a bit higher Sharpe? Where would you draw the line between that and saying, no, we’re just trend because long term, we think that’s a better strategy even if it’s a little bit more bumpy along the way?

[00:13:05] Marty

Well, I think the goal should always be to improve. Whether you measure that with risk-adjusted returns, Sharpe ratio, or some other measure, drawdown or ratio of performance to drawdown, I mean, there’s all different ways to measure performance or success in our business. I think there is too much focus on Sharpe ratio, although I also am not a believer that it’s an absolute return type strategy. There has to be some give and take.

I think the hardest thing to do, from the research perspective, is to not lose focus of what you’re trying to do. It’s easy to gravitate away from trend following when you see something that will enhance performance. But you’ve got to ask yourself, are you still doing what you say you’re doing? We’ve always been very strict about wanting to perform during trending environments. We expect to have outside performance during those periods of time and that’s the goal of the strategy.

Now, if we develop something that’s different, that’s fine. If we think it’s a good quality product, we’ll offer it to the community, but it will be offered as something different.

[00:14:34] Niels

Is that what you feel stood out last year, in 2022? Obviously, performance stood out but also was it just, by all measures of account, an incredibly trending year in your opinion? If I’m trying to be objective here, was it also the fact that maybe the markets we trade, compared to people who trade 200 markets, were a little bit more trending perhaps, or maybe a combination of the two?

[00:15:04] Marty

There could be some of that, but I think it’s really just a focus on… I call 2022 a year of validation for trend followers, because I think a lot of people in the industry lost focus, started gravitating away from trend, and the people that stayed the course and believed in the trend and kept that as the focus of their systems, were validated in their belief. We had that core belief. We knew that it was just a matter of time before this would fall back in favor. You have to play through the whole investment cycle, which we have done now. I think not only has it been validated as a core strategy, but I think it’s been recognized in the investment industry as a focus going forward for portfolios.

[00:16:02] Niels

I was just going to follow up on that actually, because that’s an interesting point. Do you feel that this is a little bit different to 2009, where, again, on the back of a very strong year, I think a lot of us felt that this is going to be an amazing time to get institutional adoption into this strategy but it turned out to be a little bit harder? Do you think that there’s something different this time around maybe?

[00:16:29] Marty

Yes. I think institutionals are recognizing things a little differently this time. I believe that 2022 was a year of inflation and we haven’t seen the recessionary trade yet, which I believe trend followers will also benefit from. I think the other thing that’s different is now institutionals who, in the past, felt like their allocation to fixed income was their insurance policy – that obviously didn’t work and they’re seeing the value of trend following as part of that protection. But I think the other thing that’s going to happen is institutionals have also made very large allocations to private equity, both in real estate, private equity, and equity markets.

Now, I believe there’s going to be a lag in the pain that’s going to be felt in those allocations because the marks are basically internal. So people tend not to show the bad performance for a while. It’ll lag the markets. The liquid alts is going to be the hedge to the non-liquid alts and I think institutional players are going to start realizing that and be looking to trend following and CTAs as that liquid hedge to their private equity allocations.

[00:18:12] Niels

I agree with that. I actually think one thing you’re absolutely right about is the fact that we’ve seen, in the last few years, this term risk mitigation. We’re now seeing that parts of institutional portfolios are being labeled risk mitigation. Actually, the core part of the risk mitigation portfolio, so to speak, is actually trend following. So I agree with that, and obviously, we hope that more people will go down that path.

Alan, do you want to jump into one of your favorite topics?

[00:18:46] Alan

Yeah. Maybe just to follow up on what we’re talking about and then lead into research. Obviously, you want to deliver returns in a period of trending markets. But the other point that was picked up with the Cliff Asness paper was delivering returns in crisis alpha periods or equity down markets. I’m just wondering, how does that play into your mind in terms of thinking about the speeds of systems?

Obviously, if you’re slower or medium to slower, you’ll stick with the trends, but it might be a bit slower to respond at equity turning points. So, is that something you worry about or is that an argument for having some element of more responsive systems as part of the suite or not? Is the focus primarily on not worrying about those short-term reversals and focus primarily on just capturing those big moves in markets?

[00:19:48] Marty

That’s something that we’ve done a lot of thinking about and I think the main driver in that has to do with drawdown. What we’ve found over the years in research is shorter timeframes or shorter lookback periods can mitigate drawdowns. But we also know that from a performance standpoint, the performance is not as good. But it’s become aware to us that institutional clients aren’t necessarily looking for the knock-the-ball out-of-the-park kind of performance. They’re more concerned about that drawdown.

So we are toying with the idea of restricting some of the lookback periods with the idea of being more flexible in terms of, just like you said, the shorter time periods to move quicker against equity drawdowns, knowing that the overall performance is not going to be as good. But it may be providing a product that there’s clients out there that are looking for. Then again, it’s just an idea of full transparency and being upfront with people about what it is they’re getting.

[00:21:17] Alan

Absolutely, I suppose you hear people talking about the utility that you get from different programs or investment offerings, and the utility from that kind of return profile for certain types of investors may be greater than the utility of a higher return but with a less a favorable drawdown profile.

[00:21:35] Marty

Right. So at DUNN, we’ve always been really focused on providing what we think is the best overall product, and maybe we haven’t been as receptive to what the institutional investor was telling us. So, a lot of the institutions may not gravitate toward DUNN just because of the type of product we offered, which was what we consider the best product over the long term. That might not have met their needs so we’re now probably going to be more open to addressing what the investors are looking for, just making sure that it’s clear what it is, and if it’s a different product which we feel isn’t going to generate as large of a return over a long period of time but it may meet the needs of the client.

[00:22:26] Alan

Yeah, fair enough. You touched on two enhancements you’ve made to the program over the years, one being the exit strategy, and the second being this adaptive risk profile. So clearly, this has been the result of research. When you do research, obviously, when you do something, looking in the back mirror, presumably, it’ll look better. How do you think about this would have worked better in the past, how do you make the assessment that it’s likely to continue to be better looking forward?

[00:23:03] Marty

Well, it’s all about not data mining, right? So you don’t want to trick yourself into believing something that isn’t true. I think that’s the hardest thing that we, from a research perspective, we’re very focused on that aspect of it. We want to be regimented, we want to be robust about our research. I can honestly tell you that the majority of everything that we get involved in, from a research perspective, doesn’t pan out.

When you’ve been around for 45 years, there’s a lot of things that you’ve looked at over time and a lot of things that you tend to revisit over time to see if maybe there’s something that we’ve missed that does improve it. For the most part, most of the projects just don’t pan out. For us to have something like the adaptive risk profile… Most of the time these things grow out of research you’re doing in a different area and you just kind of haphazardly fall into something that hey, wait a minute, there’s an idea, and you start moving forward with it, and lo and behold, it works.

[00:24:22] Alan

Does the research tend to come in response to a difficult period, that you identified something that you’re trying to solve, like the drawdown was very severe or the giveback in a number of individual trades seem to be very large so that might be a better? Is that what tends to happen?

[00:24:37] Marty

I think you tend to work a lot harder when you’re going through bad periods. But the truth be told, there’s such a lag time in research that something may start during a period of time of poor performance, by the time it’s actually implemented, the markets have changed drastically. So it’s just an ongoing thing. I think the key to it is to maintain the communication and the dialogue internally within the group and be constantly talking about different ideas and different things and being open to ideas, both internally and externally.

A lot of things come out of reading papers that are presented. You might not end up implementing anything that has to do with the paper, but the paper may jog another idea that you have to implement something.

[00:25:36] Alan

You mentioned, at the start, how the essence of those original build-on models from the ‘70s are still underpinning a lot of the current models. I think you had the expression, “technologically more advanced.” But outside the execution and the technology in the way of running and monitoring all the systems, in terms of the signals, if you were to run those 1970s models on today’s markets, would they still be working and how much better?

[00:26:06] Marty

Yeah. Trend following is not rocket science. There’s only so many ways to determine trend. It’s time and noise. It’s very straightforward. So the reality is that what generates the signal hasn’t really changed over the last 100 years. It’s the way you implement that signal that has changed – so, the risk management aspects, the data aspects, the trading aspects, the portfolio development aspects. Think about it, in the early ‘70s, there was only a handful of markets that had futures contracts.

So as time has changed and more and more futures contracts are available to you, that diversity is a real advantage to what we do. We look at markets and we look at markets that can provide a diversified revenue stream to what we already have. That helps mitigate the risk. Now, there’s a whole lot of markets out there that have futures that aren’t really viable for one reason or the other. Either they don’t have the volume to trade it easily or the exchange they’re traded on might not be something that you would trust, whether they’re regulated or non-regulated.

We don’t trade any futures contracts in China, for instance, because I’m just not comfortable with the counterparty risk. When you think about it, all our private net worth is involved in these systems. We invest in the same systems that we offer to our investors. I don’t want to take that risk with my own money so why would I take that risk with investors’ money?

[00:28:06] Alan

Fair enough. You also mentioned one of the other enhancements or one of them was the exit strategy that was significant. Is that like a profit-take-type enhancement?

[00:28:22] Marty

It’s not a stop-loss criteria, it’s more of a profit-taking type enhancement. Where we see trend following’s weakness is you tend to get into trends slowly and you get out of the trends slowly. The idea is to get into the trend slowly but accelerate getting out of the trend. Now, I will tell you, there are times when exit strategy is a benefit and there are times when exit strategy is not a benefit. I would say that over the last year, it hasn’t been of benefit, but the positives outweigh the negatives. So, we’re not going to remove it just because of a short period of time where it didn’t provide a benefit.

[00:29:12] Alan

Maybe just one final point on this. A lot of the old-school traders who started off running technical trading systems saw their portfolio as a bunch of individual trades. You get discreet signals in different markets and it aggregated up into a portfolio but they were essentially managed.

[00:29:31] Marty

Yeah, that’s how DUNN was originally too.

[00:29:33] Alan

Yeah. Whereas the more European perspective is often looking at the overall portfolio and managing the risk from that perspective. Was there an evolution then in DUNN’s history from the original approach to the more portfolio approach and was that as you added more markets? How did that evolve?

[00:29:54] Marty

Basically, in 2006, we gravitated away from looking at individual markets. So we would basically develop an individual market and then put all the markets together and come up with our risk sizing after the fact. In ’06, we decided to take a more portfolio view where we used the same parameter picks on every single market we trade. The only thing we’re interested in is what the effect of the overall portfolio is. By doing that, it makes the system more robust, less chances of data mining, more chances of being adaptive to whatever the given market will be going forward.

That’s the key to everything we do is that you want to be robust and adaptive to the market conditions as they change because you have no way of predicting what’s going to happen in the markets going forward. So we’re basically counting on the system, the systematic automated nature of the system, to adapt to whatever the market conditions are. Thank God people don’t have to rely on me sitting in my office going, “Oh, I see this going forward, let’s make this change.” We’re counting on the system to do that automatically.

[00:31:17] Niels

I just want to say, you’ve covered a lot of ground, some of the things that I had planned. But I want to stay with the number of markets a little bit because I do think that DUNN is maybe a little bit different in that group as well, when it comes to markets traded. We’ve seen a lot of our peers embrace hundreds of markets traded. So, besides obviously liquidity as such, do you have a view on what you feel is a realistic “maximum number of markets” that actually exists that gives enough diversification benefits without giving up any liquidity concerns? Is it 60 markets, do you think nowadays, or is it 100? Where do you see that evolution?

[00:32:15] Marty

Well, all that I can speak to is the way we view it internally. So we’re comfortable with the number of markets we’re trading. We don’t add markets just for the sake of adding markets. I believe that a lot of our peers have gravitated to such a large number of markets mainly from an AUM standpoint. The larger the number of markets, the easier it is to manage the portfolio. But you don’t want to add markets if it’s not going to give you any real benefit. So we have added markets mainly from the standpoint of where we see a diversification benefit. We’ve added some metals recently because we see that as markets that are different from what is in the portfolio. So I think we’ll continue to move in that area.

Now, I will say that from a diversification standpoint, I think people tend to put too much weight on it. There’s studies that have been shown that it really doesn’t take that many markets to be diversified. But it kind of brings us back to this new idea of people may be duplicating CTAs through ETFs with very minimal markets. Those types of strategies work really well. The diversification during a normal market environment is not that big of a deal. But when things go south or something happens in the markets and it’s not a normal market environment, all of a sudden, that diversification difference plays a big role. It’s one of those things, everything works fine until it doesn’t. I think we haven’t gotten to that point where it doesn’t.

[00:34:24] Niels

Is that the main risk you see in these replication strategies? Obviously, it’s been a topic that we’ve discussed with the other managers in this series, but also generally, it’s been a topic that we’ve talked about a lot on the podcast is this CTA replication. It started out, actually, many years ago, where people were just trying to create quote-unquote “cheap” trend following models, and now they’re doing linear regression based on the performance data. Do you have a sense of one versus the other or are they a little bit the same in the end?

[00:35:00] Marty

I think it’s hilarious the lack of due diligence on these types of strategies, because literally, everything that’s presented in their presentations is all simulated data. There is no real trading, no real execution, everything is simulated, and people are making investment decisions based on this data that’s being provided. So there’s no real true history.

[00:35:29] Niels

Not along one at least, that’s for sure.

[00:35:32] Marty

No, and people are allocating lots of money to it. So, it’ll be interesting to see what happens when there’s a little stress added to the market and people say, “Oh, how did we get involved in this? We didn’t expect this to happen?” We’ll see.

[00:35:55] Niels

Yeah, absolutely. Time will tell.

Speaking of risk and drawdowns, Alan, is that where you’re heading next?

[00:36:00] Alan

We’ve touched a little bit on some of the approaches you’ve made in terms of drawdown and the portfolio dynamics as well. One of the topics that comes up a lot, and we don’t want to dwell on it too much, is the whole dynamic versus static position sizing. It sounds like you went through that kind of evolution in that 2006 shift. Prior to that, were positions sized more individually and allowed to run like the classic trend follower? Whereas, if the volatility picks up, that contract will have a large contribution to the overall portfolio. Did you decide to move away from that?

[00:36:54] Marty

Dynamic risk sizing, which is one of those topics that people can just lose hours discussing, and people in the industry have very, very emotional ties to both ways of doing it. I’m not emotional about it, I have no problem with people that use the old-style methodology of sizing positions where basically, you enter the position based on the volatility, and you don’t adjust that position until you trade out of the position or you roll the position, and you may adjust for volatility at that time again. I don’t have a problem with that methodology. It has a place in trend following.

The whole idea is that as the volatility picks up, then the trend should be stronger and you should want to stay in that position. You’ve added risk automatically to your positioning. But what we do feel, as institutional investors, and from our comfort level, if we know that the risk has changed and we’re targeting a risk dynamic, we want to adjust the portfolio to that targeted risk. So we are going to dynamically size our positions on a daily basis.

One of the things that we will take into account for that is going to be volatility. We’re also going to look at correlations and trend strength, and we’re going to plug all that into the risk dynamic of the portfolio. So we’re a true believer of dynamic sizing. I don’t have any problem with people in any industry that aren’t, and I think there’s a place for that.

[00:38:54] Alan

Obviously, you’re looking to generate outsized returns when markets trend, but could you generate even more of a positive skewness, more of a convex return profile if you didn’t vol size your position?

[00:39:10] Marty

Yes, absolutely. I think that’s true. But you’re giving up something, right? You’re giving up control over the risk. So, you have to measure one against the other. If you look at CTAs, I think the skew has come down as an industry as more people in the industry are dynamically sizing positions.

[00:39:38] Alan

I guess you’re kind of capturing two different things. One is trend and then volatility expansion is another feature, and if you have that more static position sizing, you can get exposure to two factors. Obviously, people will manage the positions at different speeds. Outside of that, is volatility targeting the main way you think about risk in the portfolio or is it exposure or margin?

[00:40:08] Marty

No. I think the biggest focus that we’re looking at is correlation of markets. So the cross-market correlations, we think, have a bigger factor on risk than the volatility.

[00:40:22] Alan

Okay. Is that something then that… You mentioned shying away from discretionary inputs, but can there be periods where you can overly rely on correlation if, historically, we had a negative correlation between bonds and equities (in the last decade in particular). If you believe that correlation, could you be overly leveraged on being long bonds and equities in those periods?

[00:40:52] Marty

Well, of course. So there are two different things going on there. The data will tell you one thing, then you’ve got to take your emotion out of it. You may believe that there’s a correlation going on, but if the data tells you something different, and the correlations have changed, then obviously, the system needs to gravitate with that change. So that’s why it’s important that it’s 100% systematic. So you let the data dictate. It’s not our interpretation or what we believe correlations are, it’s what actual correlations are.

[00:41:29] Alan

What’s the right lookback for if you want to measure the volatility of a market or if you want to measure the correlation between markets?

[00:41:38] Marty

We think those lookback periods are constantly changing. So the way the system is designed, it gravitates through shorter and longer periods of lookback. We don’t restrict what that lookback could be. Now, what I will tell you is it will never take the really short, like a week, type lookback, because it just isn’t profitable over any length of time and the cost associated with trading such short lookbacks basically eats up the profit. We haven’t decided to go that route where we want to be competitive in a shorter high frequency-type trading environment.

So we’re comfortable with where we are, which is the medium to long-term type trend following. I think there’s a place for shorter term windows, but it’s a very expensive and low return type environment to get involved in. So, there are people such as Citadel and some of the other firms that are involved in short-term trading or high frequency type environments that make money consistently. But yeah, the cost of doing that is excessive. I’m not going to try to compete with that.

[00:43:09] Niels

Just sort of expanding a little bit on that, but in a slightly different direction, another thing that is very much determined in terms of the timeframe you trade is often linked to then the capacity that you have in your strategies. Of course, even in the trend following space, we see quite a lot of dispersion in terms of size of managers. So I’m curious how you think about capacity, how you think about DUNN’s capacity, what might give you a clue that we’re getting close.

Of course, that may also tie into the other question or topic that we’ve been discussing with our colleagues and that is fees, where maybe (and this is kind of my own observation), that during the times, 2015 through 2019, when there were some institutional inflows, but where they were also able to get some very good deals from people offering very low flat fees, etc., etc. Perhaps now, some of those managers who took in a lot of money at very low fees are kind of regretting that to some extent. So, again, capacity fees, I would love to hear your thoughts about that from DUNN’s point of view, but also from how you look at the industry.

[00:44:30] Marty

I think one of the advantages that DUNN has is the fact that we’re kind of a niche player. We’re not large so capacity is not a concern of ours. It brings me back to what I said earlier about 2022 as a year of validation, because we were one of those firms that had been approached by a number of institutions offering a product at a very low fee level back at a time when, yeah, AUM would have been nice to be able to add easily. But we weren’t willing to sacrifice what we bill ourselves as, as a zero-management fee, incentive fee-only firm. We’ve always prided ourselves as being client-centric, so we weren’t willing to go that route and I think it was a big benefit to us later that during this good period of time, we were able to benefit from it.

I think there’s a place for potentially offering a product from an institutional standpoint that may not be, which we talked about earlier, may not be what you think is the best product available. But it may be something that is providing a need for an investor or a client. At that point, you may negotiate a different kind of fee structure for that particular investor. But I think from the industry as a whole, there’s a lot of very large trend followers that are trading $20 billion. So DUNN is not at that point. I believe that we’re comfortable where we are and we’re comfortable if we were to double our AUM. I think if we reached a point where we were touching on $5 billion, we’d probably pull back a little bit and readdress where we were.

Bill used to always say that if you ever had a capacity issue, you just raise the fee and that will take care of it. I don’t think I’m looking to do that route. Truth be told, there’s a lot of people that are doing what we do, so there’s a lot of competition out there. I feel like the way we do it is better than most so I feel comfortable with our position in the industry as a whole.

[00:47:14] Niels

Yeah, absolutely. Another thing before I turn it over to Alan, another thing that actually came up in one of our conversations, this was with the Swedish firm Lynx, because they are also a little bit similar to DUNN, meaning they’re off the beaten path. They’re not in one of these financial centers. Stuart, Florida is not a financial center, I think we can agree on that. How do you think about location? Do you think about that as being an advantage for what we do or a disadvantage? How do you think about that?

[00:47:46] Marty

I see it as a non-issue. Being where we are makes it less convenient for institutions to see us and talk to us. But in this day and age of technology, it’s really a non-issue. It’s easy to get on a Teams call or a Zoom call and talk to people. It’s easy enough to get on an airplane and travel to see people. People want to do the due diligence. Most people are very comfortable when they come and see our offices and what we’re doing. They understand why we are where we are. Stuart is the worldwide headquarters for DUNN. We were in Florida before everybody else started gravitating here. Now basically every major bank in the world is opening offices up 45 minutes south of us in Palm Beach. So we were just ahead of our time.

[00:48:47] Alan

I just wanted to follow up on a point, I suppose, related to markets, traders, and then specifically, liquidity. You mentioned not trading Chinese futures, I think, from the counterparty risk perspective. So, in terms of market selection and then specifically around liquidity, what’s your thinking on that now? I mean specifically from the perspective that people present about concerns in some markets with respect to liquidity recently.

Obviously, with the gilt market, we had exaggerated moves. Every so often, it appears there’s a gap move like cable earlier this year and then you had the issue with the Treasury market in 2020. Obviously, you’ve been involved in markets and very close to markets going back over a number of decades. So when you look at the liquidity profile of markets, are you comfortable with that? Which ones obviously, have you chosen not to be involved in from a liquidity perspective?

[00:49:51] Marty

One of the things we’ve looked hard at is LME because of what they did with the nickel earlier this year and the disconnect there. Currently, as we call it, we have them in the penalty box and we’re waiting to see how they respond to the investigation and what they implement to improve their marketplace. That’s a tough one because if you think about it, that’s the oldest exchange in the world. You wouldn’t have thought that this would be a problem. But clearly, there was some internal, what I would call, corruption going on and they reacted according to what they thought was best for them, but it wasn’t best for the markets as a whole.

Hopefully, they will implement some of the things that need to be done and we will start trading those markets again. But the volatility profile of markets is one of the reasons the trading that we do here at DUNN is not automated. So in other words, we have traders that actually execute every order that we implement. Now, they have a lot of tools at their disposal. In other words, algorithms and different things that they can utilize in the trading, but they supervise or oversee the trading. So that when you have a volume profile that’s broken, if you’re using an automated system, you can really get hurt in those environments. I think some of those environments present themselves just for that reason. It’s basically computers taking advantage of other computers. I feel like if you have a trader that’s supervising that process, it mitigates that risk.

[00:52:00] Alan

So that’s just managing the execution of the algorithm.

[00:52:06] Marty

Right. When you’re looking at medium to long-term trend following, the execution itself becomes less important. You’re not looking for pennies at that execution point. What you’re looking for is execution that is controlled, and you don’t take a bath at that point. When you’ve got to experienced traders that control that process, that’s a big advantage.

[00:52:40] Alan

Are you monitoring those traders to assess their entry against a certain slippage budget? How do you think about that?

[00:52:51] Marty

We definitely monitor the slippage. We get reports all the time. I can pleasantly say that most of our slippage is positive in nature, so a big hand goes out to our traders.

[00:53:07] Alan

Very good. There’s one topic I wanted to delve into and we kind of talked about it earlier a little bit. It’s the role of trend within a larger portfolio. You mentioned thinking about being more responsive to investor requirements or demands or around that. But I suppose there’s a few questions that you often get when you’re representing managed futures to investors, so I might just put them to you.

Should we think about managed futures and trend following as a return generator or a portfolio diversifier or is it protection? And then in terms of funding the allocation, should it be funded more out of the equity side or the bond side? If you got those questions from investors, which I’m sure you probably have, at some point, how do you address those?

[00:54:03] Marty

Well, the first thing we start out with is it should be a core allocation. I assume under most scenarios, it’s a part of their alt budget and I would think that it would be funded equally out of their fixed income versus equity. I think in the past, it was probably just funded out of equity. I think moving forward, people will start looking at it as a funding out of fixed income since this will probably be a replacement for part of that fixed income allocation moving forward.

The other thing is, I think most institutions will look at it from a standpoint that they have got a convexity type allocation. They may have long-short type allocation, and then they’ll have a trend following allocation. The three of those things come together to form their alt budget, potentially. Now, the convexity thing or the black swan, the tail risk hedging that they’re doing, they know that that’s going to cost them money basically for the majority of the time until it kicks in and provides that benefit.

Whereas I think they’ll look at the trend following portion of the budget to not be a negative drag on the portfolio. It will be an overall positive from a performance standpoint. It just won’t be performing as well during bull markets as their equity allocation. But it’s an important allocation because it provides that alpha, depending on how you define alpha, but it provides that alpha during crisis environments.

[00:55:58] Alan

A second topic on this question, you mentioned private equity and private markets in general. I suppose if you’re sitting in the allocator seat, you might say the reason for allocating to private equity, and this was the argument that obviously, there’s some kind of illiquidity premium so you could say you can get public market returns plus an illiquidity premium, so whatever that is. So allocators would have a way of thinking about what the returns would be.

How should people think about the returns from managed futures, the potential returns for managed futures and trend following to think about well, okay, how much should I allocate and in what area of the portfolio? Is it all driven by what has been produced historically? Is there any other kind of process to try and think about what returns are achievable?

[00:56:49] Marty

I think that is an analysis that they have to do internally to determine what it is they’re trying to accomplish and to make sure they have an allocation that’s large enough to get them there. What we see is they tend to under-allocate to the strategy so that when it does kick in and works, it doesn’t really provide them any benefit because they didn’t allocate enough to it. Now, let’s go back to the whole private equity allocation, and be perfectly honest.

Why are they allocating to private equity? Because it’s a smooth performance, because it’s not real, there’s no true mark to market. That’s kind of the negative that they get with allocating to CTAs or trend following because it is very transparent and it is mark to market. So they see that volatility, that volatility is reported constantly. That doesn’t provide a lot of comfort, although it’s a liquid alt. So they know exactly where their values are on any given day, and it’s always available to them. Whereas the private equity is not.

The private equity they set aside, it gives them comfort because they never see a big swing. But that money is not available, they don’t have any ability to get their hands on it, and when it starts going south, it might be smooth and consistently going south, but there’s nothing they can do about it. I think what you’re going to see moving forward is they’re going to be allocating to trend followers because when that private equity is getting down month after month after month, they’ll have the trend following hedge that will be generating performance basically during a recessionary period.

[00:57:14] Alan

I know we’re moving up in time so I’ll hand it back to Niels.

[00:59:02] Niels

Yeah, exactly. There’s a few more topics that we wanted to cover with you, Marty. One of the things actually that we have brought up with people, and just to hear your thoughts on that, for the last, I don’t know, 10, 15 years, this was an area that didn’t require too much work because cash management was a thing where you just have to try and minimize the drag from these zero or negative interest rates. In today’s world, interest rates are not zero anymore. Share with us how you think about the cash management part of the funds that DUNN manages and how you do that.

[00:59:41] Marty

We think that’s really important. Most CTAs or managed futures products, I think, have overlooked the cash management aspect of it. A lot of times, they just leave it in the hands of the brokers or just buy treasuries and let it sit. We’ve been very active because historically, there’s been counterparty risk associated with brokers. So we try to mitigate the amount of money that we have with a particular broker, especially in clearing. We have a firm that we basically own 49% of the equity of in New York that manages all of our cash.

Over the last two years, the value of that has really come to the forefront just because of how poorly fixed income has done. You had a lot of ETFs and mutual fund bond investments that were down 16% to 20% over the last year. So, managing that cash becomes a very key component to the process. We rely on experts to basically do it. The reason we use a firm that we have some equity invested in is so that we have control over that process or at least transparency into the process.

So, I see every confirmation for every purchase or sale that’s done in the fixed income sector and we keep a very close watch on it. It has bode well for our investors and I feel comfortable with the way we handle it.

[01:01:32] Niels

Yeah, and of course, probably worth mentioning that obviously, we’re not the only CTA that they do this work for. They do it for some of our friends and competitors or peers in the industry as well.

[01:01:46] Marty

When we decided to go this route, the whole idea was for them to be providing this service, not just to us, but anybody else in the CTA space that wanted to avail themselves of this service.

[01:02:00] Niels

One more thing was maybe something that, I don’t know exactly what to call this kind of question, but I’m curious anyways, about if there’s something you hear people say about trend following and every time you hear it, you say no, I definitely disagree with that. Some kind of description of what we do as an industry where you say no, that’s just not something I agree with. Is there anything that comes to mind that you’ve heard over the years again and again?

[01:02:28] Marty

It seems like over and over, people tell us that trend following is dead, right? I’ve heard that so many times over the years that it just makes me laugh. I think, “Well, we’ll see.” And there again, validation during the last year. People are constantly believing that the markets have changed. I do not believe that the market has changed. The markets may be controlled where there are outside influences that control the markets, especially equity markets. You have the Fed, you have government intervention, you have a lot of things going on that influence markets. But that tends to just stretch the markets out. It’s like a rubber band. It just stretches out and then they snap and you’re right back into what you would expect to see the markets do. So the trending environments, they may take longer to come to fruition, but when they come, they come back with a vengeance.

[01:03:43] Niels

Yeah. Now that we also have Alan here as an allocator, I’m curious to ask you the question, though, Marty, and that is if you were an allocator and you go into these conversations with managers, what’s the one or two things that you would definitely ask the manager that maybe you don’t see a lot of allocators coming in to visit ask?

[01:04:11] Marty

I think the biggest thing I would be focused on is style drift. You want to make sure that you’re getting what you’re looking at or what your expectation is. For instance, I’ve seen a lot of managers that have really good historical numbers. But I know by following them that they’re no longer doing what they were doing when those historical numbers were generated. So are you really buying those historical numbers or are you buying something different? That’s the big concern from an allocator standpoint. Know what you’re getting.

Most managers aren’t going to answer that question. Unless you are on the inside looking at the changes that have happened in code, there’s no way that you can know whether that’s happened or not.

[01:05:11] Niels

I should ask you, Alan, whether you agree with that question as an allocator.

[01:05:14] Alan

I do. Absolutely. It makes a lot of sense. Marty touches on style drift. That can come in different shapes or forms. It can be managing the volatility profile, that’s one thing, or it can be just adding some beta, which would be another. You would pick up the latter over time in numbers, but obviously, it wouldn’t be evident in the full track record. So, absolutely. As we’ve said before, managers will always have narratives, it’s the allocator’s job to try and see beyond the narrative.

[01:05:54] Niels

Absolutely. Final question, Marty. As we are at the beginning of 2023, what are you most excited about when you look into the new year? Do you have any concerns for the new year?

[01:06:09] Marty

No concerns. I really believe we’re transitioning currently from an inflationary trade to a recessionary trade, which are two very different animals. So, from a trend following perspective, there’s going to be some pain related to that transition. I think we’re seeing some of that early this year. I don’t have a problem with that. I’m comfortable with that. I think the other thing is to see the growth and the development of DUNN in particular and the industry as a whole because I believe that the industry is really coming into its own.

I think this is different from 2007, 2008. I think people are starting to understand the value of a core allocation to this type of strategy, and I want to see it be more accessible to all parts of the investment community, not just institutionals, but the retail clients. I’d like to see the fee compression happen so that it becomes profitable for retail as opposed to having the fees so high that people aren’t really making any money at it. So we’re going to become more mainstream. That’s what I’m looking forward to is the industry as a whole becoming more mainstream, being more accepted.

[01:07:44] Niels

Good stuff, Marty. On that note, we’re going to wrap up this fascinating conversation. Marty, thank you so much for being on the podcast and for sharing your thoughts and insights with us. We hope we can do this sometime again in the future. To all of you listening today, I hope you were able to take something from today’s conversation onto your own investment journey. If you did, please share these episodes with your friends and colleagues.

From Alan and me, thanks so much for listening. We look forward to being back with you on the next episode of Top Traders Unplugged as we continue our deep dive into the CTA industry. In the meantime, go check out the show notes of this episode and all the other resources you can find on our website, and not least, take care of yourself and take care of each other.

[01:08:27] Ending

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